What are Preference Shares?
Preference shares form part of the share capital, but their holders do not possess the same status as ordinary shareholders. Although ordinary and preference shareholders theoretically own the company, preference shareholders cannot claim to be the ‘real’ owners.
The following features of preference shares will demonstrate the extent of such shareholders’ rights to company ownership:
(1) They usually do not have any voting power. This effectively eliminates any possibility of this class of shareholder influencing the policy-making process.
(2) Their claims on the company’s profits come before ordinary shareholders’ claims, but it is restricted to a predetermined maximum. This maximum is stated by way of a percentage of the nominal value.
Thus, a 7% preference share will be paid 7% of its nominal value as a dividend before any dividend is paid to ordinary shareholders. However, even if the company records a bumper profit, the rate of dividend payable on preference shares will remain at 7%.
If the profits are low, the ordinary shares may be less than 7% or even a nil dividend, while preference shareholders still receive their 7% dividend. Hence, preference shareholders do not carry the same degree of risk as ordinary shareholders.
(3) Their claim on the company’s properties comes after outsiders but before the ordinary shareholders.
In the event of a company’s liquidation, first, the outside creditors are paid their dues in full. If any assets remain, their proceeds refund the capital to the preferred shareholders; but only to the extent of the par value of their shares.
The assets that are left over after preference shareholders have been paid belong to the ordinary shareholders.
Types of Preference Shares
Preference shares may be classified as follows:
According to Redemption
This means that there may be redeemable or irredeemable preference shares. A redeemable preference share can be bought back by the issuing company after a specified minimum period and before a specified maximum period.
The two periods are stated at the time of issue. Thus, a 5-7-year preference share will be redeemed, at the company’s discretion, after five years of its issue and before the expiry of seven years.
If these shares are not redeemed after seven years, the preferred shareholders attain the status of creditors and can sue the company to recover their investment.
An irredeemable preference share is never redeemed during the lifetime of the company: its principal is returned to the shareholder only when the company is liquidated.
However, these shares are transferable and can be sold to anybody else, except the issuing company, should the shareholder wish to convert them into cash.
According to Payment of Dividends
This means that there may be cumulative or non-cumulative preference shares. A cumulative preference share receives a yearly dividend, but if a dividend is not declared for a particular year, it is accumulated until it is finally paid.
Thus, if a company fails to declare a dividend for three years in a row but declares it for the fourth year, a 7% accumulative preference share will be paid a 28% dividend (i.e., the dividend for four years) before any can be paid to the ordinary shares.
Non-cumulative preference shares receive dividends only for the year of declaration.
Thus, if a company failed to declare any dividends for three years but declares it in the fourth year, a 7% preference share receives only a 7% dividend, foregoing the dividend for the three years.
According to Participation in Profits Beyond the Specified Maximum
This means that there can be participating or non-participating preference shares.
A participating preference share may receive something in addition to the stated maximum if the company records high profits and the ordinary shareholders have been adequately rewarded.
A non-participating preference share receives nothing more than the specified maximum rate of dividend regardless of the volume of profit made by the company in any year.
According to the Right to Convert
This means that there can be convertible or non-convertible preference shares. A convertible preference share has a right to be converted into ordinary shares after a certain period of issue.
The terms and conditions under which the conversion takes place are clarified at the time of issue. A non-convertible preference share remains a preference share forever and does not have a right of conversion into any other type of share.
Unless specified otherwise, a preference share is taken to be cumulative, non-participating, irredeemable, and non-convertible.
Thus, if the balance sheet of a company simply says 9% preference shares, the students are advised to treat these shares as cumulative, non-participating, irredeemable, and non-convertible.
Comparison of Preference Shares to Debentures
Preference shares and debentures often appear similar to students. For example:
(a) Both carry a fixed rate of return. Except for participating preference shares, all preference shares and debentures carry a fixed rate of dividend or interest determined at the time of issue and beyond which they cannot get any part of the company’s income.
(b) Both have a claim on the company’s profits and properties ahead of ordinary shareholders. However, debenture holders have precedence over preference shareholders.
(c) Neither has voting power. Only ordinary shareholders have voting rights.
(d) Both are often redeemable.
(e) Both have the accumulative right of return.
These two instruments of raising capital – namely, preference shares and debentures – differ from each other in the following respects:
(a) Preference shareholders own the company while debenture holders are creditors.
(b) Preference shareholders receive a dividend which depends on the availability of profits, while debenture holders receive interest, which is payable regardless of the volume of profit or loss made by the company.
(c) Debenture holders’ claims on the company’s properties come before those of preference shareholders.
(d) Usually, debentures are redeemable, and preference shares are irredeemable.
(e) Certain preference shares may participate in profits beyond their guaranteed minimum, while a debenture holder can never expect to receive more than the agreed interest rate.