Preferred stock is a class of stock in a company that often gains priority over common shares, but are not yet actual shareholders of the company. Preferred stock is often used in private financing rounds, can offer interest or dividend payments and can ultimately convert to common stock per the terms of the preferred share class. Companies wishing to issue preferred stock to investors to raise capital, must first take many factors into consideration when assigning price each preferred share.
Valuation of the Business
The primary factor that needs to be calculated in any form of capital raising activity, including preferred stock issuance, is the valuation of the business. The valuation assigned to the company depends on the company's earnings, book value, fixed assets, intellectual property, peer company performance and previous valuations assigned at various fund raising stages. Once the valuation of the business is agreed upon by the company and the investors, a price per share for the outstanding shares of common stock can be identified.
Amount of Capital to be Raised
Since issuing preferred stock is a mechanism to raise capital for the company, the desired amount of funds that the company is seeking to raise must be considered. Part of pricing the preferred shares depends on the company's current valuation and how much capital needs to be raised with this offering of preferred shares. For instance, the price of the preferred shares will vary greatly for a company worth $100 million and seeking to raise $10 million versus $50 million.
Preferred Share Structure and Privileges
Preferred shares can be structured in a myriad of ways. The investors and the company need to agree on items such as voting rights of preferred shares versus common shares. Some preferred shares earn interest and pay out periodically or accrue and are not paid until the preferred shares expire. Preferred shares typically have a conversion factor that specifies the number of common stock shares the holder receives upon conversion. The price of a preferred share depends on all of these factors.
Interest Rate
Most preferred shares have an interest rate or set dividend payout attached to them. In some cases, dividends must be paid on preferred shares before they are paid on common shares. Preferred shares can also be structured as loans paying or accruing interest at an agreed upon rate. This rate, which can be zero percent or any rate drives the pricing of the preferred shares. Preferred shares that offer higher interest payments tend to carry a higher price than preferred shares that pay no dividends or interest.
Expected Return of the Investors
Investors demand higher potential returns for taking on higher levels of risk in an investment. If the company is a start-up venture or is having financial difficulty, investors expect to receive a higher rate of return on their investment at some point in time. Generally speaking, companies that are at higher risk of failure tend to price their preferred shares lower versus companies that are more financially stable.
