A company seeking to raise capital through a private placement generally looks to either debt or equity. Each has its respective advantages and disadvantages, both to the company and to the investor. An equity investment presents the investors with the possibility of a larger upside participation, but does not does not require the repayment of capital. A debt investments provides a periodic, fixed return to investors, but can put the company at risk if the company cannot timely meet its debt repayment obligations. If your company wants the benefits of debt without the risk of default, consider a hybrid approach: preferred equity.
A Debt/Equity Hybrid
Preferred equity, such as “preferred stock” in a corporation or “preferred membership interest” in an LLC, can be structured to allow investors to receive fixed, periodic distributions (monthly or annually), in perpetuity as long as the preferred equity is owned. Preferred equity payments, as well as liquidation priority, are generally given in preference to the common interest holders. Hence the origin of the term “preferred” equity/stock.
Like equity, the investment capital need never be repaid. One of the key advantages to a company of preferred equity is that, unlike debt payments, which cannot be missed without risking default, preferred distributions may be suspended and accrued when the company is unable to pay (cumulative preferred) or omitted entirely (non-cumulative preferred).
Flexibility
Preferred equity is a flexible instrument, and a company can structure it in a myriad of ways and combinations. Preferred equity can be voting or nonvoting, redeemable at a certain price, convertible to common equity, and can have liquidation preferences, or even liquidation multiples, allowing an investor to be returned a multiple of its investment upon liquidation. Preferred equity can also be “participating,” meaning that in addition to generating a fixed periodic return, they also participate in distributions with other equity classes. Of course, used in this way, preferred equity would no longer resemble a debt instrument.
Some Cautions
For many of our clients, substituting debt for preferred equity has been an attractive option. However, companies need to remember that preferred equity financing represents a perpetual payment obligation. Unlike debt, for which obligations to investors cease upon repayment, preferred equity only terminates upon redemption of the equity. This can be mitigated by reserving for the company an option to redeem the preferred equity at a pre-determined price calculation.
Tax considerations
Another consideration is the difference in tax treatment of debt and preferred equity. Under a debt instrument, interest expense is tax deductible and the company can recoup a portion of the interest payment in tax savings. Under a preferred equity instrument, dividends and distributions are after-tax payments.
