Preference share capital is money a company raises by selling preference shares. Preference shares are a type of stock that gives shareholders priority over common shareholders regarding dividends and company assets. Preference shares are a type of stock that provides shareholders with certain rights over common shareholders. They are also known as preferred stock. Investors looking for safe investments and priority dividend distributions consider these shares preference shares. These shares award a fixed dividend and ensure shareholders get payment before equity shareholders. However, preference shareholders generally do not get voting rights in company affairs. Companies issue preference shares to raise capital while not diluting ownership control.
Preference Share Capital Meaning
Preference shares are stocks whose shareholders have certain rights over common shareholders. Alternate names include preferred stock. Preference shareholders earn fixed dividends before common shareholders. However, unlike common shareholders, they generally possess no voting rights in company decisions. These shares thus give stable and predictable income, making them attractive to risk-averse investors. By issuing preference shares, a company aims to raise capital while affording certain benefits to its investor base and maintaining control of the company.
Features of Preference Share Capital
Of course, preference shares have distinctive qualities from equity shares.
- Fixed Dividend Rate: Preference shareholders receive fixed dividends, guaranteeing stable income.
- Priority in Dividend Distribution: Dividends are paid to preference shareholders in priority to equity shareholders from the corporation’s profits.
- Priority in Capital Repayment: In liquidation cases, repayment to preference shareholders takes precedence over equity shareholders.
- No Voting Rights: Preference shareholders are not entitled to vote; they remain passive investors.
- Convertible and Non-Convertible: While some preference shares can be converted into equity, some will remain preference shares for a lifetime.
- Redeemable and Irredeemable: Redeemable preference shares have a fixed maturity date, while irredeemable ones do not.
- Cumulative and Non-Cumulative: Cumulative preference shares allow missed dividends to be carried over later, while this does not apply to non-cumulative shares. Having understood some of the basic features, let us discuss the types of preference shares.
Types of Preference Share Capital
Companies issue different types of preference shares to conform to their financial needs and the preferences of investors. Each type has its peculiar characteristics.
Cumulative Preference Shares
Cumulative preference shares guarantee dividends to shareholders even if the company fails to pay them for that particular year. Any dividends that are not paid will accumulate and be paid subsequently when the company’s profits allow. This type of preference share is satisfactory for those investors seeking some assured returns over time.
An example is where a company cannot pay dividends for 2 years due to losses; the amount accumulates for unpaid dividends. The pending dividend will then be paid to preference shareholders before equity shareholders receive anything once the company becomes profitable.
Key Benefits
- Guarantee investors to have dividends paid on any future date.
- Stable and predictable returns to investors
- Good for risk-averse investors.
Disadvantages
- This is a huge financial burden on companies as it has to take unpaid dividends.
- Investors have to wait for the dividends until the company makes a profit.
Non-Cumulative Preference Shares
Non-cumulative preference shares do not carry forward unpaid dividends. If the company does not declare a dividend for a given year, no payment is granted to the shareholders for that year. The company is not obliged to pay dividends in the future that were missed.
A business issuing non-cumulative preference shares may declare that no dividends will be paid for that financial year, which means that the investors will not receive that income for the period even if the company has made profits in subsequent years.
Key Benefits
- Companies are relieved from paying cumulative dividends.
- Good for companies with irregular profits.
Drawbacks
- Investors lose out on dividends in case the company doesn’t declare them.
- Carries comparatively higher risk for investors compared to cumulative shares.
Redeemable Preference Shares
Redemption preference shares are shares with a set maturity date. The company promises to buy back the shares after a time. It is thus very similar to a debenture in that it offers fixed returns for a fixed term.
For example, a company may issue redeemable preference shares for 10 years. After 10 years, the company redeems those shares from investors.
Key Benefits
- Investors have some knowledge of when they will be receiving their capital back.
- Companies are relieved of the long-term financial burden.
Disadvantages
- The period of investment is very short.
- For redemption, companies must have enough funds in hand.
Irredeemable Preference Shares
Irredeemable preference shares do not mature on a specific date. These shares are active except when the company is dissolved or such shares are voluntarily bought back. Investors get dividends forever. For example, if a person has invested in irredeemable preference shares, he will continue with the dividends if the company is going well.
Key Benefits
- Source of long-term income to investors.
- There is no obligation for companies to redeem shares at a fixed date.
Disadvantages
- There’s no exit option for investors.
- Companies will be liable for dividends unknowingly forever.
Convertible Preference Shares
Convertible preference shares can be converted into equity shares after a period expires. This allows the investors to take advantage of the company’s growth. For instance, an investor with convertible preference shares may choose to convert them for equity shares when the stock value rises exceedingly.
Benefits
- Allows switching to ownership of equity, which fetches higher returns.
- Suitable for companies with high growth potential.
Drawbacks
- Stops fixed dividend payments after conversion.
- If equity value declines, the conversion can incur losses.
Non-convertible Preference Shares
Non-convertible preference shares are fixed along with income in regular dividends during the investment term. For instance, an investor who has invested in non-convertible preference shares will have fixed returns without affecting his income due to stock price fluctuation.
Advantages
- It just guarantees fixed returns.
- Required for the investment of those individuals who like security over growth.
Limitation
- Those investors will not be able to reap the benefits of business growth.
- Returns are nevertheless restricted to fixed dividend payments.
Participating Preference Shares
Invest participating preference shares, with the expectation of obtaining some additional dividend when the income for the company goes above certain levels. After it has received its fixed dividend, the participating preference shareholder may take a share of residual profits with equity shareholders. For example, if a company has high revenue, the participating preference shareholders may receive additional dividends in addition to their fixed returns.
Advantages
- Investors benefited from fixed dividends as well as additional dividends.
- Suitable joint ventures with high growth potential.
Drawbacks
- Additional dividends are given only to the performance of the company.
- Profit distribution is not under the control of investors.
Non-Participating Preference Shares
Only fixed dividends are received in the case of non-participating preference shares. Investors will not accept additional profit-sharing returns if a company has high revenues. For example, if a company goes through record profits, non-participating preference shareholders will still gain only their agreed-upon dividend.
Advantages
- It gives returns that are quite steady and predictable.
- Companies are not required to distribute excess profits.
Drawbacks
- Investors miss out on earnings entirely from profits that the company grows.
Perpetual Preference Shares
It is perpetual preference shares that have not defined maturity dates or maturity dates. They give fixed dividends for an indefinite period and are long-term investors. For instance, such an investor buying perpetual preference shares of a company will always receive dividends so long as the company functions.
Key Benefits
- Endless flow of fixed income.
- Suitable for people looking for long-term stability.
Drawbacks
- There is no exit way unless the company buys back shares.
Adjustable-Rate Preference Shares
The dividends are adjustable based on interest rates prevailing in the market. The dividend rate shall be revised occasionally based on economic conditions. For example, a rise in the economy would mean a rise in dividend payment of adjustable-rate preference shares. Key
Benefits
- Inflation protection to investors.
- Fair dividend payments depend on market conditions.
Drawbacks
- Uncertain dividend payments.
- Risk return would be lower with the reduction of interest rates.
Advantages of Preference Share Capital
Preference shares offer a lot of good advantages to both investors and companies. These features attract people looking for a stable, predictable return.
- Fixed Income to Investors: These dividends are fixed in nature and will, therefore, give an investor a steady source of income, regardless of how the company does overall.
- Lower Investment Risk: Preference shares are safer than equity shares because they have a priority in dividend payments and capital repayments.
- Equitable Convertible Option: In Growth, Convertible preference shares give one the ability to turn into equity to profit from this growth in the company.
- No voting rights: Reduce conflicts over management. Being without voting rights prevents interference in the management of the company.
- Flexible Financing for Companies: Thus, raising funds will not add to the building of debt for companies. However, preference shares, despite advantages, have some disadvantages. Let us discuss all those now.
Disadvantages of Preference Share Capital
Though preference shares confer some advantages, they also carry some limitations, which an investor must carefully view.
- Limited Profit Potential: Fixation of dividends renders preference shareholders deprived of the company’s extra profits.
- No Voting Rights: Entitlement to Investors Preference shares do not have voting rights; thus, they may be unappealing for investors seeking to influence ownership.
- Higher Cost for Companies: Preference shares carry an obligation of fixed dividends to be paid, thus making these a costly source of finance to companies, especially during the financial slump.
- Limited Market Liquidity: Preference shares will hardly be traded compared to equity shares, making them harder to sell in the secondary market. Despite such drawbacks, preference shares remain a good channel of investment.
Preference Share Capital FAQs
1. What are the rights of the preference shareholders?
The rights of preference shareholders comprise the right to receive fixed dividends before equity shareholders and the right to claim their capital before equity shareholders in case of liquidation.
2. What role do preference shares play under the company law?
Under company law, preference shares constitute a part of a company’s capital structure. They enable raising funds for the company without giving preference shareholders control, as they do not have voting rights.
3. What are the differences between redeemable and irredeemable preference shares?
Redeemable preference shares have a specific maturity date for repayment, while irredeemable preference shares exist until the dissolution of the company.
4. Are preference shares good investments?
Preference shares are good for those who want steady returns and relatively low risk. They have fixed dividends and a higher ranking in liquidation.
5. What is meant by cumulative preference shares?
These are cumulative preference shares whereby unpaid dividends are accumulated for payment at a later date, thus ensuring that shareholders will receive their expected return over time.
