Preference shares or preferred stocks are company stocks which extend dividends to its shareholders. Though such shares extend a fixed dividend, they do not come with any voting rights.
Notably, a company often issues different types of preference shares which are distinct in their features and associated benefits.
What are Preference Shares?
Preference shares or preferred stocks come with a preferential right when it comes to the distribution of dividends or during the liquidation of a company. It means, in both situations, preference shareholders are given more priority than other shareholders.
Typically, preference shares are released to raise capital for the company, which in turn is known as preference share capital. It must be noted that preferred stockholders are partial owners of a company, but unlike common shares, preferred shares do not come with any voting rights.
However, shareholders’ opinions may be taken into consideration during dissolution or altering the functions of an existing venture. Notably, the decision to announce dividends on preference shares lies entirely on the company’s management.
Experienced investors and those who wish to stay invested in the market for a long time, find this share suitable. The fact that preference shares generate substantial earnings makes it a viable option for risk-takers.
Based on differences in their structure, type of dividend pay-outs, maturity period and shareholder’s participation, preference can be classified into different types.
Types of Preference shares
This list below highlights some of the most prominent types of preference shares.
1. Cumulative preference shares
These shares come with a provision that entitles shareholders to receive dividends in arrears. So, when a company does not make enough profits in a year to pay dividends, they pay cumulative dividends in the following year.
Suppose a company Star Labs Private Limited issues cumulative preference shares for Rs. 1000 each and promises to pay 10% as dividend annually. Ideally, in a good economy, shareholders would earn Rs. 100 on their investment. However, owing to low returns, the company could only pay Rs. 50 as a dividend that year. Subsequently, in the next year with the worsening condition, the company could not pay the dividend of Rs. 100. Once profits were generated, the company decided to pay off the current dividend along with the outstanding dividend of Rs. 150 to shareholders. So cumulatively, the company paid Rs. 250 as dividend to shareholders.
2. Non-cumulative preference shares
These shares do not accumulate dividends. It is mostly because non-cumulative preference shareholders are paid from the current year’s net profits. So, if a company is met with loss in a particular year, the outstanding dividends cannot be claimed by shareholders from future profits.
3. Redeemable preference shares
These preference shares are also known as callable preferred stock and serve as one of the most effective ways to finance big companies. These shares come with a blend of equity and debt financing and are readily traded on stock exchanges.
Typically, a company has the right to repurchase the shares it had issued to satiate its own purpose. Consequently, the redeemable preference shares are repurchased at a fixed rate on a fixed date or by announcing the same in advance. Notably, redeemable preference shares come in handy for cushioning the impact of inflation and the decline of monetary rate.
4. Irredeemable preference shares
This particular share cannot be redeemed or repaid during the active lifetime of a company. To elaborate, shareholders will have to wait until the company decides to wind up its current operations or liquidate the venture altogether to initiate the same. It makes the shares a perpetual liability for the company.
5. Participating preference shares
The said shares extend the right to partake in surplus profit during liquidation once the company in question has paid its other shareholders. So, to elaborate, the participating preference shareholders receive a fixed rate of dividend and also have a share in the company’s extra earnings. Most individuals invest in participating preference shares of those companies which are more likely to generate robust profits.
An agreement pertaining to this preference share may include these following features –
- When the company generates profit, a certain share of profits along with the pre-fixed dividend will be paid to the participating preference shareholders.
- In the event of the company winding up, shareholders will be entitled to receive a certain share of the net sale generated.
- Participating preference shareholders may have voting rights or authority over certain decisions pertaining to the sale of the business venture or crucial assets.
- The shares may be cumulative, which means shareholders will receive the unpaid dividends before it is paid to the equity stockholders.
6. Non-participating preference shares
As the name suggests, non-participating preference shareholders do not have a share in the extra earnings or surplus assets during the liquidation of a company. This type of share entitles its shareholders to receive only the pre-fixed dividends.
7. Convertible preference shares
Convertible shares are fundamentally those shares which enable holders to get them converted into equity shares at a fixed rate. Notably, these shares can only be converted after the expiry of a specified time and within a given period, as stated in the memorandum.
Ideally, these shares are considered to be beneficial for those investors who intend to receive preferred share dividends. It also proves rewarding for those who wish to partake in the change in the price of equity shares. Thus, such shares help investors generate fixed earnings along with the opportunity to accrue higher returns frequently.
8. Non-convertible preference shares
Non-convertible shareholders cannot convert their shares into equity shares. Regardless, they enjoy the preferential benefit when it comes to accruing dividends or during company’s dissolution.
9. Adjustable-rate preference shares
The rate of dividend paid on this share is floating in nature and is heavily dependent on the prevailing market rates. It directly influences the amount of dividend received by the shareholders throughout the investment.
The table below shows the classification of preference shares in a nutshell.
|Types of Preference Shares||Description|
|Convertible||These shares can be readily converted into equity shares.|
|Non-convertible||Though these types of preference shares cannot be converted into common stock, they are still prioritised over them.|
|Redeemable||Typically, these shares come with a maturity date. On maturity, the company repurchases its shares from the investors at a fixed rate and ceases their dividend.|
|Non-redeemable||These shares cannot be redeemed in the lifetime of the company. Notably, they come with a fixed rate of dividend.|
|Participating||Besides extending dividends, participating preference shareholders are also entitled to surplus profits of the company.|
|Non-participating||These shares do not entitle shareholders to any surplus profit but offer them the promised dividends.|
|Cumulative||In the event of loss, a company is liable to pay the shareholders’ outstanding dividends.|
|Non-cumulative||The non-cumulative shareholders are not entitled to receive dividends in arrears.|
|Adjustable||In case of this share, the rate of dividend is not fixed and gets influenced by prevailing market rates.|
Difference Between Equity Shares and Preference Shares
Some of the features of the various types of preference shares are similar to equity shares in general; they are two distinct entities. This table highlights the basic differences between equity shares and preference shares.
|Parameter||Preference Share||Equity Share|
|Definition||It offers preferential rights in terms of receiving dividend or capital amount.||It represents shareholders’ ownership in a company.|
|Rate of dividend||Dividend payout’s rate is fixed.||Dividend payout’s rate fluctuates with more earnings.|
|Dividend payout||Preferred stockholders are given more priority over common stockholders during dividend payment.||Shareholders avail dividend only after other liabilities have been paid.|
|Bonus shares||Shareholders may receive bonus shares against current shareholdings.||Shareholders may receive bonus shares against their shareholdings.|
|Capital repayment||Capital repayment is made before equity shares.||Capital is repaid at the end.|
|Voting rights||Shareholders do not enjoy voting rights.||Shareholders avail voting rights.|
|Participation in management||Shares do not come with management rights.||Equity share allows shareholders to partake in company management.|
|Convertibility||Preferred stocks can be converted.||Equity stocks cannot be converted.|
|Arrears of dividend||Shareholders may receive a cumulative dividend.||Shareholders are not entitled to avail cumulative dividends.|
|Types||Preference shares and its types include, convertible, non-convertible, participatory, non-participatory, cumulative, non-cumulative, etc.||They are simply classified as ordinary or common stock of a company.|
|Issuance||It is not mandatory to issue preference shares.||Companies must issue equity shares.|
|Suitability||It is considered suitable for investors with low risk-taking capacity.||It is considered for investors who can take risks.|
The differences between the two indicate that preferred stocks have some advantage over equity shares. Based on the features and benefits of the different types of preference shares, individuals should decide their ideal investment avenue. Also, they need to factor in their risk-taking capability and understanding of the market to make the most of the preferred stocks.