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Warren Buffett: The Rationale for Issuing Preferred Stock

·2 mins read

- By Stepan Lavrouk

Running a big corporation is about much more than just management - it requires an excellent knowledge of corporate governance, tax law and the ways in which that company can be structured. Berkshire Hathaway's (NYSE:BRK.A)(NYSE:BRK.B) Warren Buffett (Trades, Portfolio) is an expert on all of these things, and - luckily for aspiring investors - he has on many occasions shared his knowledge on these matters.

During the 1995 annual Berkshire Hathaway shareholder meeting, Buffett explained why a business might want to issue preferred stock, using his own company as an example.

It doesn't really matter what mechanism you use to buy a business

Buffett was explaining to shareholders why he wanted to pass an amendment to Berkshire's certificate of incorporation that would authorize him to issue preferred shares:

"When we acquire businesses, sometimes the seller wants cash, sometimes they would like common stock. And it's certainly possible, as one potential seller did last year, that they would want a convertible preferred stock...We don't care what form of consideration we use, because we equate the value of cash, versus a straight preferred, versus a convertible preferred, versus common stock, whatever it may be. So, if the worry is that we will do something dumb in issuing the preferred stock, you should - that's a perfectly valid worry. But you should worry just as much we'll do something dumb in terms of using cash or common stock."

The guru didn't even have any solid commitments to issue preferred stock - he just wanted the freedom to do so if need be. Of course, there are a number of considerations that need to be take into account when issuing preferred stock - there is a fee for issuance that scales with the number of shares issued. Furthermore, preferred stock deals often allow the transaction to be carried out with a lower tax cost. Another benefit of using stock (of any kind) is that a company can theoretically issue as much of it as it wants - although, of course, in practice, issuing more will dilute the value of the existing shares outstanding.

The important thing to take away from this is that it really doesn't matter how an acquisition is carried out, so long as the acquiring company accurately calculates the value of the shares that it is allocating to the seller, and Buffett is certainly good at doing that.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.