Preference shares are a type of company’s stock in which dividends are paid to the shareholders before they are issued to the common stockholders. There are two major types of shares that can be issued by a company.
- Equity Shares
- Preference Shares.
People who own these stocks are known as preference shareholders, and they are entitled to be paid from the company’s assets before the common stockholders in case a company goes bankrupt.
These shares have a fixed dividend while the common stock’s dividends depend on the profitability of the company and the money they would retain for the future activities of the company.
Types of Preference Shares
1. Cumulative Preference Shares – These have a provision of getting paid in arrears. Often, the company does not have the financial capacity to pay dividends, so these are paid in the next year. In many cases, interest is also paid along with the arrear dividends.
2. Non-cumulative Preference Shares – The shareholders of these kinds of shares are given dividends from the year’s profit only. In case the company does not have the financial capacity to pay such dividends, then these are not paid to the shareholders in the future, neither can they claim it in the future.
3. Redeemable Preference Shares – In this type, the company can buy back the shares on a specified date in the future, or they can buy back after giving notice after some time.
4. Irredeemable Preference Shares – These types of shares can only be redeemed at the company’s liquidation.
5. Participating Preference Shares – In this type, the company pays increased dividends every year for the preference shareholders. The rate of the dividend of these shares increases at a constant rate every year. These shareholders have the right to the company’s assets at the time of liquidation of the company.
6. Non-participating Preference Shares – The non-participating preference shareholders are entitled to only fixed dividends and no surplus dividends. The surplus profit with the company is distributed among the common stockholders.
7. Convertible Preference Shares – These shareholders have the option to convert the common stock to preferred stock. The shareholders’ can get two benefits from this – first, dividends paid on the shares and second, from the increase in the value of the common stock. These can only be converted within a specific period, which has to be stated in the memorandum.
8. Non-convertible Preference Shares – Shareholders’ of Non-convertible preference shares do not have the right to convert their common stock to preferred stock.
9. Preference Shares with a Callable Option – The issuing company has the right to buy back these shares from the shareholders’ at a predetermined price and after a set date. The call premium for such shares is already given in the issuing prospectus.
10. Adjustable-Rate Preference Shares – The dividend rate for such shares is not fixed and depends on the market interest rate.
1. Preference Shareholders receive a fixed dividend, irrespective of the profits earned by the company.
2. Preference shareholders do not have voting rights in the annual general meeting.
3. Investors usually invest in these shares for a long-term horizon.
4. Higher dividend rate as compared to the debenture interest rate.
5. Shareholders of these shares have the first right over the company’s assets at the time of liquidity.
6. The dividends issued on these shares are not tax-deductible.
7. The shareholders of these shares have a preferential right to receive dividends.
Unlike common stockholders’, preference shareholders do not have the right to vote in any resolution placed in front of the company in the annual general meeting. The preferential shareholders’ have voting rights only in those resolutions that will affect their dividend payment.
However, Section 47(2) of the 2013 Act states that in case the dividends to preference shareholders’ are due from 2 years, the preference shareholders’ voting right on every resolution is placed in front of the company.
Advantages of Preference Shares
1. Fixed Dividend – The preference shareholders’ receive a fixed dividend on their investment. That means it is a source of regular income for some investors.
2. First Preference – At the time of bankruptcy, the preference shareholders have the first right over the company’s assets.
3. Improves Borrowing Capacity – Preference shares are part of the net worth of the company. It does reduce the Debt/Equity Ratio and allows the company to raise more capital.
4. No Dilution of Control – Preference shareholders’ have no voting rights. Thus, the control is in the hands of the management of the company only.
Disadvantages of Preference Shares
1. Costly Source of Finance- When compared to debt sources of finance, these are most costly because debt is a tax-deductible expense, but preference shares dividends are paid out of the divisible profits.
2. Mandatory Dividend Payment – Similar to interest payment on the debt, dividend payment on these shares is also compulsory. Failing to do so may disregard market image.
3. Voting Rights – The shareholders’ do not have voting rights in any resolution placed in front of the company during the annual general meeting.