If you took a guess as to what preference shares mean, you’d probably be right. It’s one of those self-explanatory names, but the devil is in the detail. So let’s get right to it.
What are preference shares?
Preference shares are a type of share where shareholders are given preferential treatment during the payment of dividends. These shareholders are given priority or a greater claim over others. They are also entitled to a fixed dividend rate.
That said, although the dividend rate is fixed while issuing these shares, they may not always receive that sum if the balance sheet shows a loss. Whether they receive it or not depends on the specific type of preference share.
What are the types of preference shares?
Not all preference shares work in the same way. There are some differences that you should know about if you are considering investing in this type of share.
1. Cumulative shares
The shareholders of these shares have the right to a cumulative dividend payout even when the company is in loss. Meanwhile, ordinary shareholders will receive a dividend. The company may, however, pay these cumulative dividend amounts in the future when it does make a profit.
The shareholders first receive arrears. The rest comes to them only after ordinary shareholders receive their due for that year.
2. Noncumulative shares
Preference shares where the company does not carry over unpaid dividends to future financial years are called non-cumulative shares. The holders of such shares will have priority over dividend payouts only for the current year.
3. Redeemable shares
Redeemable preference shares are shares the issuing company can redeem after a specified period. Alternatively, the company may also give advance notice to the shareholders to redeem the shares.
4. Irredeemable shares
These are preference shares that do not come with a clause allowing the issuer to redeem shares. Companies can only redeem such shares at the time of liquidation. Since these are preference shares, when the company is shutting down, these shareholders are prioritized over those who hold ordinary shares.
5. Convertible shares
These preference shares contain specific clauses that allow the shareholders to convert them into ordinary shares at a future date or when a specified event—like an IPO—occurs.
6. Nonconvertible shares
Non-convertible shares are yet another type of preference share. These shares cannot be converted into ordinary shares. They ensure that the shareholders remain entitled to preferential treatment during a dividend payout or liquidation.
7. Participating shares
These are preference shares that entitle the holder to a specified fixed rate of dividend every year, along with the extra advantage. In addition, these shareholders receive an additional profit share called a participating dividend.
8. Non-participating shares
The shareholders of this type of share do not have the advantage of participating in dividends. They will be entitled only to the predetermined fixed rate of dividend.
Features of preference shares
Preference shares come with the following features. It will help to keep them in mind if you are considering purchasing them.
Preference in dividends
These shares offer preferential treatment when the profits of the company are distributed. The specific nature of this preferential treatment varies from company to company. The differences depend on the type of preferential share they are offering.
No voting rights
Ordinary shareholders have voting rights in relation to the running of the company and certain matters. Preference shareholders, however, do not have these rights.
Right to claim the assets
Preference shareholders have the first right over company assets during liquidation. Only after their claims are sorted do ordinary shareholders get the remaining assets.
Advantages of preference shares
This type of shares come with a host of benefits for the shareholders as well as the company. Below, we divide the advantages according to the beneficiary for the sake of clarity.
For the shareholder
1. Shareholders get priority during dividend payouts or if the company shuts shop. They have the first claim over the assets of the company.
2. Preference shares assure the shareholder of a fixed return as a dividend.
For the company
1. By issuing preference shares, the total of the management’s shareholding is not diluted. On the contrary, when equity shares are issued, the original management loses some of its holds.
2. The cost of these shares tends to be lower than ordinary shares.
Disadvantages of preference shares
1. The value of these shares can decrease when market conditions are unfavorable.
2. Since the dividend rate is fixed for these shares, when there is an overall increase in the interest rate in the market, the value of these shares tends to take a beating.
3. While these shares certainly have the edge over ordinary shares at the time of the company closure, these shareholders will have to wait till the dues to the creditors, the bondholders, and the debenture holders are settled.
Conclusion
Preference shares have the attributes of equity instruments (in sharing the profits) and debt instruments (in their capacity to earn a fixed return). So, they constitute a hybrid class of financial instruments.
Such shares do have their disadvantages. While safer than equity investments, preference shares don’t look great when the company makes a healthy profit. Because your return is fixed. Also, preference shareholders do not have voting rights. They also do not get the bonus issues that other shareholders sometimes receive.
However, they are a safe option that does not require constant monitoring. And that’s a huge plus for the risk-averse.
FAQs
What are preference shares?
These shares offer preferential treatment when dividends are paid. The shareholders are entitled to a fixed rate of dividend. These shares do not come with voting rights, but shareholders are given over others during liquidation.
What are the advantages and disadvantages of preference shares?
Such shares are advantageous because they offer preferential treatment for dividend payout. Additionally, they offer a fixed return on investment.
The disadvantages are:
– They decrease in value during unfavorable market conditions.
– They continue to earn only the fixed interest even when interest rates increase.
– During liquidation, shareholders can stake a claim on the assets only after creditors, bondholders, and debenture holders.
What are the 4 types of preference shares?
The four types of preference shares are:
1. Cumulative Preference Shares
2. Non-Cumulative Preference Shares
3. Participating Preference Shares
4. Non-Participating Preference Shares
What are the two types of preference?
Preference shares have various types, but the two primary categories are:
1. Cumulative Preference Shares: These guarantee unpaid dividends accumulate and must be paid in the future.
2. Non-Cumulative Preference Shares: Unpaid dividends do not accumulate; if not paid, they are forfeited.
