Preference shares, more commonly referred to as preferred stock, are shares of a company’s stock with dividends paid out to shareholders before ordinary stock dividends are issued. Preference shareholders hold preferential rights over ordinary shareholders when sharing profits. Consequently, if a company lands into bankruptcy, preference shareholders are issued dividends first or have the first right to the company’s assets before ordinary stock investors.
The holders of preference shares are typically given priority when it comes to any dividends that the company pays. In exchange, preference shares often do not enjoy the same level of voting rights or upside participation as ordinary shares. Like bonds, preferred stocks are rated by major credit rating agencies. Their ratings are generally lower than those of bonds because preferred dividends do not carry the same guarantees as interest payments from bonds and preferred-stock holders’ claims are junior to those of all creditors.
Types of Preference Shares
- Cumulative Preference Shares: It is the most common type of preferred equity where the dividends, if not paid, are considered in arrears and are given priority over other dividend payments. The law forbids the company from making any dividend payment to common shareholders unless and until the preference shareholders receive dividends.
- Non-cumulative Preference Shares: This category of shareholders are not compensated for unpaid dividends, unlike the cumulative preference shares. If a company skips the dividend payment after making an announcement, it is under no obligation to adhere to its earlier announcement of paying dividends.
- Redeemable Preference Shares: In the case of redeemable shares, a company has the right to buy back the shares for its use from shareholders at a fixed date or by giving prior notice after a period of time.
- Irredeemable Preference Shares: These shares can only be redeemed at the time of liquidation or when the company winds up operations.
- Convertible Preference Shares: Shares are convertible to common equity at a specific time and price; considered the most versatile and appealing form of preferred equity with diversified risk exposure.
- Non-Convertible Preference Shares: Shareholders who own non-convertible preference shares do not possess the right to convert those into common equity.
- Participating Preference Shares: The issuing company must pay an increased dividend to the owners of preference shares if there is a participation clause in the share agreement. These shares also have a fixed dividend rate.
- Non Participating Preference Shares: The shareholders are entitled only to the dividends at a fixed rate and not to the surplus profit. The extra profit is distributed among the common shareholders.
- Callable Preference Shares: The issuing company has the right to buy back these shares at a certain price on a specific date. Since the call option tends to cap the maximum price a preference share can appreciate (before the company repurchases it), it restricts stock price appreciation.
Advantages of Preference shares
Some advantages of investing in preference shares include:
- No Legal Obligation for Dividend Payment: There is no compulsion of payment of preference dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt, which has to be paid in all circumstances.
- The primary advantage for shareholders is that the preference shares have a fixed dividend. This payout is typically done before any dividends are paid to common shareholders. If the company turns a profit, the dividends are paid on preference shares. This generally permits the aggregation of unpaid dividends. The preferred shareholders get priority when it comes to remitting unpaid dividends over ordinary shareholders.
- Flexibility: A company can issue redeemable preference shares for a fixed period. The capital can be repaid when it is no longer required in business. There is no danger of over-capitalization, and the capital structure remains elastic.
- No dilution in control: Issue of preference share does not lead to a dilution in control of existing equity shareholders because the voting rights are not attached to the issue of preference share capital. The preference shareholders invest their capital with a fixed dividend percentage, but they do not get control rights.
- Since preference shareholders get the first claim upon liquidation (before common shareholders) and have a fixed return, they are considered more popular amongst investors. Investors prefer investing because it is considered to be a low-risk investment.
Disadvantages of Preference shares
Some disadvantages of preference shares include:
- No voting rights: The critical 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 instead of equity shareholders. If the business turns a profit and the interest rate increases, the preferred shareholders will be stuck on the fixed dividend.
- Fixed Obligation: Dividend on preference shares has to be paid at a fixed rate and before any dividend is paid on equity shares. The burden is more significant in the case of cumulative preference shares on which accumulated arrears of dividends have to be paid.
- High costs: Preference Shares prove to be costly in the longer term. This is because the dividend charge is higher than the interest rate charged on long-term investment instruments, like debentures.
- Low Return: When the company’s earnings are high, fixed dividends on preference shares become unattractive. Preference shareholders generally do not have the right to participate in the company’s prosperity.
- Fear of Redemption: The holders of redeemable preference shares might have contributed finance when the company badly needed funds. But the company may refund their money whenever the money market is favorable. Even though they stood by the company in its hour of need, they were shown appreciation.
Preference shares are an excellent way to earn a respectable position in a company’s group of shareholders. If the company sees liquidity in stocks, in that case, preference shareholders will get the significant advantages of claiming dividend payments. While preferred shares offer more dividend security than common stocks, dividends still are not guaranteed. To learn more about common stocks, click here.