Preference Shares and its Different Types
Published by Sharekhan Education | May 16, 2020
Preference Shares and its Different Types
A preference share is unlike a common share is an investment vehicle for raising capital with a fixed dividend to the preference shareholder. The capital raised by such issuance is called as preference share capital. The preference shareholder has priority over the common shareholder, as they receive fixed dividends from profits generated before any dividend is paid to the common shareholder. Secondly, in the event of a liquidation, the preference shareholders have the first right of claim on the net assets (assets left over after paying all the creditors) before the common shareholders. Preference shares, with their fixed dividends, exhibit characteristics of both debt and equity, making them a hybrid investment.
However, preference share has its own set of disadvantage such as:
- Dividends are paid when the company earns a profit and hence the returns are not assured. Due to this higher risk attached compared to a normal debt, wherein the interest has to be paid, the preference share generally command a higher rate of dividend than any form of the debt instrument.
- Dividends are paid from the profits of the company and hence are tax-deductible.
- Preference shares typically lack voting rights but can claim them if dividends remain unpaid for two years or more on cumulative preference shares and three years or more on non-cumulative preference shares. This makes it important to understand the different types of preference shares.
Types of Preference Shares:
Cumulative and Non-cumulative Preference Shares
Cumulative preference shares have the right to collect dividends that are not paid in particular years, in the future years. For example, suppose the company did not pay dividends on preference shares for two years 2019 and 2020. Then the company will have to pay dividends for 2019, 2020, and 2021 in the year 2021, altogether.
Unlike cumulative preference shares, the non-cumulative preference shares do not have the right to accumulate dividends and pay at a later date. If the company doesn’t pay dividends for a particular year due to losses, shareholders cannot claim them later. Hence, the risk is much higher in investing in non-cumulative preference shares.
Redeemable and Non-redeemable preference shares
Non-redeemable preference shares are perpetual in nature and can never be redeemed in the future. As such companies act does not allow the company to issue any preference shares which are redeemable or non-redeemable beyond 20 years from date of issue.
Participating and Non-participating preference shares
Participating preference shares have right in surplus profits of the company beyond the fixed rate of dividend. Non-participating shares receive only a fixed dividend and hold no rights in the surplus profits. Usually, preference shares are non-participating unless expressly mentioned.
Convertible and non-convertible preference shares
Convertible preference shares have an option to convert the preference shares into common shares after a pre-decided time. This gives preference shareholders the advantage of investing at a fixed rate for a specified time and then potentially earning higher returns through common shares.
Non-convertible shares cannot be converted into common shares.
Preference share with the callable option
The company issues this type of preference share with an option to buy back at a pre-decided date and time. This investment vehicle allows the company to raise money at a lower future interest rate.
Under Adjustable preference shares, the rate of dividend is not fixed and would depend on the current interest rate in the market.
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