Preference shares, also known as ‘preferred stock’, are shares that are given priority as to dividends, capital, or both. However, they often carry little to no voting rights.
They usually have a fixed rate of income and are therefore less impacted when a company has a difficult financial season. This usually makes them a more secure form of investment.
The exact terms of the preference shares of any company are set out in the articles of association.
The Three Distinct Features of Preference Shares
Companies can allocate multiple types of share classes. Ordinary shares are the most common type of shares. However, companies can also allocate non-voting shares, redeemable shares, and preference shares.
Today we’ll focus on preference shares. Preference shares have three distinct features:
- A preferential right to dividends – They have a fixed rate of dividend that is paid out before any other kind of share – hence why they are called preference shares. Any remaining surplus of the dividend is shared between the owners of ordinary shares after the preference shareholders have been paid their fixed rate.
It should be noted that if there hasn’t been sufficient profit for distribution as a dividend, then the preferred shares can’t and won’t be paid in full; despite being first in line if there are enough profits in the relevant financial period.
Dividends are usually paid twice a year.
- Return of Capital Contribution – If the company is wound up, then holders of preference shares qualify to receive their capital contribution before ordinary shareholders.
Despite this, creditors are repaid their capital contribution even before holders of preference shares.
- Lack of Voting Rights – Preference shares usually hold no automatic voting rights. This is unlike most ordinary shares.
Above you can see the features that differentiate preference shares from ordinary shares. As you can expect, they also share many of the same features as ordinary shares, such as:
- They are perpetual shares. This means that there is often no obligation for the company to repay the sum invested during the company’s lifespan. Only once it is wound up does the company have an obligation to repay the capital contribution of the shareholders.
- Like other categories of share, the shares are allotted then transferred from one shareholder to another.
- Dividends can only be paid if there has been a profit.
- The company directors can decide not to pay the dividend to shareholders, rather reinvesting the profits directly back into the business.
Subcategories of Preference Share
There are multiple features that can be added to preference shares. The features can be added both singly and in combination with a company’s preference shares. Below we cover some of the most common additions. However, the exact arrangement of a company’s preference shares will be written in the articles of association.
- Cumulative Preference Shares – These take into account poor financial periods. When a fixed rate of dividend is not paid in full, the loss on that financial period is made up for in future dividend payments where the financial period has been more profitable.
Preference shares are always cumulative unless stated otherwise in the articles of association.
- Convertible Preference Shares – This type of preference share is able to change into a set number of ordinary shares, at a particular future date or within a specified period. This is beneficial to shareholders of an increasingly profitable company as they are given access to the increasing value of ordinary shares – if it is at a time where the preference shareholder can convert his shares.
Preference shares are never convertible unless stated otherwise in the articles of association.
- Redeemable Preference Shares – If the shareholder of redeemable shares leaves the company, then the company can buy back these shares. This will usually be after a defined period has elapsed, on or between certain dates, or otherwise at the directors’ discretion after having given notice to shareholders. The precise terms of redemption are written at the time the shares are issued, in the articles of association.
The Companies act of 2006 places numerous restrictions on how capital can be returned to the original shareholders.
Preference shares are never redeemable unless stated otherwise in the articles of association.
- Participating Preference Shares – A company has the option to allow preference shareholders to participate along with ordinary shareholders on the surplus of dividends in any given financial season. Usually, preference shareholders are only allowed to participate once ordinary shareholders receive dividends above a certain level.
Occasionally these shares may also have the ability to share in any surplus assets if the company is liquidated. Again, the articles of association will state if this applied and what ratio of assets is to be shared between ordinary and preference shareholders.
Preference shares are never participating unless stated otherwise in the articles of association.
- Adjustable Rate Preference Shares – Rather than being a fixed rate of return, these preference shares float. A reason for having these adjustable shares is that the rate of return may be linked to a prevailing interest rate.
The Advantages of Preference Shares
- Preference shares usually give a higher degree of safety to investors therefore making risk averse investors more likely to invest.
- Initially, preference shares will likely have a higher profit than ordinary shares. Therefore preference shares will likely be useful to investors looking for a high level of income. This is supported by the safety of the shares which protect the rate of return of the investor (unless there is a lack of profits to pay the dividend).
- They are more likely to allow their shareholders a return of investment and the ability to recoup any losses if the company gets into financial trouble.
- Investors are returned their capital investment before any other shareholders if the company is wound up.
- With multiple sub-categories of preference share, these shares are advantageous to both the company and the investor who can tailor the shares to suit both their needs.
The Disadvantages of Preference Shares
- When there are high dividend profits, the holders of preference shares will not reap the benefits of this high financial period.
- Similarly, they will potentially receive a much lower dividend payment than ordinary shareholders. In fact, due to the lack of risk, an investor should often expect lower returns.
- Holders of preference shares will not be able to share in higher dividends when the business has a successful financial season.
- There is a small market for preference shares and this could make them harder to sell.
- Preference shares can not be used for Seed/Enterprise Investment Schemes ((S)EIS).
- Although preference shares offer great adaptability, this can often be difficult for a company to manage from the administrative side. The articles of association will need to be fully updated and sufficiently studied so that both the corporation and the investors know the exact nature of their shares.
Why should a company Issue Preference Shares?
One reason for issuing preference shares is to attract investment from more cautious investors.
This is why some investors and shareholders see this type of share as an alternative to a loan arrangement: there is a fixed rate of return for the shareholder. However, there is no debt involved and cannot be classed as a creditor relationship.
Preference shares may attract investment without giving up control of the company. Preference shares don’t automatically give voting rights to its shareholders, therefore, allowing the holders of ordinary shares to retain their impact on the company.
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