Acquiring a company’s common shares gives shareholders various rights. Firstly, it allows them to become part-owner of the company. Similarly, these shares allow the shareholders the right to vote in a company’s decisions. For most shareholders, the primary advantage of holding a company’s shares is the payments they receive from it. These payments usually come in the form of dividends.
However, there are some disadvantages of holding ordinary shares. Usually, shareholders only receive dividends if the company makes a profit. There is no guarantee of the profits or the shareholders getting a portion. Similarly, if the underlying company liquidates, these shareholders will be the last to receive compensation. In those instances, the shareholders may be at a disadvantage. However, preference shares can change that.
What are Preference Shares?
Preference shares are a type of equity instrument that companies issue to shareholders. As the name suggests, these shares provide shareholders with a preference in various matters. Most importantly, it gives them a higher claim on the issuing company’s assets. However, it also comes with benefits when it comes to receiving dividends. Apart from this preference, stockholders may also get other advantages.
Another name used for preference shares is preferred stock. This stock allows shareholders to receive compensation regardless of whether the company makes a profit. Hence, preference shares come with guaranteed payments in most cases. Any compensation paid to preference shareholders falls under interest payments rather than dividends. Therefore, they do not need profits to receive income from the company.
The most critical characteristic of preference shares is the preferred treatment during liquidation. If a company liquidates, its stockholders have a right to its assets. However, these only include any residual resources after paying off the company’s liabilities. However, preference shareholders will receive their claim to the assets before the common shareholders do.
Overall, preference shares are securities that get a priority claim over common shares on a company’s assets. Shareholders who hold these shares get a preferred treatment when it comes to receiving dividends or during liquidation. In essence, they have similar characteristics to debt. However, they qualify as shares due to the equity component involved. Some preferred stock may also be convertible into common stock.
What are the types of Preference Shares?
Unlike common shares, preference shares have various types. These types provide unique benefits to the shareholders but may also take some features of preferred stock away. Similarly, some of these are more advantageous for the holder, while others benefit the underlying company. Companies can choose which of these types they can issue based on their circumstances.
In total, there are four primary types of preference shares. Each of these types of preference shares has its advantages. However, they may also come with some drawbacks or costs for the investor. An explanation of each of the four types is as below.
Convertible Preference Shares
Convertible preference shares are the most common types of preference shares. These shares give the holder the option to convert their stock to common shares at a later date. Usually, the company provides a fixed ratio that dictates how many common stocks the holder will get in exchange. Some companies also impose terms that force the conversion at maturity.
The option for conversion with convertible preference shares lies with the holder. Usually, the conversion ratio depends on the market value of the company’s common stock at the time. Therefore, the holder must decide whether the conversion is beneficial in the profits they can make. If the terms of these shares enforce conversion, the shareholder won’t have a say in it.
The opposite of convertible preference shares is non-convertible preference shares. These shares do not allow the holder to convert their preferred stock into common stock. However, non-convertible preference shares are the primary preference share. These shares do not constitute a type of preference shares. Instead, preferred stocks which do not come with the conversion option are known as non-convertible preference shares.
Callable Preference Shares
Callable preference shares switch the option to choose from the holder to the company. With these shares, the underlying company decides whether to call in or redeem the stock when it matures. Usually, both parties will agree on a predetermined price and premium for the call option. Once they enter into the callable preferred stock contract, they cannot alter it.
Similar to convertible preference shares, callable preference shares are very prevalent in the market. It usually comes from companies that have an advantage. Callable preference shares place the holder at a higher disadvantage since it takes away their choice. Despite that, these shareholders can get a premium on conversion, providing them with a benefit.
The opposite of callable preference shares is retractable preference shares. With these shares, the holder decides whether to sell back their shares or redeem them. The underlying company loses the option to choose to call in the preference shares. Therefore, retractable preference shares are more advantageous to the shareholders rather than the company.
Cumulative Preference Shares
Cumulate preference shares are not similar to callable or conversion shares. These shares fix a dividend for the shareholders. However, the company does not guarantee these fixed dividends at regular intervals. The company may not pay the shareholder these dividends for a long time if it chooses to do so. However, the shareholder will still be entitled to receive these payments.
With cumulative preference shares, the fixed dividends accumulate over time. If a company does not pay these dividends, it will still be an obligation toward the holder. However, holding off these dividends is only possible if the company chooses not to pay its equity shareholders. Once the company releases dividend payments, the cumulative preference shareholders will receive their accumulated dividends first.
Cumulative preference shareholders allow a company to hold off dividend amounts in case it needs resources. However, it does not eliminate its obligation toward the holder. The preferred stockholder will receive their fixed payment at a future date. This payment will include all unpaid dividends until the date. For the investor, these shares provide more certainty due to the fixed dividends and guaranteed payments.
Participating Preference Shares
One of the most significant disadvantages of preference shares is exclusion from a company’s profits. Usually, preference shareholders get a fixed income from holding these shares. However, the participating preference share comes with both benefits. It allows the holder to receive a part of the underlying company’s profits while also benefiting from a fixed dividend. However, the company only pays additional dividends if its common stock dividends exceed a specific limit.
Participating preference shares place the underlying company at a significant disadvantage. However, for most companies, they may be the only option to raise capital. When companies foresee a challenging future, they will use these shares to gather finances. Most analysts see the issuance of participating preference shares as a last resort to save a company from hostile takeovers.
However, participating preference shares provide investors with significant advantages. Not only do they receive their fixed income, but they also receive additional profits. As mentioned, however, the underlying company must be able to afford these payments. The participation benefits only become applicable if the dividends paid to common stockholders exceed a specific limit. These shares also provide additional benefits if the company gets liquidated.
Preference shares are a type of equity instrument issued by companies. These shares provide the holders with preferred treatment. Usually, preference shares come with guaranteed income and preference in liquidation. There are several types of preference shares. These include convertible, callable, cumulative, and participating preference shares.