Preference shares

3 key takeaways

• Preference shareholders receive dividends before common shareholders.
• These shares typically do not carry voting rights.
• Preference shares can be cumulative or non-cumulative, impacting how missed dividends are handled.

What are preference shares?

Preference shares, also known as preferred stock, are a class of shares that provide certain advantages over common shares. Holders of preference shares are given priority when it comes to dividend payments and the distribution of assets if the company is liquidated.

This makes them a hybrid security, having characteristics of both equity and debt.

Types of preference shares

Cumulative and non-cumulative

• Cumulative preference shares: Dividends accumulate if not paid in a given year, and they must be paid out before any dividends on common shares.
• Non-cumulative preference shares: Dividends do not accumulate. If the company does not declare a dividend in any given year, shareholders do not have the right to claim unpaid dividends in the future.

Participating and non-participating

• Participating preference shares: Shareholders may receive additional dividends in addition to their fixed dividend if the company achieves certain financial goals.
• Non-participating preference shares: Shareholders are entitled only to the fixed dividend and do not participate in the company’s additional earnings.

Convertible and non-convertible

• Convertible preference shares: These shares can be converted into a predetermined number of common shares after a specified period or upon certain conditions.
• Non-convertible preference shares: These shares cannot be converted into common shares.

Benefits of preference shares

For investors

• Priority dividends: Preference shareholders receive dividends before common shareholders, providing a more predictable income stream.
• Reduced risk: In the event of liquidation, preference shareholders have a higher claim on the company’s assets compared to common shareholders.
• Fixed income: Many preference shares offer a fixed dividend rate, similar to bonds.

For companies

• Flexible financing: Issuing preference shares allows companies to raise capital without increasing debt levels or diluting control through voting rights.
• Attractive to investors: Preference shares can attract investors looking for a balance between equity and debt investments.

Drawbacks of preference shares

For investors

• Limited upside potential: Preference shares typically do not benefit from the company’s growth in the same way common shares do.
• No voting rights: Preference shareholders generally do not have voting rights, limiting their influence on company decisions.

For companies

• Fixed dividend obligations: Companies are required to pay fixed dividends to preference shareholders, which can be a financial burden, especially during low-profit periods.
• Complexity: Managing different classes of shares can add complexity to a company’s capital structure.

Understanding preference shares is crucial for both investors and companies as they offer a unique blend of features from both equity and debt securities.

Exploring related topics like common shares, bonds, and corporate finance strategies can provide a more comprehensive view of investment options and financial structuring.