What Are Preference Shares & How Preference Shares Work?

An equity share represents the unit of ownership in a company. The price of the shares is determined by the market forces of demand and supply. There are two types of shares issued by companies in the stock market. These are equity shares and preference shares.

Preference shares are a type of security that give investors certain rights over ordinary shareholders. Let us discuss what are preference shares and the types of preference shares.

What are Preference Shares?

Preference shares are types of shares that have preferential rights over ordinary shares. They provide shareholders with an opportunity to receive a fixed rate of return. They act as hybrid instruments offering the benefits of both equity shares and fixed income securities.

Also known as preferred stock, preference shares provide investors with a fixed rate of dividend. They also get priority over common shareholders in receiving dividend payouts as well as receiving their share of assets in the event of liquidation.

However, preference shareholders do not have voting rights in the company. Although some companies may offer voting rights. Preference shares can also be convertible into equity shares or redeemable after a specific period of time, depending upon the terms of their issue.

What are the Features of Preference Shares?

To make it easier for you to get a full understanding of preference shares, here are a few salient features of the same:

• Shareholders with preference shares have a preferential right over the company’s assets.

• Preference shareholders receive dividends before the ordinary shareholders. The rate of dividend on preference shares is also fixed and pre-decided.

• In the event of liquidation of the company, the preference shareholders have the right to receive their share in assets before the ordinary shareholders are paid off.

• Preference shares can also be redeemed after their maturity period.

• You can convert preference shares to equity shares if the preference shares are convertible.

• Certain preference shares also allow you to earn cumulative arrears or dividends.

• Preference shares do not carry voting rights.

• You can invest in preference shares for a medium to longer term and enjoy lower risks when compared to equity shares.

What are the types of Preference Shares?

The different types of preference shares are as follows:

Cumulative Preference Shares: These kinds of preference shares allow investors to receive dividend payouts in arrears. Sometimes, the company may not be able to pay dividends as it could not earn profit. In such cases, the company can decide to pay cumulative dividends in the next year or whenever it turns profitable. Do note that the payouts to preference shareholders are to be given out before those are handed out to common shareholders. Preference shares can also receive interest on the dividend arrears.

Non-Cumulative Preference Shares: These shares are given dividends only from the current year’s profits. The company does not issue unpaid dividends to such shareholders. The Non-Cumulative Preference shareholders cannot claim unpaid dividends.

Participating Preference Shares: These shares come with a right to be paid surplus dividend, over and above the generally specified rate of preferred dividends, based on a predetermined condition.

Moreover, at the time of the liquidation of the company, participating preferred shareholders also have the right to the surplus assets of the company.

Non-Participating Preference Shares: These shares have the right to only receive pre-determined dividends at the fixed rate and nothing from surplus profits.

Redeemable Preference Shares: These shares can be redeemed or bought back by the company from the shareholders at a fixed date.

Non-Redeemable Preference Shares: These types of preference shares cannot be redeemed by the company during its lifetime. They can only be redeemed when the company liquidates.

Convertible Preference Shares: These kinds of preference shares come with an option to be converted into common equity shares. However, this can only be done after a certain period.

Non-Convertible Shares: These kinds of shares do not come with a right to be converted into equity shares.

Conclusion

Preference shares are useful avenues for investors as they allow them to earn fixed dividend income but with a lower degree of risk than ordinary shares. It is also important to understand the terms of the investment and the potential risks and rewards associated with the preference shares. Ultimately, the decision to invest in preference shares should be based on careful consideration of the individual investor’s risk tolerance and multiple other factors.