Some companies distribute multiple types of shares to shareholders. Ordinary shares are the most common type (one vote per share), but there are also non-voting shares, redeemable shares and what we will look at in this blog – preference shares.
What are preference shares?
There are three main features of preference shares:
1. Fixed rate of dividend
Preference shares, also known as preferred stock, are named as such because they have a fixed rate of dividend which is paid out before the other types of shares. In other words, preference shares take precedence over ordinary shares (and other share classes) in terms of the payment of any dividends.
Any remaining profits available for distribution as dividends are shared between the holders of ordinary shares after the preference shareholders have been paid their fixed rate of dividend.
It should be noted that preference shares do not guarantee payment of any dividend to their holders (i.e. if there have not been sufficient profits). But they are first in line if there are any profits in the relevant financial period.
2. Return of capital
Another feature of preference shares is that, in the event of the company being wound up, holders of preference shares are entitled to be repaid their capital contribution before ordinary shareholders. However, priority is still given to creditors over shareholders – preference or otherwise.
3. No voting rights
In general, preference shares generally do not come with any automatic voting rights – unlike most ordinary shares.
What sub-types of preference shares are available?
- Cumulative – this means that, if the fixed-rate dividend is not paid in respect of one financial period (i.e. due to poor profits), it will accrue and be added to future dividend payments when profits improve.
- Convertible – these allow preference shares to be converted into ordinary shares.
- Redeemable – these can be bought back by the company (e.g. if an employee shareholder leaves the company).
What are the advantages of preference shares?
Preference shares generally offer a higher degree of security to their holders compared to ordinary shareholders. This is both in terms of receiving a return on their investment and recouping any losses should the company get into financial difficulty.
What are the disadvantages of preference shares?
Because the dividend rate is fixed, preference shareholders will not reap the benefits of unexpectedly good profits. They will also potentially receive a much lower dividend payment compared to ordinary shareholders.
It should also be noted that dividend shares do not usually come with voting rights.
When should preference shares be issued?
One of the reasons for issuing preference shares is to attract investment from risk averse shareholders. Some companies and investors view preference shares as an alternative to a loan arrangement, providing the release of capital with a fixed rate of return, even though this does not involve debt and is therefore not a creditor relationship.
However, preference shareholders will not necessarily see regular payments if company profits plummet, and their investment remains more at risk than creditors such as bank lenders, etc.
Another reason for issuing preference shares as opposed to ordinary shares is that they do not dilute the voting rights of existing shareholders, because they do not come with voting rights. So they can be a good option for companies looking for more investment, but who do not want to give up control held by existing shareholders.