What are Preference Shares?
Preference Shares are shares that are issued by the company to the general public, as a token of ownership in the company, against a certain price.
In this regard, it can be seen that preference shares entitle the shareholder to a fixed dividend payment.
When the company issues shares, there are two main categories of shares, preference shares and common shares.
As far as common shares are concerned, they do not necessarily receive dividends every year, and when they do, their dividend yield is variable.
However, in the case of preference shares, the dividend yield is constant regardless of the profits that the company pays.
Preference shareholders do not have any voting rights in the company, and therefore, they do not have a say in how the company runs.
Regardless of their inability to vote, preference shareholders are still entitled to get their share price back, before the common shareholders, in the case of liquidation.
This means that their investment is supposed to be repaid on a high priority basis.
Preference Shares are issued at a par value, based on which yearly dividends are calculated. Once purchased, they can be traded with other investors on the stock exchange, in the case of a publicly listed company.
Advantages of Preference Shares
Preference Shares are considered to be widely popular sources of finance for companies, as well as investors. Some of the advantages of preference shares are enlisted below:
- Preference Shares are considered to be a very resourceful source of finance for the company. This is primarily because of the fact that issuing preference shares is easy, in the case where the company has undergone an IPO and has Authorized Share Capital.
- The amount that is raised by selling preference shares does not have to be repaid back by the company. This means that the principal that is raised by the company as a result of selling preference share can be considered to be a long-term investment, which does not need to be paid back at a later date.
- Preference Shareholders are entitled to a fixed quarterly (or yearly) return. This means that companies know exactly what amount they need to pay out as dividends. It tends to be more convenient for the investor, as well as the issuer since both parties know the dividend they are entitled to.
- Issuing preference shares does not affect the decision-making ownership structure of the company. Since Preference Shares do not have voting rights, they do not have control over the operational affairs in the company. Hence, it acts as an incentive for the common shareholders, because they still hold the voting rights.
- Since preference shareholders get the first claim upon liquidation (prior to common shareholders), and they have a fixed return, they are considered to be more popular amongst investors. Investors prefer investing because it is considered to be a low-risk investment.
- Depending on the long-term strategic positioning of the company, preference shares can be aligned to meet the long-term objectives. In the case where the company wants to raise finance for a shorter time period, they can move forward and issue redeemable (or Callable) preference shares. Therefore, it offers much-needed flexibility for companies.
Disadvantages of Preference Shares
Despite the fact that preference shares are considered to be highly popular, yet it can be seen that it has a number of disadvantages from the perspective of the issuing company. These disadvantages are as follows:
- Preference Shares tend to incur a fixed dividend every year. This dividend needs to be paid to the shareholders, regardless of the volume of profit that the company has generated in the given year.
- Preference Shares prove to be costly in the longer term. This is because the dividend charge is higher than the rate of interest that is charged on long-term investment instruments, like debentures.
- Only public limited companies can sell shares to the general public on the stock exchange. Therefore, this option is only available to medium and large organizations that are formally listed on the Stock Exchange.
- In the case of cumulative preference shares (which are the most commonly used preference shares), if the company is unable to pay dividends for one particular year, the dividend accumulates and is carried forward to the next year. Therefore, this means that it might be a burden for the company to settle the dividend payments in the years where they were not able to make substantial profits.
- Preference Shareholders need to be paid on a high priority basis (before common shareholders) in the case of liquidation.