Preference Shares Features: Know about the types and benefits

12 May 2020  Read 4622 Views

Preference shares as the name suggest infers a preferential treatment. They enjoy preferential rights to claim dividends during the lifetime of the company and to claim repayment of capital on wind up. The percentage of dividend is fixed and receives the dividend payout before it is paid to other classes of shareholders.Preference shares are one important source of hybrid financing because it has some features of equity shares and some features of debentures. These shareholders enjoy preferential rights as regards to receiving dividends and repayment of capital in case the company winds-up.

Features of preference shares:

Preference shares have a wide range of features as corporate emphasize a set of features while issuing them such as:

  • Dividends for preference shareholders

  • Preference shareholders have no right to vote in the annual general meeting of a company

  • These are a long-term source of finance

  • Dividend payable is generally higher than debenture interest

  • Right on assets when the company is liquidated

  • Par value of preference shares

  • Fixed-rate of dividend irrespective of the volume of profit gained

  • Preemptive right of preference shareholders

  • Hybrid security of preference shares because it also bears some characteristics of debentures

  • The dividend is not tax-deductible expenditure

  • Shareholders also enjoy preferential right to receive a dividend

Types of preference shares

There are various types of preference shares according to the clause contained in the agreement at the time of issue, some important kinds are listed below:

  • Cumulative Preference Shares: These shares include a provision that requires the company to pay all the dividends, including those that have been outstanding in the past, before the equity shareholders can receive their dividend payments. These dividend payments are guaranteed but not always paid out when they are due. Unpaid dividends are assigned the moniker "dividends in arrears" and must legally go to the current owner of the stock at the time of payment. At times additional compensation by way of interest on the outstanding dividends is awarded to the holder of this type of preferred stock.

  • Non-cumulative Preference Shares: Non-cumulative preferred stock does not issue any unpaid dividends. If the company has not paid dividends in any given year, the shareholders have no right or power to claim such forgone dividends any time in the future.

  • Participating Preference Shares: Participating preference share is where the issuing company is entitled to pay an increased dividend to the owners, in addition to preference dividends at a fixed rate. Such shareholders may also have the right to share the surplus asset of the company when it’s winding up.

  • Non-participating Preference Shares: Preference shares having no right to participate in the surplus profits or any surplus on liquidation of the company are referred to as non-participating preference shares. Here, preference shareholders receive only stated dividends and nothing more.

  • Convertible Preference Shares: Convertible preference shares are the type of preference shares where the holder has the option to convert into the common/equity share of the company. This kind of preference share is useful for the investors who want to receive a preferred share dividend and also participate in any kind of upward change in the price of the issuer’s common shares. So, an investor has the benefit and security of a fixed return along with a chance to earn a higher return on his/her investment. But the convertible preference shareholders can convert into common shares within a certain period as agreed in the memorandum.

  • Non-convertible Preference Shares: The shares that cannot be converted to equity are referred to as non-convertible shares. These can also be redeemed.

  • Redeemable Preference Shares: Redeemable preference shares are referred to as shares that can be redeemed or repaid after the fixed period as issued by the company or even before that. A redeemable preference share is good for the company. These act as a hedge against future inflation and when the monetary rate declines in the country.

  • Non-Redeemable Preference Shares: Not redeemable preference shares are referred to as shares that cannot be redeemed during the lifetime of the company. As per the Companies Amendment Act, 1988, no company can issue any preference share which is irredeemable or redeemable after 20 years from the date of the issue.

  • Adjustable-Rate Preference Shares: For adjustable-rate preference shareholders, the rate of dividend is not fixed and depends on current interest rates in the market.

Benefits of Preference Shares

1. Dividends are paid first to preference shareholders

The primary advantage for shareholders is that the preference shares have a fixed dividend. This payout is typically done before any dividends being paid to the equity shareholders. The preferred shareholders get priority when it comes to remitting unpaid dividends, over common shareholders.

2. Preference shareholders have a prior claim on business assets

In the event of liquidation of the business, preference shareholders can stake a higher claim on the assets of the business. This makes the risk of investment tolerable as opposed to equity. If the business does opt to shut down its operations, the preferred shareholders will be adequately compensated for their investments.

3. Add-on Benefits for Investors

With preference shares, shareholders are allowed to trade in their convertible shares for a pre-decided number of equity shares. If the company can meet a specified profit mark that was determined earlier, then the shareholder has the opportunity to experience add-on dividends. This can be an advantageous prospect, especially if the value of common shares starts increasing. To generate long-term income, this particular segment of preference shares are low risk and offer additional benefits as a type of investment instrument.

Drawbacks of Preference Shares

1. There are no voting rights for preference investors

The key disadvantage of owning preferred shares is the absence of ownership rights in the business. From an investor perspective, the business is not liable to preferred shareholders as opposed to equity shareholders. If the business turns a profit and the interest rate increases, the preferred shareholders will be stuck on the fixed dividend.

2. Higher cost than debt for issuing company

To finance projects, businesses will try to raise capital through debt and equity issues which are costs that are associated with operations. Large corporations issue preferred stock to the public in addition to raising funds through the equities and corporate bonds. Businesses that choose equity in place of debt issues can attain a lower debt to equity ratio. This offers them a significant benefit in terms of leveraging for additional financing from new investors.

Key takeaways: 

  • Preferred shares are an asset class somewhere between common stocks and bonds, so they can offer companies and their investors the best of both worlds.

  • Companies can get more funding with preferred shares because some investors want more consistent dividends and stronger bankruptcy protections than common shares offer.

  • Some companies like to issue preferred shares because they keep the debt-to-equity ratio lower than issuing bonds and give less control to outsiders than common stocks.

Significance to Investors

Preference shares are an optimal alternative for risk-averse equity investors. They are typically less volatile than common shares and offer investors a steadier flow of dividends. Also, preference shares are usually callable; the issuer of the shares can redeem them at any time, providing investors with more options than common shares.

Most shareholders are attracted to preferred stocks because they offer more consistent dividends than common shares and higher payments than bonds. However, these dividend payments can be deferred by the company if it falls into a period of tight cash flow or other financial hardship. This feature of preferred stock offers maximum flexibility to the company without the fear of missing a debt payment. When it comes to bonds, a missed payment puts the company at risk of defaulting. Resulting in a credit downgrade.

Why Corporations Supply Preference Shares

Companies that offer preferred shares instead of issuing bonds can achieve a lower debt-equity ratio. That allows them to gain significantly more future financing from new investors. A company's debt-to-equity ratio is one of the most common metrics used to analyze the financial stability of a business. The lower this number is, the more attractive the company looks to investors. Additionally, bond issues can be a red flag for potential buyers. The strict schedule of repayments for debt obligations must be maintained, regardless of the company's financial circumstances. Preferred stocks do not follow the same guidelines of debt repayment because they are equity issues.

Finally, some preference shares act as "poison pills" in the event of a hostile takeover. They often take the form of a detrimental financial adjustment with the stock that can only be exercised when controlling interest changes.

Quality Check

Before investing in preference shares one should look at the company's past profitability and dividend payouts and how it plans to use the funds from the issue. The credit rating of the company is very important. It will help you understand what kind of company you are investing in and whether it will grow in size and popularity.

About the Author: Bernadine | 33 Post(s)

An MBA Finance graduate, having worked in the Telecom and Banking sector as a Risk and Compliance Manager. An avid blogger with a penchant for traveling

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