A Comprehensive Guide to Preference Shares
Companies release preferred shares or stocks to raise capital. Preferred shares or stocks have the characteristics of debt and equity investments. They're considered hybrid securities that allow shareholders to receive dividends before equity shareholders.
When a company faces financial challenges like a loss or winding up, the first payments are made to preferred shares.
Preference shares (preferred stocks) are distinct from ordinary shares in several aspects, like dividend payments and voting rights. They have unique features that favour shareholders and companies more than ordinary shares.
Features of Preference Shares
Preference shares' prefs' offer multiple preferential rights to their shareholders instead of holders of ordinary shares. The two preferential rights consist of:
- Preferential dividend payments
- Preferential return of capital
- Voting rights
Preferential Shares Dividend Payment
Preference shares are unique in many ways, but what stands out most is that they have a fixed dividend rate, which is paid out before any other shares. Preference shares take precedence over ordinary and other share classes in dividend payments. Thus, preference shares have higher security for shareholders in return on investment (ROI).
The remaining profit is then shared as dividends with other shareholders. It's important to note that preference shares don't guarantee their holders a dividend if the company doesn't have enough profits. But they're first in line when there are profits during the financial period.
Preferential shares have a flip side whereby the holders aren't considered for excess profits even when a company makes healthy profits. WHY? Because preferential shares are paid at a fixed dividend rate. On the other hand, holders of ordinary shares can enjoy higher dividend payments when the company is doing well.
Preferential Return of Capital
Another feature that makes preference shares is the return on capital. Prefs stand out when a company is winding up as the holders are entitled to receive repayment of their capital contribution before ordinary shareholders.
As a result, preference shareholders have adequate security even when a company faces financial difficulty. Priority is granted to creditors, who include holders of preferential shares.
In the same way, prefs don't guarantee dividend payments to shareholders; there's also no guarantee that their capital will be retrieved from a company when matters go south.
Voting Rights of Preferential Shareholders
One downside of preferential shareholders is that they’re not guaranteed voting rights. This sets them apart from holders of ordinary shares, who are typically entitled to vote on company decisions.
Types of Preferential Shares
There are various classes of preferential shares and they’re all unique. Here’s a detailed look into each class:
1. Cumulative
Cumulative prefs are attractive for startup investors looking for a predictable income source. WHY? Cumulative preferential shares allow dividends to accumulate and are paid to the holders when the startup can afford them. The investment is particularly suitable for investors looking for a stable income stream from their investment.
2. Non-cumulative
These preferred shares are helpful for startups that become profitable only over time and may not be able to pay dividends in the short term. Non-cumulative preferred shares are more flexible for startups since they aren't required to pay back missed dividends.
3. Convertible
Convertible preference shares offer holders an opportunity to convert to ordinary shares. The conversion can be set for a specific period or fall on a particular date in the future. The main benefit of convertible shares is overcoming the fixed dividend rate.
Unlike ordinary shares, whose dividend rate varies depending on profits, non-convertible preference shares may receive fewer dividends due to fixed rates.
4. Redeemable
Shareholders can't demand a refund of investment in shares from a company. The shares have no automatic refund policy unless a company enters dissolution.
Likewise, the issuing company can't forcibly buy back shares from shareholders. However, a company can issue redeemable shares, which makes it easy for shareholders to return the shares and redeem them at their initial value.
Since preference shares are purely an investment vehicle, making them redeemable is attractive to investors. These shares are also helpful to a company that plans to buy back its shares.
5. Participating
Startup investors willing to take more risk and prospective higher returns can go for participating preferred shares. These shares offer investors a fixed dividend and a share of any additional dividends paid to other shareholders, which is a good incentive.
6. Adjustable-rate
Investors looking for a more predictable income source will find these shares attractive. Their dividend rate is fixed to an arranged benchmark or interest rate.
7. Floating-rate
Startups use floating shares to offer investors an adjustable dividend rate over time based on changes in a benchmark interest rate. Investors are attracted to these shares because they provide a potential rise in income if interest rates increase in the future.
8. Perpetual
Perpetual shares have no maturity date, and shareholders receive dividends indefinitely. Startups offer this opportunity to investors looking for a steady, long-term income source.
Advantages of Preference Shares
Preferential shares offer investors many advantages, which makes them popular. As such, startups should understand the motivation and leverage demand.
1. Higher dividends Than Ordinary Shares
Preferential shareholders are prioritised over ordinary shareholders in dividend payments. This means that when a company pays dividends, preferential shareholders receive their dividends before any other shareholder. The dividend rate is higher than ordinary shares, offering investors a reliable and stable income source.
2. Lower Risk Level
Preferential shareholders have priority in the event of dissolution and dividend payment. They are paid first if a company is winding up or sold. Unlike common shareholders, preferential shareholders are more likely to get back their investment if a company is unable to settle all its obligations.
3. Investment Flexibility
Preferential shares have flexible terms and conditions. The investment allows investors to choose the type of preferential shares suitable for them based on objectives and risk tolerance. For instance, cumulative preference shares accumulate unpaid dividends, while perpetual prefs pay dividends indefinitely.
Disadvantages of Preference Shares
Preferential shareholders have no voting rights like common shareholders, which means the company isn't beholden to them like the typical equity shareholders. Although preferential shareholders have a guarantee on the return on investment, the dividends are paid at a fixed interest rate even when profits rise.
What Startups Should Know About Preference Shares
Startups should know that all shares are not equal, and investors will often go for preferential shares because they're low risk, hence protecting their investment. Thus, before issuing shares or negotiating with investors, they should understand the following:
1. Terms and Conditions
Please review the terms of any preferential shares carefully before issuing them. They vary significantly depending on the issuer's goals and the market trends at the time of issue.
2. Ownership and Control
Issuing preferred shares dilutes the ownership and control of other shareholders, including company founders. Therefore, it's essential to consider this twist before issuing preferred shares.
3. Rights and Restrictions
The rights and regulations associated with preferential shares can impact a company's future. For instance, some preferential shares may restrict how a company uses the proceeds unless it meets specific financial performance targets.
4. Long-term Plan
Think about the long-term effects of issuing preference shares to the company. Although preference shares are an effective way to raise capital, they create a long-term obligation that must be fulfilled for an extended period. Consider whether you'll be able to pay dividends over a long period and the effects it may have on your financial performance.
5. Future Funding
Issuing preference shares can limit a company's capital raise in future funding rounds and cause conflicts when investors seek different terms.
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Frequently Asked Questions
How do preference shares work?
Preference shares or preferred stock are company stocks that pay dividends to holders. The dividends of preference shares are paid before those of common stock at a fixed rate.
How can I evaluate preference shares?
You can evaluate preference shares by calculating them as a fraction of dividends and the discount rate. However, the result can vary depending on characteristics like callables.
How can I classify preference shares, namely, debenture or equity?
Preference shares are classified as equity, giving owners preferential rights in dividend payment or company dissolution. A debenture is a debt security issued by a corporation or government without asset security.
Can I convert preference shares into equity?
You can convert preference shares into equity before the company shares are listed on the stock exchange. The board must convene a meeting to pass a resolution for converting preference shares into company equity shares.
How do I treat preference shares in accounting?
Since preference shares pay dividends at a fixed rate, you should treat them as a liability in accounting. The company has a mandate to pay dividends and offer redemption features in the future.
In Summary
Generally, investors view preference shares as a safer investment vehicle than ordinary shares. With that in mind, companies seeking new investors can decide to offer them as an alternative to a business loan.
In effect, issuing preference shares is like a loan arrangement where capital is released into a company at a fixed interest rate (dividends). Moreover, preference shares don't come with voting rights, meaning the dilution of their voting rights. Thus, the existing shareholders aren't threatened by the company's control being handed over to the new investors.
Preference shares aren't a form of debt and don't create a creditor-debtor relationship. Pref shareholders may not receive regular dividend payments if the company doesn't make a profit. Thus, preference shareholders' investment is at higher risk than creditors who receive their payments regularly regardless of whether the company is making a profit. You can contact our Incorpuk expert here if you have more questions about preference shares