Definition:
Preference shares, also known as preferred stock, are preferred over ordinary or common shares. This preference is given when a company pays dividends.
Preference shares are also preferred to common shares when a company is liquidated, but a company’s liquidation occurs in rare cases.
The majority of preference shares also have a pre-determined amount of dividends. Even if common shareholders are not given dividends, preference shareholders with a fixed dividend are paid.
While preferred shares are given preference, they don’t come with voting rights. This makes them a great tool for companies that want to raise finance without diluting their voting rights.
As opposed to debt finance, a company does not have any obligations to pay dividends to preference shareholders when it does not have any earnings, and it does not have to provide any security to obtain preferred equity.
In addition, companies also have flexibility with the types of preference shares they can issue.
For investors, preference shares provide them with security. As mentioned above, in the case of the company’s liquidation, preferred shareholders are paid off first before paying off common shareholders.
Risk-averse investors prefer the security that comes with preference shares.
Preference shares also come with some disadvantages for both companies and investors. For companies, preferred stockholders with a fixed dividend rate obligation must be paid dividends regardless of whether the company opts to pay dividends or not.
This can affect a company adversely in times of a business downturn. These dividends become similar to interest payments, though, they do not come with the tax deductions advantage that interest payments are due.
For investors, preference shares do not offer any voting rights. This means if the company opts to go forward with a decision that is not in favor of preference shareholders, the investors cannot interject.
Preferred stock with fixed dividends can favor investors when the company’s earnings are down. Still, when the company earnings go up, common equity holders may get more dividends than the fixed dividends preference shareholders.
Finally, while the preference shares are a lower risk as compared to common equity shares, there are lower-risk instruments that investors can opt for such as treasury bonds.
Types of Preference Shares
There are 4 main types of preference shares or 4 main categories. These are callable preferred stocks, convertible preferred stocks, cumulative preference stocks, and participating preference stocks.
1) Callable Preferred Stocks
Callable preferred stocks are also known as redeemable preference stocks. Callable preferred stocks are the type of preference shares in which the issuing company has the option to call in or redeem the stock on its maturity at a pre-determined price.
The price and premium, maturity dates, and other terms of the stock are agreed upon with the investors before the sale of the stock. Once the terms are agreed on, these terms cannot be changed.
Callable preferred stocks are the most popular type of preferred stocks and are widely traded. Preferred stocks give the issuing company a great advantage as it allows the company to buy back the preferred stock if the preferred stock price is higher in the stock market.
While the issuing company has the upper hand regarding callable preference shares, investors can also benefit from them.
Generally, companies purchase back their preferred stock at the original price plus an extra called premium. This compensates the investors for their risk in the preferred stock.
2) Retractable Preferred Stocks
Retractable preference shares are the opposite of callable preference shares. Retractable preference shares give the buyer of the stock the option to sell the shares to the issuer if they wish to.
The issuing company does not get the option to choose with retractable preferred stock.
3) Convertible Preferred Stocks
The convertible preferred stock allows the buyer to convert the preferred stock to common shares on maturity.
However, the issuing company might impose terms to allow it to force the conversion. The conversion is done based on a fixed pre-determined ratio. These terms are agreed upon before the time of sale.
On the maturity date, investors can look into the price of a common share of the company. If the price of the common share of the company exceeds the price of the preferred stock, investors will opt to convert their preferred stock.
If the price of preferred stock is higher than the price of the common share, investors will look to not convert their stock.
Convertible preferred stocks generally come with a predetermined conversion rate. For example, if a preferred stock offers a conversion ratio of 4 for $100, it means that for every $100 worth of preferred share, the investor has the option to convert it to 4 shares.
So, investors will want to determine if the price of each common share exceeds $25 ($100/4) to make a profit.
4) Cumulative Preferred Stock
Cumulative preferred stocks do not stipulate the option to redeem or convert.
Instead, cumulative preferred stocks come with a fixed dividend for preference shareholders and have a term that dictates that in case the company cannot pay these fixed dividends and any dividend to its equity holders, the company must pay the cumulative dividends to the cumulative preferred stockholders before paying any dividends to common stockholders.
For example, a cumulative preferred stock may come with a fixed dividend rate of $20 per annum. Suppose the company fails to pay dividends to its equity holders for 2 years.
In that case, the company must pay $60 to the preferred stockholder in the 3rd year ($20 x 2 years unpaid + $20 for 3rd year) to the cumulative preferred stockholders before making any payment to common equity holders.
For the issuing company, it provides the advantage of not having to pay dividends to the preferred stockholders during a downturn.
For investors, on the other hand, cumulative preferred stocks ensure they ultimately receive their dividends first.
This helps lower the risk of investment and makes the investment attractive, especially for risk-averse investors.
5) Participating in Preferred Stock
Participating in preferred stock gives investors the benefit of a profit guarantee and a fixed dividend rate.
This means that participating preferred stockholders not only get their fixed rate of dividend but also participate in the company’s profits.
However, the portion of the profit available to participating preferred stockholders depends on whether the dividend received by common stockholders exceeds a certain, pre-determined limit.
Participating preference shares are very rare in the market and are issued by companies only in times of necessity.
These are often issued when the company foresees a hostile takeover and wants to discourage it.
Participating in preference shares is seen as a last effort to save the company from a hostile takeover as they are more disadvantageous, in terms of dividends paid, to a company.
A company in a normal situation would not issue participating preferred stocks.
For investors, participating in preferred stocks are the best option. Not only do they get their fixed dividend rate but also a percentage of the profit.
Furthermore, if the company gets liquidated, the participating preferred stockholders get their original consideration for the participating preferred stock back and a portion of the remaining value of the company after all its liabilities have been paid off.
Conclusion
Preference shares are shares that are preferred over common equity shares of a company.
Preference shares provide both the company issuing them and the investors buying them with advantages and disadvantages. There are 4 preference shares, each of which differs from the other.
