Preference Shares - Meaning, Types and Advantages

Preference Shares Meaning

• Preference Shares are type of equity shares in which the preference shareholder gets the first claim on the company’s profits and dividends after the creditors. Preference share also provides fixed income in the form of preference dividends. Preference shares are not risk free bonds. Preference shares also experience fluctuations and the principal amount is not fully secured.
• Preference shares are given to raise capital for the company. And this is known as Preference share capital. In case if the company is winding up, the last payments will be made to preference shareholders before equity shareholders. Preference shares can be converted in to equity shares and are called convertible preference shares.
• In India Preference shares must be redeemed within 20 years of issuance and these types of preference shares are called redeemable preference shares.

Why Preference Shares are issued by Companies?

There are basically three reasons why Preference Shares are issued

1. Debt Equity Ratio

Companies try their best to avoid debt in their balance sheet. Because investors and analysts monitor company’s Debt to Equity Ratio. Debts on balance sheet leads to poor credit rating which is a negative remark for the company.  To avoid all this, companies prefer giving preference shares and raising money instead of adding debts.  And the best way to raise fresh capital without any impact on debt equity ratio is by issuing preference shares.

2. Retain Voting Rights

Next important point is voting rights.  Preference shareholders are not given any voting rights for any of the t 10% company’s decision.

3. Avoid Sharing of Profit

When equity shares of a company are purchased there is no cap on the dividend income that you earn. If the company performs exceptionally well, then the investors earn more dividend. But that is not the case with preference shareholders.  If the dividend rate for preference shareholder is fixed @10% then preference shareholders will definitely get their 10% dividend irrespective of whatever profits the company earns.  It is not compulsory for companies to share its entire profits with the preference shareholders like in the case of equity.

How does the Company Issue Preference Shares?

• The company first needs to ensure if issuing preference shares are authorized under the Articles of Association of the company.
• In AGM, points such as size of the issue, number of preference shares, nominal value of the shares, Nature of the shares, Objectives of the issue. Terms of the issue, Rate of dividend and tenure of redemption etc are discussed.
• After this the company passes a resolution and a statement is filed with the Registrar of Companies within 30 days.
• A company shall redeem its preference shares within 20 years from the date of issue.
• The minimum application size for each investor should not be less than Rs 10 Lakh
• Issuing company must obtain at least AA or AAA ratings from the credit rating agency.

Who can Buy Preference Shares?

Preference Shares are not traded in the stock exchanges. Hence they are not available for retail investors. Companies issue these shares under private placement. Preference shares are issued to financial institutions, HUF and other lending firms.

Types of Preference Shares

1. Cumulative Preference Shares

Cumulative Preference Shares Permit investors to receive dividends in arrears. The company’s financial position prevents it from paying dividend to its stockholders.  Dividends cannot be paid to common shareholders unless preference stockholders are paid.  Under such circumstances the corporation decides to pay cumulative dividends the following year.

2. Non-Cumulative Preference Shares

Non-cumulative Preference Shareholders do not receive dividends in arrears. They are only eligible for dividends from the current year’s profit. If the company makes loss in a particular year in that year these shareholders cannot claim the dividend.  So the shareholders will not receive dividend for that year.

3. Redeemable Preference Shares

Redeemable Shares gives the company the right to buy back the share from the shareholders on a set due date or by giving prior notice.  The company can buy back their shares. The company prefixes the prices of such shares.

4. Irredeemable Preference Shares

In irredeemable Preference shares the company can redeem their shares only when the liquidation of its operations occur.

5. Participating Preference Shares

Participating Preference Shares means the shareholders can demand a part in the company’s surplus profit at the time of liquidation after the dividends are paid.

6. Non-Participating Preference Shares

In Non Participating Preference Shares the shareholders does not get the option of earning dividend from the surplus profits but receives fixed dividends offered by the company.

7. Preference Shares with a Callable Option

In Preference Shares with Callable Option are the shares that the company can choose to buy back at a fixed price in the future. This benefits the issuing company because it enables the company to put a cap on the value of the stock.  The word callable means “right to buy”.

8. Adjustable Preference Shares

In the case of Adjustable Preference Shares the dividend rate is not fixed and is influenced by current market rates.

Features of Preference Shares

The below mentioned are Features of Preference Shares

• They can be converted in to Common Stock

Preference Shares can be converted to Common Stock. If the shareholder wants to change its holding position they are converted in to predetermined number of preference stocks.

• Dividend Payouts

Preference shareholders get their dividend paid whereas other shareholders may or may not get their dividend paid.

• Dividend Preference

Preference Shareholders gets their dividend paid first compared to other equity shareholders.

• Voting Rights

Preference Shareholders are entitled to the right to vote in case of extraordinary events.  Generally preference shareholders do not have any voting rights.

Risk Associated With Preference Shares

• Market Risk: The value of these shares can decrease in unfavorable market conditions.
• Interest Rate Risk: If the prevailing Interest rate in the Market Increases, the demand for these shares are likely to decrease resulting in reduction in market prices.
• Liquidation Risk: Preference has lower liquidation risk than what equity shareholders face. Preference Shareholders can only claim assets remaining after creditors and bondholders/debenture holders are paid

Conclusion

Whether you should go for preference shares, depend on your investment objective. You may find it suitable if you want consistent returns and benefits from the capital appreciation at a lesser risk than equity shares.