Advantages of Preferred Stock & Subordinated Debt

Deal consideration can come in almost unlimited forms with an even larger list of various structures and options. Understanding the various options available and how such options impact both buyers and sellers is an important component in completing a deal. One area where this is readily apparent is when it comes to choosing between subordinated debt and preferred stock.

There are various scenarios where a buyer or seller may enter into an arrangement that includes one, the other, both or some eventual conversion between the two. Here are some general considerations in determining a proper fit.

Benefits of Preferred Stock

Preferred stock occupies a unique position in a company’s capital structure — senior to common equity but generally subordinate to all debt. For buyers who face covenant restrictions from senior lenders, issuing preferred stock can be an elegant way to bring in additional capital without triggering debt-incurrence tests. Key benefits include:

1. Increases the equity line on the balance sheet. Because preferred stock is classified as equity — not debt — it bolsters the equity section and can improve leverage ratios that senior lenders monitor.
2. Protects companies with high debt-to-equity ratios from going insolvent. When a company’s debt load approaches covenant thresholds, substituting incremental debt with preferred equity can provide critical headroom.
3. Makes the company more attractive to senior lenders, including those issuing junk bonds. A cleaner leverage profile often unlocks more favorable terms on senior tranches, which can reduce the all-in cost of capital.

Avoiding insolvency is perhaps one of the biggest benefits of issuing preferred stock. Because an insolvent company cannot transfer or divest property or assets without being paid full consideration, remaining solvent by using preferred stock can be extremely helpful. If assets are transferred when a company is insolvent, an illegal act has typically been committed as the creditors have been defrauded.

Why Sellers Often Prefer Subordinated Debt

Typically a seller will prefer subordinated debt over preferred equity as consideration for a sale. There are a number of reasons for this. First, payments on subordinated debt are due whether or not the company has positive earnings (unless some subordinated provisions for some reason state otherwise). Second, a seller’s note could be worth more than preferred stock to the seller if he or she intends to sell it back to the company. Third, some seller notes may hold security interests to the company that — while junior to senior debt — are still one step in front of any stockholders in the event of insolvency.

Similarly, subordinated debt through a note or other instrument has the following key benefits:

1. Interest payments are tax deductible whereas dividend payments from preferred stock are not.
2. Debt can allow the buyer to elect pass-through status with an S-corp as long as there is not some reclassification provision that requires the note or debt to be converted to equity. Unlike debt, preferred stock carries some tax disadvantages as well.

Sellers should not have any problem accepting a subordinated note over preferred stock. The hurdle is usually not convincing the seller — it is usually in convincing the other senior and junk bond lenders to allow the company to incur more debt as a seller’s note. If, for some reason, the other lenders reject a subordinated note over preferred stock, the buyer may be able to structure a deal with convertible, preferred stock that converts to a note once the company achieves a specific cash flow level or net worth.

Furthermore, the buyer may be able to convince the seller to convert the preferred stock to a note after some time has lapsed and some of the other more senior lenders have been paid down a bit. Readers exploring this dynamic in more depth may find our overview of senior debt structure and hierarchy a useful companion.

Convertible Structures: Bridging the Gap

When buyers and sellers cannot agree on whether to use preferred equity or subordinated debt outright, a convertible instrument often serves as a practical compromise. A convertible preferred share — or a convertible note — starts life as one instrument and transitions to another upon a defined triggering event, such as a minimum EBITDA threshold, a refinancing, or the passage of a specified holding period.

This flexibility allows the seller to benefit from any equity upside during the conversion window while the buyer preserves debt-like economics until the business demonstrates sustained performance. Structuring these instruments requires careful attention to anti-dilution provisions, conversion ratios, and the treatment of accrued but unpaid dividends or interest — all areas where experienced capital markets advisors add significant value.

Practical Considerations When Choosing a Structure

Deciding on the right structure for your purchase or sale will require a detailed look at the current capital stack, the future expected earnings, tax considerations, and the personal desires of both buyers and sellers. There is no one-size-fits-all approach. A few additional factors practitioners commonly weigh:

• Lender consent rights. Most senior credit agreements include negative covenants restricting the incurrence of additional debt. Review intercreditor terms before assuming a seller’s note is permissible.
• Dividend recapture risk. In certain jurisdictions, dividends paid on preferred stock within a look-back window prior to insolvency can be clawed back. Subordinated debt interest, by contrast, is generally treated as an ordinary business expense.
• Voting and control provisions. Preferred stockholders sometimes receive voting rights upon a dividend arrearage, which can complicate future governance. Subordinated debt holders typically have no such path to the boardroom.
• Tax basis step-up eligibility. In asset deals, the distinction between debt and equity can affect each party’s ability to step up tax basis in the acquired assets — a nuance worth exploring with qualified tax counsel alongside a review of potential tax advantages when selling a business.

For sellers evaluating how this instrument choice interacts with the overall deal structure, a review of how stock as consideration in M&A transactions functions in practice can provide useful framing. Those weighing the relative merits of different security types may also benefit from a closer look at the risks outlined in our discussion of stock deal disadvantages.

If you are preparing for a transaction and want to work through the right capital structure for your deal, start the process here to connect with an advisor who can help evaluate your specific situation.

Frequently Asked Questions

What is the primary difference between preferred stock and subordinated debt in an M&A transaction?

Preferred stock is an equity instrument that sits above common equity but below all debt in the capital stack, while subordinated debt is a loan obligation that ranks above equity but below senior debt. The key practical distinctions are tax treatment (interest on subordinated debt is deductible; preferred dividends are not), payment priority in insolvency, and how each instrument appears on the balance sheet.

Why do sellers generally prefer a subordinated note to preferred stock?

A subordinated note provides the seller with a contractual right to periodic interest payments regardless of company earnings, a potential security interest in company assets (even if junior to senior debt), and the ability to sell or transfer the note. Preferred stock, while senior to common equity, offers dividends only when declared and provides no payment certainty in the way debt does.

Can a buyer use both preferred stock and subordinated debt in the same deal?

Yes. Layered capital structures that combine senior debt, subordinated debt, and preferred equity are common in leveraged buyouts and growth recapitalizations. The relative sizing and terms of each tranche depend on the target’s cash flow profile, existing lender covenants, and the negotiated economics between buyer and seller.

What triggers a conversion from preferred stock to subordinated debt?

Conversion triggers are negotiated contractually and vary widely. Common examples include the achievement of a minimum EBITDA or revenue threshold, the completion of a refinancing event, the passage of a set time period (such as three or five years), or a change of control. The specific trigger and conversion ratio should be clearly defined in the purchase agreement or instrument documentation to avoid disputes.