Is payback of preferred stock interest/investment deferred or non-deferred?

February 03, 2023

by a searcher from Cornell University - SC Johnson College of Business in Salt Lake City, UT, USA

When offering preferred stock to investors as a self-funded searcher, which of the following is the most common?

1) Defer preferred stock interest payments and investment payback until sale of company
2) Pay back as cash becomes available
3) Pay just the interest as cash becomes available and defer paying back the investment portion until the company is sold

Also, in any of these cases, if the interest and investment are paid back, does the stock usually convert to common at that time? Are future dividends then split according to common equity %?

Looking for some examples of this or for lawyers who have created term sheets for self-funded search investors. Thank you.

Reply by a professional
from Dartmouth College in Los Angeles, CA, USA

Lots of different variations, but the way to think about it is that the preferred has priority on distributions, typically for their investment amount and the preferred return. So the first money out goes to them (to the extent money is distributed). Sometimes the Class B or common can participate along the way, provided that on sale or liquidation the preferred has to receive their capital and return first. Also, sometimes after the preferred is paid back there is a "catch-up" for the searcher or operator, which basically means if there's excess distribution they get to participate as if they were receiving their % from dollar 1. And otherwise the preferred and common split pro rata, though there's not necessarily a conversion for the preferred. Not legal advice and this is a rough sketch, but should give you an idea. Can discuss more if you like.

Reply by a searcher
from University of Pennsylvania in Dubai - United Arab Emirates

There are many ways to structure this but i would suggest you keep the following points in mind. As stated previously the Preferred dividends have priority on payout. if your cashflows allow It is to your benefit to pay rather than accumulate these dividends to avoid compounding . The same applies to the principal which will act as debt on exit as far as the common equity is concerned. Once converted to common, assuming it is not extinguished, the sharing is as per common equity split.

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