Key Differences Between Preference and Ordinary Shares

When a business entity decides to issue shares as a means of raising capital, it does not do so equally. The difference between preference and ordinary shares is that in terms of ownership, profit participation and voting in the company among others. For both new investors who are trying to create an investment portfolio or traders with a high level of experience, knowledge about the different types of shares in India is essential. This article will provide a comprehensive overview of preference vs ordinary shares in all aspects including dividends, voting rights, and suitability to help make informed investments decisions.

What Are Shares?

As defined in the Companies Act 2013, a share is the measure of a shareholder's interest in a company's assets, in other words, shares represent a shareholder's stake of ownership in a company. Public limited companies raise capital for their business by issuing stocks. The shares not only provide an ownership right to an individual, but also carry other entitlements.

Under Section 43 of Companies Act 2013, the shares are majorly classified into two types which are Ordinary Equity Shares and Preference Shares. To understand what each type of share represents and what rights it confers on the holder, it is important to know the difference between preference and ordinary shares.

What Are Ordinary Shares?

Ordinary or equity share is a common variant of stock that a public company issues to raise capital. Typically, holders of ordinary shares enjoy voting rights, can attend general and annual meetings of a company, and are also entitled to a company's surplus profits.

In practical terms, ordinary shares make their holders part-owners of the company with both the upside of profits and the downside of losses.

Key characteristics of ordinary shares:
 

• Voting rights: Ordinary shareholders can vote on company decisions such as the mergers, election of directors, and changes in policies.
• Dividends: These dividends are declared by the board of directors and ordinary shareholders get paid their dividends only after the preference shareholders.
• Surplus profits: If there is surplus profit in the company, then ordinary shareholders will get their share in the surplus profits.
• Capital repayment: In the case of liquidation, the ordinary shareholders get capital repayment only after all other claims have been met.
• Market-linked returns: Ordinary shares have their values depending on the market situation.

Also Read: Types and Advantages of Equity Share Capital

Types of Ordinary Shares in India

When it comes to types of shares, ordinary shares involve classification based on two understandings, where one is definition-based, and the other is feature-based.

Definition-based types of ordinary shares:
 

• Authorised share capital: The company is permitted to raise a certain amount of maximum capital through share issuance, which is stated in Memorandum of Association.
• Issued share capital: The portion of authorised capital which the firm has issued to the shareholders.
• Subscribed and paid-up capital: The portion of issued capital that investors have actually purchased and paid for.

Feature-based types of ordinary shares:
 

• Voting and non-voting shares: Majority of ordinary shares have voting power; non-voting shares will either have different voting powers or none.
• Sweat equity shares: Share capital issuance can be made to employees and directors as a form of reward, especially for their excellent performance. By means of sweat equity shares, companies retain efficient employees by giving them a stake in ownership.
• Right shares: A company issues this variant to its existing shareholders, giving them the right to purchase such shares before it is open for trade to external investors.
• Bonus shares: Companies issue bonus shares in lieu of monetary compensation for dividends, existing shareholders are only entitled to bonus shares. Organisations can also issue bonus shares to convert a portion of retained earnings into equity shares.

What Are Preference Shares?

Preference shares have some advantages because of their special rights, especially concerning dividend payment and payment of capital when the company is winding up. In other words, preference shareholders receive dividends on a high priority, and companies return their capital before ordinary shareholders when undergoing liquidation.

This preferential treatment in both income and capital recovery is what defines the difference between preference and ordinary shares as preference shareholders trade off growth potential for greater certainty of income.

Types of Preference Shares in India

Understanding the types of shares in India includes knowing the various sub-categories of preference shares:

1. Redeemable and Irredeemable Preference Shares

When it comes to redeemable shares, there is an agreement between the company issuing the shares and the shareholders, that these stocks could be redeemed by the company in the future either after the expiry or on a future date.

2. Convertible and Non-convertible Preference Shares

Holders of convertible preference stocks can convert their holdings to equity shares upon meeting specific conditions. However, owners of non-convertible preference shares do not benefit from this right.

3. Participating and Non-participating Preference Shares

Participating preference shareholders have the right to take part in the company’s profits after it allots dividends to the ordinary shareholders. When a company's net income is substantially high, such shareholders stand to receive a part of such profits. On the other hand, holders of non-participating shares are only entitled to a fixed dividend payment, the latter is a commoner variant.

4. Cumulative and Non-cumulative Preference Shares

If a company does not provide dividends for preference shares in a particular year, such dividend entitlement is carried forward to the following year if it is cumulative stock. On the other hand, for non-cumulative preference shares, the amount of dividend is not cumulative when the company fails to declare dividends in a particular year.

Difference Between Preference and Ordinary Shares

The difference between preference and ordinary shares spans several dimensions and they are as follows:

Understanding these dimensions clearly defines the preference vs ordinary shares debate for any investor making an allocation decision.

Preference vs Ordinary Shares

When you have to choose between preference vs ordinary shares, it is important to first know about the one that suits your risk appetite, financial goals and investment horizon.

Ordinary shares are better suited for:
 

• Suitable for investors who can stand the short-term market volatility and have a long-term horizon.
• Those seeking capital appreciation alongside dividend income.
• Investors who want a voice in company decisions through voting rights.
• Younger investors who build wealth over time through equity exposure.

Preference shares are better suited for:
 

• Investors looking for a regular and fixed income from the equity investment.
• Investors who have low-risk capacity but wish to take on equity exposure.
• Retirees or income-seeking investors that focus more on capital protection than growth.
• Investors wishing to gain priority protection in case of any liquidation of the firm.

To understand this choice more deeply, exploring the advantages and disadvantages of preference shares gives a clearer picture of when preference shares add real value to a portfolio and when ordinary shares might serve investors better.

Key Risks in Both Types of Shares in India

Understanding the types of shares in India also means understanding the risks each carries:

Risks with ordinary shares:

• The share price can fall sharply depending on market sentiment or company performance.
• Dividend payment is not certain and may even be completely skipped during losses.
• In liquidation, ordinary shareholders might get nothing at all if the liabilities exceed the assets.

Risks with preference shares:

• Fixed dividends mean no participation in a company's exceptional growth.
• Some preference shares (non-cumulative) do not carry forward unpaid dividends.
• Convertible preference shares carry conversion risk if the equity value falls before conversion.
• Illiquidity because preference shares are often less actively traded than ordinary shares on exchanges.

Conclusion

The difference between preference and ordinary shares ultimately comes down to a trade-off between certainty and growth. Ordinary shares offer voting rights, and full participation in a company's success, but with greater risk. Knowing which kind of share fits your investing style is an essential element of having a properly planned portfolio.