Preference shares, also known as preferred stock, are among the two types of shares that a company issues. The other type is equity shares. Whenever a company decides to pay out dividends, preference shareholders have the first right to receive them before equity shareholders. Capital raised while issuing preference shares is called preference share capital.
Whenever a company goes for liquidation or winding up, the preference shareholders have first right over the company’s assets. Companies must redeem these shares within 20 years from the date of issue as per the Companies Act, 2013. In India, companies cannot issue non-redeemable preference shares meaning that they do not have any option to buy back these shares.
Types of Preference Share
Here is a list of preference shares that a company can offer to potential investors:
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Convertible shares
According to the memorandum of association, one can easily convert these shares into equity shares at a particular price and before a specific period. Investors opt for this type of share as they can enjoy two benefits. One is a dividend offered by the company, and another is the returns one can earn in case the value of the stock appreciates.
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Non-convertible shares
These shares are never converted into equity shares. However, they retain all other benefits of preference shareholders like a fixed dividend and first right over the company’s assets in case of liquidation.
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Cumulative preference shares
Cumulative preference shares entitle shareholders to receive a cumulative dividend. There may be years in which a company is not making any profits, so it does not pay any dividends. However, all these dividends are accumulated as arrears and paid to shareholders cumulatively in the year in which the company earns profits.
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Non-cumulative preference shares
Shareholders of non-cumulative shares will receive dividend payouts only when a company earns profits. Conversely, if the company is incurring losses, shareholders will not receive any dividend, nor can they claim dividend arrears in any future profit-making year.
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Participating preference share
These shares provide unique benefits to shareholders. One is eligible for an additional dividend over and above the fixed preference dividend. The participating preference shareholders can also claim surplus profits and equity shareholders during the company’s liquidation.
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Non-participating preference share
These shareholders are not eligible to receive any additional dividend apart from the regular preference dividend. Individuals do not have any right over surplus profits on par with equity shareholders.
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Redeemable preference shares
As the name suggests, the company must redeem these shares at a predetermined price and within a specific timeframe. The price and time on which these shares may be redeemed are distinctly mentioned in the memorandum.
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Non-redeemable preference shares
Companies cannot redeem these shares during their lifetime. Companies may go for the redemption of preference shares only during liquidation or winding up.
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Preference shares with call option
Companies issuing these shares have a right to buy back these shares at a particular price. This call in only happens after a specific period. Companies mention the premium amount in case of share buy back in their prospectus.
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Adjustable preference shares
These shares come with a variable dividend rate. The Dividends depend on the prevailing market rates and hence are highly volatile.
Features of Preference Shares
The features of preference shares are as follows:
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Preferential treatment
As per their name, preference shares have certain preferential rights over other common stockholders. These shareholders will always receive dividends ahead of equity shareholders.
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No voting right
Preference shareholders do not have any voting rights. Therefore, they cannot participate in the decision-making process of the company.
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Convertibility
Some preference shares come with an option that they can be converted into equity shares. This conversion takes place at a specific price and only after a specified date. Some conversions can happen automatically after a certain time period, while others require prior approval from the board.
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Liquidation
In case of liquidation, preference shareholders have the first right over a company’s stock or assets. These shareholders have precedence over equity shareholders, and only after the company settles claims of preference shareholders can the claims of equity shareholders be entertained.
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Callability
Companies can call in or buy back these shares according to the terms mentioned in the memorandum.
Why Should One Invest in Preference Shares?
Preference shares have certain privileges that make these assets a very lucrative option. Some reasons why you may consider buying preference shares are as follows:
- First, the shareholders will receive dividends before ordinary equity shareholders.
- If the company does not earn any profits, then dividends due to these shareholders are accrued and cumulatively paid in the year it starts generating profits again.
- In liquidation, preference shareholders will have first right over the company’s assets.
- Some preference shareholders come with a conversion option into equity stocks. If the value of common stocks appreciates, you can convert your shares into equity and enjoy gains arising from them.
Risks of Preference Shares
Here are the dangers of preference shares:
- Unlike equity shareholders, the shareholders of preference shares do not have any voting rights. They do not have any ownership in the company and cannot have a say in any decision-making process.
- Preference shares come with a fixed dividend. So, if market interest rates increase, these shareholders will lose out on additional gains or interest that they may earn.
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Final Word
Preference share are a hybrid investment instrument as they exhibit both debt and equity qualities. Risk-averse investors can go for preference shares as these come with fixed dividends. However, individuals with a high-risk appetite may not prefer them.
Frequently Asked Questions
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Can a company issue preference shares at a premium?
Yes, a company can issue preference shares at a premium.
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How to buy preference shares?
One can purchase preference shares from the primary market (IPO/FPO) and the secondary market. One needs to open a Demat account with a registered broker and invest a certain amount to purchase preference shares.
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What is the difference between preference shares and bonds?
Preference shares and bonds have specific differences based on dividend payments and liquidity. Dividends in the case of preference shares are fixed but not guaranteed. However, interest on bonds has to be paid. On the other hand, these shares are more liquid than bonds.
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