What are Preference Shares?

Preference shares hold status as a special class of share, affording specific advantages to those purchasing them.

The following guide on preference shares looks at what these are, the different types, how these differ to ordinary shares, and how preference shares are treated in the event of bankruptcy. We also provide a useful summary of the pros and cons of preference shares.

 

What are preference shares?

Preference shares, also referred to as preferred shares or preferred stock, are equity shares that give the preference shareholders certain rights ahead of common shareholders. For instance, when a corporation or company declares a dividend, preference shareholders will be entitled to receive dividend payments before the common shareholders.

Preference shares usually have a fixed dividend, which means that the company is obligated to periodically declare and pay the dividend. This fixed dividend yield is based on the par value of the stock. The par value is its per-share value assigned by the company that issues it. This dividend is paid out at specified intervals, typically quarterly, to preference shareholders. This fixed dividend component makes preference shares similar to bonds, a form of fixed-income security which provides a return by way of fixed periodic interest payments.

The specifics of preference shares, and the rights attached to these, are usually set out in the company’s articles of association or the shareholder agreements.

 

What are the different categories of preference shares?

There are four different categories of preference shares or preferred stock, with different rights and entitlements for shareholders: cumulative preferred stock, non-cumulative preferred stock, convertible preferred stock and participating preferred stock.

 

Cumulative preferred stock

Also referred to as cumulative preference shares, this category of shares includes a provision that stipulates that a company must pay all dividends, including those that were missed previously, to cumulative preferred stock shareholders. This means that the dividends owed must be paid out to cumulative preference shareholders first, before other classes of preferred shareholders and common shareholders can receive any dividend payments. These types of shares earn a dividend on a periodic basis, which means that if the company does not declare and pay the dividend for one period, it must pay it later, where unpaid dividends accumulate until paid. A preference share is essentially a share whose annual fixed-rate dividend, if it cannot be paid, accrues until it can, being paid as ‘dividends in arrears’ to the current owner of the stock at the time of payment.

 

Non-cumulative preferred stock

As with cumulative preference shares, non-cumulative preferred shares also have a dividend right. However, if the company skips the dividend payment, this does not have to be paid later and the shareholders simply miss out. This is because non-cumulative preferred stock does not issue any omitted or unpaid dividends, where holders of non-cumulative preferred shares are not entitled to receive dividends retroactively for any dividends that were not paid in prior periods. If the company chooses not to pay any dividends in a given period, the non-cumulative preference shareholders will have no right or power to claim forgone dividends at any time in the future. However, for this reason, cumulative preference shares will generally be more expensive than non-cumulative shares.

 

Convertible preferred stock

This category of preference shares includes an option giving the shareholder the right to convert their shares into a fixed number of common shares, generally any time after a specified date, or at specified intervals, depending on the terms agreed. Convertible preference shares are a hybrid type of security that has features of both debt, from its fixed guaranteed dividend payment, as well as equity, from its ability to convert into common stock. Under normal circumstances, convertible preference shares will be exchanged at the shareholder’s request, although the company may have a provision that allows the shareholders or the issuer to force the issue.

 

Participating preferred stock

This gives preference shareholders fixed dividends, plus the possibility of extra dividends should the company achieve specific objectives or certain performance targets, such as company profits exceeding a specified level. This category of preference shares provides shareholders with the right to be paid dividends in an amount equal to the specified rate of preferred dividends, plus an extra dividend based on a predetermined condition. However, any extra dividend is usually designed to be paid out only if the dividend amount received by common shareholders is greater than a predetermined per-share amount. However, preference shareholders will get to share in the profits whenever the company’s performance surpasses a certain level.

There are also redeemable or callable preference shares. These are shares that give the company the right to repurchase the shares at their discretion.

 

What is the difference between ordinary and preference shares?

All shares represent a portion of the ownership of a company. Shares can be divided into different types, where ordinary shares, also referred to as common stock or common shares, as the name suggests, is the most common. Preference shareholders are paid a fixed percentage of yearly dividends, which is decided during the signing of the share certificates, while ordinary shareholders are compensated varying amounts of dividends each year.

Unlike preference shares, the owner of ordinary shares is not guaranteed a share dividend. This is because preference shares have a fixed dividend, while ordinary shares generally do not. This also means that shares of a company’s stock with dividends are paid out to preference shareholders before any ordinary share dividends are issued. When dividends are paid, ordinary shareholders have the right to receive them, but if a decision is made to the contrary, the company is not required to distribute them. The company can make a decision not to distribute the dividends depending upon the situation. This might be because, for example, of lower than expected earnings or because it has been decided that any profits should, instead, be reinvested into the company for future expansion purposes.

However, each share of common stock generally gives its owner not only the right to receive dividends from the company’s earnings, but also one vote at a company shareholders’ meeting. Unlike common shareholders, preference shareholders are not entitled to vote, so cannot influence decisions made at shareholder and general meetings. This means that, absent any voting rights, preference shareholders will have no say in relation to matters such as electing the company board of directors, merger proposals or company strategy. This also means that the company is not beholden to preference shareholders in the same way as it is to traditional equity or ordinary shareholders.

In summary, therefore, preference shareholders usually benefit from fixed and guaranteed dividend payments, and other priority rights, including preference over asset distribution as a result of liquidation. In exchange, preference shares do not enjoy the same level of voting rights as ordinary shares or, in most cases, upside participation or potential increase in value. By receiving fixed periodic dividend payments, should a business see a significant period of growth, this will often not be reflected in the preference shareholders payments.

 

What happens to preference shares in the event of insolvency?

In the event of company liquidation, preference shareholders, or preferred stockholders, are entitled to be paid from company assets before ordinary shareholders or common stockholders. They have preferential rights not only when it comes to dividend payments, but also capital repayment in the case of winding up. In contrast, ordinary shareholders are paid last in the case of both liquidation and dividend distribution.

If the company is liquidated, participating preference shareholders may also have the right to be re-paid the stock purchasing price, as well as a pro-rata share of the remaining proceeds received by common shareholders.

Importantly, even though preference shares will generally have priority over ordinary shares in any bankruptcy, where preference shareholders will be paid before the common shareholders, preference shares will usually have lower priority than bonds or other fixed-income securities.

 

Pros & cons of preference shares

There are various benefits and drawbacks to preference shares, some relating to preference shares in general and others relating to the specific type of preference shares:

 

Benefits of preference shares

• Preference shareholders are usually entitled to receive a fixed and guaranteed dividend payment, where the company is obligated to periodically declare and pay the dividend. This is in contrast to ordinary shares where there is no guaranteed right to receive dividends;
• When a company declares a dividend, preference shareholders receive dividend payments ahead of ordinary shareholders, giving them priority in getting paid dividends;
  If a company is liquidated due to bankruptcy, the preference shareholders are also entitled to be paid from company assets before the common shareholders, again giving them priority in asset distributions if a company goes bankrupt;
• Cumulative preference shares are guaranteed, where unpaid dividends accumulate until these have been paid, where additional compensation, or interest, can awarded to cumulative preference shareholders where payment of a dividend has been delayed;
  Convertible preference shares allow shareholders to convert their shares into common stock, which can be financially lucrative at a time when the common stock prices are rising;
• If the company does poorly, convertible preference shareholders do not have to convert their shares to common stocks, where they can usually keep their convertible stocks.

 

Drawbacks of preference shares

• Even though dividends are usually fixed and guaranteed on preference shares, if the earnings of a company increase, the company may choose to increase the dividends that it pays on common stock, leaving the preference shareholders still getting the same fixed rate. In time, the dividend rate paid on ordinary shares may surpass the rate paid to preference shareholders, where preference shares do not usually participate in the company’s success
• Unlike common shareholders, preference shareholders are not entitled to vote at company shareholder meetings, so have no say in matters like electing the board of directors, merger proposals or company strategy
• Non-cumulative preference shareholders have the right to a dividend payment but if the company does not declare and pay a dividend, the shareholders miss out, with no right or power to claim forgone dividends at any time in the future.

Convertible preference shareholders, depending on the provisions attached to those shares, may be forced to convert their shares into common stock after a defined date.

 

Are preference shares the best option?

Whether preference shares are the best option for shareholders will very much depend on the circumstances involved, including the level of any risk that any given shareholder is prepared to take, what kind of return they are looking for and how much involvement they want to have. It can also depend on the individual company and what the company’s specific articles of association state, where there is no definitive answer to whether preference or ordinary shares are the best option in any given scenario.

When purchasing equity shares in a company, potential investors may have the option of buying them in two different ways: preferences shares or ordinary shares. Broadly speaking, preference shares are typically shares that rank above other shares in terms of dividends or capital, with preferential payments of dividends and priority over capital distribution on bankruptcy, but have restricted voting rights.

As preference shareholders generally receive predetermined dividends on a periodic basis — either monthly, quarterly or yearly — and do not participate in the success of the company, they are usually considered a less risky form of investment than ordinary shares. Preference shares are therefore ideal for risk-averse investors looking for a more secure investment with a fixed income, providing a fixed and guaranteed dividend. Even though an investor will have less input into the strategy of the business or other important company matters, and provided they are content with not having a voice, they will, in return, be given priority when it comes to dividend distribution and in the case of liquidation.

Preferred shares are essentially an asset class somewhere between common stocks and bonds, so they can offer companies and corporate investors the best of both worlds. These types of shares can be used by companies to get more funding, as many investors want consistent dividends and stronger bankruptcy protections than ordinary shares can offer.

 

Preference shares FAQs

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Legal disclaimer

The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law or tax rules and should not be treated as such.

Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.

Before acting on any of the information contained herein, expert professional advice should be sought.