Preference Shares Advantages and Disadvantages

Preference Shares Advantages and Disadvantages

What are Preference Shares?

Preference shares, also known as preferred stock, are a type of ownership interest in a corporation that typically entitles the shareholder to certain preferences or privileges over other common shareholders.  Preference shares combine features of both equity and debt instruments. Shareholders receive fixed dividends, usually at a predetermined rate, before dividends are paid to common shareholders. This dividend is often higher than what common shareholders receive. In the event of liquidation, preference shareholders are also typically entitled to receive their investment back before common shareholders.

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Table of Content

  1. What are Preference Shares?
  2. Benefits of Preference Shares
  3. Disadvantages of Preference Shares
  4. Types of Preference Shares
  5. What are the merits and demerits of preference shares?

Benefits of Preference Shares

Dividends Are Paid First To Preference Shareholders:

One of the principal benefits for shareholders lies in the fixed dividend structure of preference shares. This ensures a consistent payout, typically preceding any dividends distributed to common shareholders. In the event of profitability, dividends are allocated to certain categories of preference shares, allowing for the accumulation of unpaid dividends. Additionally, preferred shareholders hold precedence in receiving unpaid dividends over common shareholders. 

Preference Shareholders Have A Prior Claim On Business Assets

In the event of bankruptcy or liquidation, preference shareholders are entitled to prioritize their claims on the business's assets, potentially receiving a higher proportion to common shareholders. This characteristic renders the investment risk more manageable for preference shareholders in contrast to their common counterparts. Additionally, preference shareholders are assured of a fixed dividend payout annually. Particularly, should the business opt to terminate operations, preferred shareholders can anticipate adequate compensation for their investments.

Add-on Benefits for Investors

Preference shares offer shareholders the option to exchange their convertible shares for a predetermined number of common shares. Should the company attain a predetermined profit threshold established beforehand, shareholders may also be entitled to additional dividends. This feature can be advantageous, especially when the value of common shares escalates. Positioned as a low-risk investment instrument, this segment of preference shares presents an opportunity for long-term income generation, accompanied by supplementary benefits. 

Disadvantages of Preference Shares

No Voting Rights for Preference Investors

One significant disadvantage of holding preferred shares is the lack of ownership within the company. Unlike equity shareholders, preferred shareholders do not wield voting rights. Consequently, from an investor's viewpoint, preferred shareholders do not hold the same level of influence as equity shareholders. Furthermore, should the business experience profitability and interest rates rise, preferred shareholders are constrained by fixed dividend payments, potentially limiting their ability to capitalize on improved financial performance. 

Higher Cost than Debt for Issuing Company

To procure funding for projects, enterprises often pursue capital through the issuance of debt and equity instruments, which are operational expenses. Typically, sizable corporations choose to offer preferred stock to the public, alongside raising capital through common stock and corporate bonds. Opting for equity over debt issuance enables businesses to maintain a lower debt-to-equity ratio, enabling them to leverage additional financing from prospective investors. 

Types of Preference Shares

Preference shares come in various types, each with its own set of rights and characteristics. Here are some common types of preference shares: 

  • Cumulative Preference Shares: These shares come with a provision that if the company is unable to pay dividends in a particular year, the unpaid dividends accumulate and must be paid in subsequent years before any dividends can be paid to common shareholders.
  • Non-cumulative Preference Shares: Unlike cumulative preference shares, non-cumulative preference shares do not carry forward unpaid dividends to subsequent years. If the company skips paying dividends in a particular year, shareholders with non-cumulative preference shares lose the right to claim those dividends.
  • Participating Preference Shares: Holders of participating preference shares are entitled to receive additional dividends beyond the fixed rate specified, if the company performs exceptionally well and distributes additional profits to shareholders. They have the right to participate in surplus profits of a company’s shares once the common shareholders receive their dividends.
  • Non-participating Preference Shares: These shares do not entitle the shareholders to participate in any surplus profits beyond the fixed dividend rate. Once the fixed dividend is paid, any additional profits are distributed among common shareholders.
  • Convertible Preference Shares: Convertible preference shares give the shareholder the option to convert their preference shares into a fixed number of equity shares after a predetermined date or under certain conditions.
  • Non-Convertible Preference Shares: These shares cannot be converted into equity shares. They remain as preference shares for the duration specified in the terms.
  • Redeemable Preference Shares: Redeemable preference shares can be transferred by the company after a specified period or under certain conditions. The redemption usually involves paying back the initial investment to the shareholder.
  • Irredeemable Preference Shares: Irredeemable preference shares do not have a maturity date and are not subject to redemption by the company unless specific conditions outlined in the terms are met.

What are the merits and demerits of preference shares?

Merits of Preference Shares:

  • Fixed Dividend: Preference shareholders are entitled to receive a fixed dividend rate before any dividends are paid to ordinary shareholders. 
  • Priority in Assets: In the event of liquidation, preference shareholders have a higher claim on the assets compared to ordinary shareholders. 
  • Limited Voting Rights: Preference shareholders usually have limited or no voting rights, which can be advantageous for companies, as it helps in maintaining control and decision-making power with the management and founders.
  • Flexibility: Companies can issue preference shares with various terms and conditions, enabling them to tailor investment needs, such as cumulative or non-cumulative dividends, convertible or non-convertible features, etc.

Demerits of Preference Shares:

  • Fixed Dividend Obligation: The fixed dividend obligation can become a burden for the company during financially challenging times. Even if the company is not making profits, preference shareholders are still entitled to receive their fixed dividends, which can drain the company's cash flow.
  • No Voting Rights or Limited Control: While limited voting rights can be an advantage for the company, it can also be a disadvantage for investors who wish to have a say in the company's decision-making process.
  • Lack of Participation: Preference shareholders generally do not participate in the company's growth in the same way as ordinary shareholders. They receive fixed dividends and do not benefit from the company's profitability.
  • Less Potential for Capital Appreciation: Preference shares typically offer less potential for capital appreciation compared to ordinary shares since the dividends are fixed and there is limited participation in the company's growth. 

Preference shares provide investors with a unique blend of stability and potential for higher returns compared to common shares. With their fixed dividend pay-outs and priority claims on assets in case of liquidation, they provide a sense of security to investors. Overall, preference shares serve as a valuable tool for investors seeking steady income streams while balancing risk in their investment portfolios. 

FAQs on Preference Shares

Preference shares provide fixed income through their dividend payments, which are typically set at a fixed rate or calculated based on a predetermined formula.

A company issues preference shares to raise capital without diluting voting control, offering investors fixed dividends and priority over common shareholders in asset distribution.

Cumulative preference shares are a type of preferred stock where any unpaid dividends accumulate and must be paid before dividends can be distributed to common shareholders.

Preference shares can be riskier than bonds due to their reduction in the capital structure and lack of a guaranteed fixed income stream.

Non-cumulative preference shares do not allow the accumulation of unpaid dividends, if skipped, shareholders cannot claim it.

Participating preference shares are a type of preference share that entitles holders to receive additional dividends beyond their fixed rate if profits exceed a certain threshold.

Preference shares may not be suitable for all investors as they usually offer fixed dividends and limited voting rights, which may not align with the investment goals or risk tolerance of certain individuals.

Yes, preference shares can be redeemed by the issuing company according to the terms outlined in the share agreement.