Preference shares are a type of hybrid securities which have features of both equity and debt securities. They are called preference shares because they carry some preference over the common equity shares. The following are the two main preferences they have over equity shares.
- Preference of dividend payment over equity shares.
- Preference of repayment of capital over equity shares, in case of liquidation of the company.
They are beneficial for both companies and investors alike.
For companies, it is a long terms source of capital but still not a permanent capital because most preference shares have a duration or maturity on which they are redeemed. The company may sometimes have the choice to either redeem them or convert them into equity shares. The preference shares do not carry voting rights and thus the promoters of the company can get the capital they want but still keep their control over the company.
For investors, it is better than a debt security because it may give higher return than a debt security. For risk averse investors, a preference share may be better than an equity share because it pays (at least conditionally promises to) regular dividends and also is less risky than a common equity share. Particularly, small investors may not be interested in exercising the voting power and take the full risk of capital of an equity share. They may be interested only in getting higher returns than a bank fixed deposit. The preference share may fit their scheme of things. Most preference shares (except the convertible ones) are redeemed on maturity at par. This helps too because if the shares are not traded in a secondary market, the investors can get back their principal by way of redemption at maturity.
The following are the advantages of preference shares.
Advantages of preference shares (for companies and investors)
- Unlike secured debt, the preference shares do not create any charge on the company's assets.
- They do not change the shareholding pattern as preference shares do not carry voting rights.
- They can be traded on a stock exchanges if listed.
- In some countries the dividend income is not taxable unlike interest on debt. Therefore, they could be a better investment option compared with debt instruments.
- Preference share, though is a hybrid security, is considered as long-term capital. This adds to the capital base of the company which helps to company to borrow more from banks and other financial institutions. Under Basel III, it is considered as a Tier-II equity capital.
- The dividend paid on preference shares is less than the dividend paid on equity shares and, hence, it is a cheaper source of capital for the company.
- For some types of preference shares, such as redeemable preference shares, the company can redeem them prematurely if they have surplus funds and have included such an option in their issue terms.
Disadvantages of preference shares (for companies and investors)
- Preference share holders do not have voting rights. Thus, they are not in a position to influence the future of the company.
- Some preference shares, such as non-cummulative preference shares, do not pay dividend if the company makes losses. The company is benefited from this but not the investor.
- The preference share holders get fixed dividend irrespective of the performance of the company. Even though they are called shares, the bulk of the profits are taken away by the equity share holders and the preference share holders do not partcipate in the profits over and above their promised dividends. On the other hand, if the company goes for liquidation, the preference share holders may not get back their full capital, even though they have preference over the equity shares, if most of the proceeds from liquidation is given away to other lenders who have a better charge over the assets such as secured bond holders, trade creditors, tax authorities, employee salaries, etc. Note that the preference share holders have preference but not any guarantee of return of their capital.
Types of preference shares
The following are the common types of preference shares.
Cumulative and Non-cummulative preference shares
- Cumulative and Non-cummulative preference shares
- Participating and Non-participating preference shares
- Convertible and Non-convertible preference shares
- Redeemable and Non-redeemable preference shares
Cummulative preference shares are preference shares whose holders have a cumulative rights over the dividend. If the company fails to pay dividend in a particular year, the unpaid dividends gets accumulated and are payable in the next year along with the dividends of that next year. In other word, the unpaid dividends are carried forward to the future, until it is paid. The dividend on the equity shares can be paid only after all dividend arrears of preference shares are paid. In some countries, if the preference share holders are not paid for a certain number of years, they acquire voting rights till the payments are made.
Non-cummulative preference shares are preference shares whose holders do not have any cumulative rights over the dividend. If the company fails to pay dividend in a particular year, the unpaid dividends are not carried forward to the next year.
Participating and Non-participating preference shares
Participating preference share holders are entitled to a share in the profits of the company over and above the preference dividend they had been promised. The term 'participation' here refers to the participation of these shareholders in the profits of the company. The participation is not equal with the equity shareholders; a ratio of participation is predetermined.
Non-participating preference share holders do not participate in the excess profits of the company. They only receive their share of preference dividend irrespective of the profits of the company.
Convertible and Non-convertible preference shares
Convertible preference shares are those shares that can be converted into equity shares after a specific period of time. Such conversion can be optional or mandatory. If it is optional, then the preference shareholder has the option to either convert them into equity shares or redeem the preference shares into cash. If conversion is mandatory then the preference shareholders do not have a choice. The preference shares are mandatorily converted into equity shares at a predetermined ratio.
Non-convertible preference shares are those that cannot be converted into equity shares. They are redeemed at maturity.
Redeemable and Irredeemable preference shares
Redeemable preference shares are those that are redeemed on maturity. The company redeems the shares and repays the principal amount and accrued interest.
Irredeemable preference shares are those for which there is no maturity date. They are perpetual in nature. They are retained by the company until its liquidation. In some countries (like India), irredeemable preference shares cannot be issued.
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