Preference Shares

Preference Shares, also known as Preferred Stock, are a class of share capital that carries preferential rights over ordinary (equity) shares in certain respects, particularly regarding the payment of dividends and the repayment of capital in the event of liquidation. They form an important component of corporate finance, providing companies with a hybrid source of funding that combines features of both equity and debt.

Meaning and Concept

Preference shares represent ownership in a company, like equity shares, but with limited rights. Holders of preference shares receive a fixed rate of dividend before any dividend is paid to equity shareholders. However, they usually do not enjoy voting rights, except in certain circumstances specified under law.
Under the Companies Act, 2013 (India), preference shares are defined as shares that carry:

1. A preferential right to receive dividends, whether at a fixed amount or at a fixed rate, and
2. A preferential right to repayment of capital upon the company’s winding up, before any payment is made to equity shareholders.

Thus, preference shareholders enjoy a safer and more stable investment than ordinary shareholders, though with less control over company management.

Key Characteristics of Preference Shares

• Fixed Dividend: Preference shareholders are entitled to receive dividends at a pre-determined rate.
• Preference in Payment: They are paid dividends before equity shareholders.
• Priority in Capital Repayment: In case of liquidation, their capital is repaid before equity capital.
• Limited Voting Rights: They can vote only on matters directly affecting their rights or when dividend arrears exist for two or more years.
• Hybrid Nature: Preference shares combine characteristics of both equity (ownership) and debt (fixed return).
• No Participation in Profits: They typically do not share in surplus profits after receiving their fixed dividend.

Types of Preference Shares

Preference shares can be classified based on various features such as dividend payment, redemption, convertibility, and participation.
1. On the Basis of Dividend Payment

• Cumulative Preference Shares: Unpaid dividends accumulate and are carried forward to future years until paid.
• Non-Cumulative Preference Shares: Unpaid dividends are not carried forward if profits are insufficient in any year.

2. On the Basis of Participation in Profits

• Participating Preference Shares: These shareholders are entitled to share in the surplus profits after dividends are paid to equity shareholders.
• Non-Participating Preference Shares: Their entitlement is limited to the fixed dividend only.

3. On the Basis of Redemption

• Redeemable Preference Shares: The company repays these shares after a fixed period or on a specific date, as mentioned in the terms of issue.
• Irredeemable Preference Shares: These are not repaid during the lifetime of the company (however, under the Companies Act, 2013, issue of irredeemable preference shares is prohibited in India).

4. On the Basis of Convertibility

• Convertible Preference Shares: These can be converted into equity shares after a specified period or under certain conditions.
• Non-Convertible Preference Shares: These cannot be converted into equity shares and remain preference shares throughout.

5. On the Basis of Priority of Payment

• Senior Preference Shares: Paid before other types of preference shares.
• Subordinated Preference Shares: Paid after certain other classes of preference shares.

Legal Provisions in India

According to the Companies Act, 2013, and the Companies (Share Capital and Debentures) Rules, 2014:

• Preference shares can only be redeemable, and their redemption period shall not exceed 20 years from the date of issue (except in specific infrastructure projects where the period may extend to 30 years).
• Redemption can be made only out of profits available for dividend or from the proceeds of a fresh issue of shares.
• Dividends on preference shares are payable only from distributable profits.
• Preference shareholders enjoy voting rights only in matters directly affecting their interests or when dividends remain unpaid for two or more years.

Advantages of Preference Shares

For the Company:

• Flexible Financing: Preference shares can be structured in various forms (redeemable, convertible, cumulative) as per financing needs.
• No Voting Dilution: Issuing preference shares allows raising capital without diluting managerial control, as voting rights remain limited.
• Financial Stability: Fixed dividend obligations make financial forecasting easier.
• Creditworthiness: Preference capital strengthens the company’s balance sheet and improves debt capacity.

For Investors:

• Stable Income: Investors receive fixed and assured returns through dividends.
• Lower Risk: Priority over equity shareholders in dividend and capital repayment offers greater security.
• Conversion Option (if applicable): Convertible preference shares allow investors to participate in company growth later.
• Suitable for Conservative Investors: Especially attractive to those seeking moderate, steady returns rather than speculative gains.

Disadvantages of Preference Shares

For the Company:

• Costlier than Debt: Dividends are not tax-deductible, unlike interest on loans, making preference capital more expensive.
• Fixed Dividend Burden: The obligation to pay dividends even in low-profit years may strain finances (for cumulative shares).
• No Voting Benefit: Since preference shareholders have limited voting rights, raising preference capital does not bring active investor engagement.

For Investors:

• Limited Profit Potential: They do not share in extra profits beyond the fixed dividend rate.
• Inflation Risk: Fixed returns may lose real value during inflationary periods.
• Dividend Dependence: Dividend payment depends on the availability of profits; if the company incurs losses, dividends may be delayed.
• Liquidity Issues: Preference shares are generally less traded and less liquid than equity shares.

Differences between Preference Shares and Equity Shares

Role and Importance of Preference Shares in Corporate Finance

• Hybrid Instrument: Acts as a bridge between debt and equity, balancing financial risk and flexibility.
• Capital Raising Tool: Useful for companies seeking long-term funds without increasing debt burden.
• Credit Enhancement: Improves financial leverage ratios and enhances credit rating.
• Investor Diversification: Attracts investors who prefer stable returns over speculative equity gains.
• Strategic Financing: Convertible or redeemable preference shares allow tailoring of financing terms to match business needs.

Example

Suppose a company issues 1,00,000 10% cumulative redeemable preference shares of ₹100 each.

• Annual dividend payable = 10% of ₹100 = ₹10 per share.
• If the company makes no profit for two years, dividends accumulate (₹20 arrears per share) and must be paid later when profits resume.
• After a fixed period (say, 10 years), the company redeems the shares by repaying ₹100 per share to investors.