What are Preference Shares?
Preference shares form a part of the share capital, but their holders do not possess the same status as ordinary shareholders. Though in theory both ordinary and preference shareholders are owners of the company, preference shareholders cannot claim to be the ‘real’ owners. The following features of preference shares will demonstrate the extent of their right to the company’s ownership:
(a) They usually do not have any voting power. This effectively eliminates any possibility of this class of shareholders influencing the policy-making process of the company.
(b) Their claim on the company’s profits comes before ordinary shareholders’ claim, but it is restricted to a pre-determined maximum. This maximum is stated by way of a percentage of the nominal value. Thus a 7% preference share will be paid 7% of its nominal value as dividend before any dividend is paid to ordinary shareholders. However, even if the company records a bumper profit the rate of dividend payable on preference shares will remain 7%. At the same time, if the profits are low, it is quite possible that the ordinary shares may be paid less than 7% or even a nil dividend while preference shareholders still get their 7% dividend. Hence, preference shareholders do not carry the same degree of risk as do ordinary shareholders.
(c) Their claim on the company’s properties comes after outsiders but before the ordinary shareholders. In the event of a company’s liquidation, first, the outside creditors are paid their dues in full. If some assets still remain, the proceeds of these assets are used to refund the capital to the preference shareholders; but only to the extent of the par value of their shares. Whatever assets remain after preference shareholders have been paid, all belong to the ordinary shareholders.
Types of Preference Shares
Preference Shares may be classified in various manners as follows:
(a) Classified according to redemption, there may be Redeemable or Irredeemable preference shares. A redeemable preference share can be bought back by the issuing company after a specified minimum and before a specified maximum period. The two periods are stated at the time of the issue. Thus a 5-7-year preference share will be redeemed, at the company’s discretion, after five years of its issue and before the expiry of seven years.
If these shares are not redeemed after seven years, the preference shareholders attain the status of creditors and can then sue the company for the recovery of their investment. An irredeemable preference share is never redeemed during the lifetime of the company, its principal is returned to the shareholder only when the company is liquidated. These shares are however transferable and can be sold to anybody else, except the issuing company, should the shareholder wish to convert it into cash.
(b) Classified according to payment of dividends, there may be Accumulative or Non-accumulative preference shares. An accumulative preference share gets dividend for every year, but if a dividend is not declared for a particular year, it is accumulated till the date it is finally paid. Thus if a company fails to declare a dividend for three years in a row but declares it for the fourth year, a 7% accumulative preference share will be paid 28% dividend (i.e. dividend for four years) before any can be paid to the ordinary shares. A non-accumulative preference share gets dividend only for the year for which it is declared. Thus if a company failed to declare any dividends for three years and declared it in the fourth year, a 7% preference share gets only 7% dividend, foregoing the dividend for the three years.
(c) Classified according to participation in profits beyond the specified maximum, there can be participating or Non-participating preference shares. A participating preference share may get something in addition to the stated maximum if the company records very high profits and the ordinary shareholders have been adequately rewarded. A non-participating preference share gets nothing more than the specified maximum rate of dividend regardless of the volume of profit made by the company in any years.
(d) Classified according to the right to convert, there can be Convertible or Nonconvertible preference shares. A convertible preference share has a right to be converted into ordinary shares after a certain period of issue. The terms and conditions under which the conversion will take place are made known at the time of the issue. A non-convertible preference share remains a preference share forever – it does not have a right”‘of conversion into any other type of shares.
(e) Unless specified otherwise, a preference share is taken to be accumulative, non-participating, irredeemable and non-convertible. Thus if the Balance Sheet of a company simply says 9% preference shares, the students are advised to treat these shares as accumulative, non-participating, irredeemable and non-convertible.
Comparison of Preference Shares to Debentures
Preference shares and Debentures often appear similar to students. Indeed, in certain respects, they are quite similar. Some of their similarities are as follows:
(a) Both carry a fixed rate of return. Except for participating preference shares, all preference shares and debentures carry a fixed rate of dividend, or interest, which is determined at the time of issue and beyond which they cannot get any pan of the company’s income.
(b) Both have a claim on the company’s profits and properties ahead of ordinary shareholders. However, between preference shares and debentures, debenture holders have precedence over preference shareholders.
(c) Neither has voting power. Only ordinary shareholders have voting rights.
(d) Often both are redeemable.
(e) Both have the accumulative right of return.
The two instruments of raising capital, namely preference shares and debentures, are different from each other in the following respects:
(a) Preference shareholders are owners of the company while debenture holders are creditors.
(b) Preference shareholders are paid a dividend which depends on the availability of profits while debenture holders are paid interest, which is payable regardless of the volume of profit or loss made by the company.
(c) Debenture holders claim on the company’s properties comes before the claim of preference shareholders.
(d) Usually, debentures are redeemable and preference share are irredeemable
(e) Certain preference shares may participate in profits beyond their guaranteed minimum while a debenture holder can never expect to be paid more than the agreed interest rate.