Accounting for Preferred Stock Redemption Rights

When an investor decides to purchase preferred stock shares, they are commonly given access to a set of privileges unavailable to buyers of standard shares. Redemption rights, or the opportunity to request that a company repurchase shares from the investor in exchange for cash, are one such "perk" of preferred shares. The process of exercising redemption rights does not always result in the return of shares for actual money. That being said, it is important for all preferred shareholders to understand exactly how this process works so that they can be prepared in the event that preferred share redemption is their best course of action.

Exploring Redemption Rights

It is not uncommon for investors to use the terms "share redemption" and "share repurchase" interchangeably. That being said, these two processes are distinct from one another and carry very different financial implications for shareholders.

When individuals purchase preferred shares, they will be given information regarding the specific "call price" at which the shares may be redeemed by the company. So, for example, if an individual purchases preferred shares that carry a call price of $40, they would effectively be entitled to a cash sum equivalent to the number of shares they own multiplied by $40 in the event that redemption occurred.

In the event that a company is hoping to begin limiting the number of shares available on the marketplace, a redemption could be advantageous. However, it is critical to take into account the current market value of the shares in order to determine whether or not a redemption is even likely. When a redemption is initiated, it is important to note that investors are required to return their preferred shares to the company.

Share Repurchase Vs. Share Redemption

Although both repurchasing shares and initiating a share redemption involve the re-acquisition of shares by a company, the method by which these shares are valued is important to consider. Unlike a share redemption, a share repurchase can be initiated without having to respect the inherent call price of the stocks. This does not mean that preferred shareholders will be required to accept a lower price than the call price they were promised at the time of the purchase. Unlike a share redemption, a share repurchase is a voluntary process and is open to all shareholders.

One of the many explanations as to why a share repurchase would be implemented could be the fact that a company believes that their long-term growth will raise the value of their shares far beyond their current price point. With that idea in mind, choosing to repurchase shares near their current value could represent a "discount" relative to the predicted price point they will eventually reach. Of course, these strategies are only effective in the event that the value of the shares does actually increase. If it does not, this could prove to be devastating for the company in question, particularly if they repurchased a large volume of their own shares.

Share Repurchase and Price Points

It is important to note here that a share repurchase, unlike a share redemption, does not automatically apply to all shareholders in the marketplace. A company can choose to repurchase as few or as many of their own shares as they deem necessary, and investors can decide on their own terms whether or not they want to take part. Typically, the repurchase offer will be communicated to investors detailing exactly how many shares the company is looking to repurchase. At this point, the designated price point at which the company chooses to buy the shares may or may not be communicated to investors.

It is also common practice for businesses to request those interested in the repurchase to set their own sale price. This tactic allows business owners to select from the lowest possible sale price in order to reacquire their shares. A business can also choose to issue their offer price, which may be preferred in situations where they are attempting to complete the repurchase at a faster rate.

Redeemable Preferred Stock Balance Sheets

When an investor makes the decision to purchase preferred stock, the value of their purchase is recorded as part of the company's "paid-in" capital amount. The "par value" of the share, or its current value, is also recorded by the company at the time of purchase. The par value of the share does not carry implications beyond acting as an accounting tool. For example, if an investor chooses to purchase the same preferred shares within the secondary market, they can do at a price that exceeds the par value documented by the company.

The reason that this type of accounting is required is primarily due to the fact that preferred shareholders are guaranteed dividends on the shares they own. In order to calculate the size of the dividend that must be paid out to an investor, the company's team of accountants will consult their own record of preferred share purchase history. Without this information, it would be virtually impossible to accurately assess the current amount of dividends due.

By gaining an accurate understanding of current dividend obligations, business leaders will also be able to assess whether or not a dividend distribution to common stockholders is also a possibility. Additionally, this information provides valuable insight into cash outflows, which can strongly influence the decision to initiate a repurchase or redemption as needed.

The Preferred Stock Redemption Process

While redemption rights are certainly a "perk" for preferred shareholders, they are not considered a ubiquitous element of modern preferred stock. In fact, only a small minority of preferred stocks will include this particular privilege. If redemption rights are granted, however, the shareholder maintains a powerful tool that can be used to hedge against market uncertainty and financial loss as needed.

Business owners can implement a variety of terms into the redemption rights in order to protect themselves against a degree of risk. For example, it is not uncommon for redemption rights to include a provision stating that the shares cannot be redeemed for at least five years after closing. This will help ensure that redemption rights do not become a source of fiscal volatility. Without such a provision, a shareholder could implement the redemption call at any arbitrary point, a decision which could wreak havoc on the financial stability of any company.

Generally speaking, casual investors will likely not have the leverage needed to persuade a company to incorporate redemption rights into their preferred shares. That being said, institutional investors wielding significant sums of money will likely have a much better form of leverage in order to ensure that these protections are included in the shares themselves.