Preference shares are a long term source of finance for a company. They have elements of both Equity shares and Debts.
Preference shares are those shares of a company with dividends that are paid out first to their shareholders before dividends on equity shares are issued. In other words, these are shares which are preferred over equity shares in payment of surplus or dividend.
The preference shareholders have a preferential right to receive dividend at a fixed rate before any dividend is paid on equity shares. Also, in case of winding up ore liquidation of a company, preference shares have a right to return on capital before that of equity shares but after bondholders and creditors. Preference shares also carry some more rights such as right to participate in excess profits after dividend has been paid to equity shareholders.
Preference Shares vs Equity Shares
Dividend: Preference shares enjoy dividend at a fixed rate while for equity shares, the dividend payout may vary depending on the profits of the company. The dividend payout to equity shares may be higher or lower than that paid on preference shares as the rate of dividend is not fixed for equity shares. It all depends on the profits or losses that the company incurs.
Liquidity: Preference shares are not liquid shares as they are not traded on stock exchanges. Equity shares, however, are highly liquid.
Preferential rights: Preference shares enjoy preferential rights to receive dividends before it is paid to equity shareholders. Equity shareholders receive dividends only after preference shareholders are paid their dividend.
Upon winding up/ Liquidation: Preference shares carry a right to return on capital before equity shares, giving more safety to a preference shareholder. Equity shareholders will be paid only after preference share capital is fully paid.
Voting rights: Preference shares carry no voting rights in the general body meetings of the company. Equity shares carry voting rights in company meetings.
Participation in management: Preference shares carry no right to participate in the management of the company while equity shares entitle their holders to the right to participate in the management of the company.
Types of Preference Shares
There are various types of preference shares based on their structure, maturity terms, nature of dividend payments, etc. Some of the common types of preference shares are as follows:
Cumulative and Non- Cumulative Preference Shares– Cumulative preference shareholders will not lose anything even at the time of inadequate profit of the company. The dividend arrears will get accumulated and be paid to them in the future. However, in the case of non- cumulative preference shares, the company can skip the dividend in any year where it has incurred losses.
Convertible and Non- Convertible Preference Shares– Convertible preference shares posses an option or right whereby they can be converted into ordinary equity shares at a future date on the fulfillment of some agreed terms and conditions. Non- convertible preference shares do not have the option to convert into equity shares but possess all other characteristics of a preference share.
Redeemable and Irredeemable Preference Shares– Redeemable preference share carries a maturity date on which date the company will repay the capital to the preference shareholder. Dividend payment thereon on those shares will be discontinued. Irredeemable preference shares do not carry any maturity date. However, like any other preference share, they enjoy priority in payment of both dividend and capital over the equity shares. Since there is an absence of maturity date, they are also known as perpetual preference share capital.
Participating and Non- Participating Preference Shares– Participating preference shares have an additional benefit of participating in profits of the company apart from the fixed dividend. Of course, the agreement will carry terms and conditions to this and may vary from case to case. Non- Participating preference shares do not carry any additional benefit of participating in profits of the company after the dividend payout.
Preference shares are offered as part of the share capital. The dividend income on these shares is tax free in the hands of the investors. However, the company has to pay a dividend distribution tax. Before investing on preference shares, one should look at the company’s past profitability and dividend payouts and how the company plans to use the funds from the issue. My next post will carry further information on the next important instrument of the stock market, i.e, Bonds.