Preference share – Look for which type is for your portfolio

Preference shares refer to ownership in a listed company that bears higher right on assets and profits than common stock. Also, if you hold preferred shares you will receive the dividend before common shareholders. However, this class of shares does not bring voting powers.

What do you mean by preference shares?

Thus, from the above, the meaning of preferential shares is clear. In other words, preference shares are the shares those are preferred over common shares at the time of profit distribution. Owners of preference shares receive regular dividends. Consider a situation where a company goes into liquidation. In such situation, you will get your share after bondholders and creditors. However, you will get it before an equity holder.

Thus, preferred shares combine features of debt and equity. Debt because it pays fixed dividends. And equity, because there is potential for price appreciation. The details of each preferred stock depend on the issue.

Features of preference shares 

You qualify for the following before any ordinary shareholders, in case you own preferential shares in a company –

• Dividend at a fixed rate or a fixed amount on your shares before common equity holders.
• During the liquidation of the company, your return on preference share capital is coming prior to the equity share capital

Besides above-mentioned features of preferential shares, some other importance of preferential shares is also there. Preference shareholders, have right to participate in any excess profits. Excess profit is those profits which remain with the company after paying to equity shareholders. You also have a right to participate in the premium at the time of redemption. However, there is the greatest limitation to a preferential shareholder. You do not carry any voting rights, like an ordinary shareholder.

Preferential shares are for what type of investors?

Preference shares are an optimal choice for risk-averse equity investors. These shares are typically less volatile than common shares. It also offers investors a steadier flow of dividends. Moreover, they are usually callable. It means that the issuer of the shares can redeem them at any time. Thus it provides investors with more options than common shares.

How preference shares differ from ordinary shares

Indian companies issues two different types of shares to the public. The first one is ordinary shares and the other is preference shares. The law of the land permits to attach different rights to both types of shares. The various purposes for the same are as follows –

• distinguish voting rights
• prioritize distribution of dividends and claim on assets during liquidation
• to issue fresh shares to raise funds with debt features
• investors get an option to invest and redeem it in future. Thus, allow the investor to exit 

Let us now understand the basic difference between preference shares and ordinary shares of a company.  The following table explains the two common types of shares and the different rights attached to them.

What are the types of preference shares?

Basically, the difference in the types of preference shares arises due to various rights associated with it.  Whether it is right on dividends of the company, or it relates to voting in the business and management, or the right to which you can hold such shares. The following are the major classes of preference shares –

1. Right on dividend – cumulative and non-cumulative preference shares

Depending upon the right on the dividend paid by any company, preference shares can be cumulative or non-cumulative. There is an obligation or no obligation on the company to pay dividends, irrespective of profits in any year. The dividends accumulate, and there is an obligation on business to pay it out of profit in later years only to preference shareholders. This is possible only when you hold a cumulative preference share.

On the other hand, in case you hold a non-cumulative preference share, you are treated same as ordinary shareholders. The only thing is that the company needs to declare a dividend in case of profit in a particular year. However, the difference is you will get the dividend prior to the ordinary shareholders and at a pre-decided fixed rate.  

Any unpaid dividends on cumulative preference shares accumulate. Also, the company has to make provision to pay these arrears before paying to ordinary equity shareholders. In general preference shares are cumulative except explicitly specified as non-cumulative.

Let us understand this with an example. Suppose a company has 1000 8% preference shares of Rs. 10 each. Also, the company did not pay the dividends for 2011 and 2012 so far. Now suppose in 2013, the company made a profit after the gap of 2 years of no or very low profit. Then in such case, the management must keep aside and pay Rs. 24,000 for the year 2011, 2012 and 2013 to shareholders of cumulative preference shares before declaring dividends to ordinary shareholders for the year 2013.

 2. Option to convert to ordinary shares – redeemable and non-redeemable preference shares 

There is an option attached to preference share. The option related to the conversion of preference shares unit to ordinary shares in, say 5 years or 7 years period. You can exercise such option during the filling the application for the preference share. In this case, you become entitled to convert such shares to ordinary shares on prespecified date and price. This option is known as convertible preference share. The other name of this category is redeemable preference shares. These preference shares are redeemed or repaid after the expiry of a fixed period or as per the prescribed notice issued by the company.

The opposite to this right is non-convertible preference shares or non-redeemable preference shares. Here, there are no such options to convert the preference shares into common shares of the company. The end of such shares is possible only when the company goes into liquidation. There may be an option attached to resell such non-convertible preference shares in a stock market.

3. Right to vote – non-participating & participating preference shares

Ordinary shareholders have right to vote in the working of the business. Companies need to seek permission from common shareholders before any ordinary or extraordinary decisions. However, preference shareholders are not entitled to vote in any such decision-making process. But there are some instances where such preference shareholders have voting rights with limited scope.

A participating preference share makes the holder eligible to participate in the balance of profits with ordinary shareholders. Even, after they receive nay fixed rate of dividend on shareholdings. They may also have the share in any surplus assets in case of winding up of the company.

On the other hand, a non- participating preference shares get only a fixed rate of dividend. They do not share the surplus profits. In general preference shares are non-participating in nature, unless expressly mentioned in the memorandum or the articles of the issue of preference shares.

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