Preferred shares are a type of equity security that represents ownership in a company.
Businesses can use preferred shares to raise capital by issuing them to investors in exchange for money. The investors become shareholders in the company and are entitled to fixed dividend payments and potential appreciation in the value of their shares. By issuing preferred shares, businesses can raise capital quickly without incurring debt or giving up control to outside investors.
Preferred shares can be a useful tool for businesses to raise capital, but they also come with some limitations and risks. For example, fixed dividend payments may be a burden on the company’s cash flow if it is not generating enough profits to cover them. Additionally, the terms of preferred shares, including the dividend rate and other rights and preferences, may be less favorable to the company than those of debt financing. As a result, businesses should carefully consider the trade-offs and potential consequences before issuing preferred shares to raise capital.
The opinion in Media Space, Inc. v. Commissioner, 135 T.C. 424 (2010) provides an opportunity to consider these issues and preferred shares, generally. The question of whether to issue preferred shares is one of the first things growth-oriented companies have to consider when starting their business.
Facts & Procedural History
The business this case was an advertising agency that had issued preferred stock to certain investors.
The terms of the preferred stock included a provision allowing the investors to redeem their stock on September 31, 2003. However, the agency faced financial difficulties and was unable to pay the redemption price at that time.
As a result, the agency entered into a forbearance agreement with the investors, under which the investors agreed to defer their redemption right until September 31, 2004 in exchange for forbearance payments from the agency.
The forbearance payments were calculated as interest on the redemption amount.
The dispute with the IRS was whether the forbearance payments were deductible for the business. We are not addressing the tax aspects of this case, but rather, the manner in which the taxpayer structured their preferred stock and forbearance.
What Are Preferred Shares
Preferred shares are also referred to as preferred stock. It is a class or type of stock issued by a corporation or interest in other entities that entitles the holder to certain privileges above other stockholders or interest holders.
Preferred shares or interests may bet a right to receive dividends before common shareholders and the right to receive company assets before common shareholders in the event of liquidation. Preferred shareholders may also have voting rights, but these rights are typically less extensive than those of common shareholders. Preferred shares may be issued with or without a stated maturity date. The terms of preferred stock are typically set forth in the corporation’s articles of incorporation or bylaws.
In this case, the preferred shares came with a stated redemption date and price. This is common for preferred shares issued to experienced investors who are providing short-term financing. It differs from a loan in that the investors are taking on more of the liquidation risk in the transaction. The investors tried to limit their risk by limiting the time period. This is no doubt why the company agreed to make forbearance payments in exchange for the investors extending the time–i.e., the investors extended their risk window.
Forbearance Payments
In this case, the term “forbearance payment” refers to a payment made by the business to its investors in exchange for the investors agreeing to postpone the exercise of their redemption rights. The redemption rights allowed the investors to require the business to redeem their preferred stock for a specified price. The forbearance payments were intended to be treated as interest payments by the parties as would be the case with a loan.
The court concluded that the forbearance payments were not a loan for Federal income tax purposes. This was based on a finding that there wasn’t an existing, unconditional, and legally enforceable obligation for the payment of a principal sum.
While that may be the case for Federal income taxes, it is not clear whether a court applying state law would treat the transaction and payments as a loan with interest payments. Regardless, the case provides one answer to the question of how a corporation can deal with preferred stock commitments that it cannot currently meet.
Additional remedies might include negotiating an actual payment plan or restructuring the terms of the original preferred stock obligation, seeking financing or investment from external sources, or selling assets or equity in the business in order to raise the necessary funds to pay the preferred stockholders.
The key to these options is a belief that the business will be able to turn around or meet its obligations. The solution is finding the investor or lender that has this belief. This is where turnaround experts can really help. They often have the experience and connections to put the company on its best footing in terms of presentation and third parties willing to buy in.
The Takeaway
Preferred shares are a common method that businesses use to raise capital. These types of shares typically come with certain concessions or terms that must be met by the issuing company. It is important for businesses to carefully evaluate whether they can fulfill these concessions before issuing preferred shares. If the concessions are not met or cannot be met, the business may need to consider alternative options such as forbearance payments, which involve the extension of the redemption period for the preferred shares.