Preference shares (also known as preferred stock) represent a class of ownership in a corporation that possesses a higher claim on assets and earnings than common stock. Preference shares typically provide dividends that must be paid out before dividends to common shareholders.
Characteristics of Preference Shares
Preference shares generally have several distinctive features:
- Dividend Payments: Holders of preference shares receive dividends before common shareholders.
- Dividend Rate: Often, preference shares provide fixed dividend rates.
- Priority in Liquidation: In the event of a company’s liquidation, preference shareholders are paid before common shareholders, but after debt holders.
- Non-voting Rights: Generally, preference shareholders do not have voting rights in the company’s general corporate governance.
- Convertibility: Some preference shares are convertible, allowing holders to convert their preference shares into a specified number of common shares.
Types of Preference Shares
Cumulative Preference Shares
Cumulative preference shares accumulate unpaid dividends, which must be paid out before any dividends can be paid to common shareholders.
Non-cumulative Preference Shares
Non-cumulative preference shares do not accumulate unpaid dividends. If the company does not declare a dividend in one year, shareholders of these shares cannot claim the missed dividend in subsequent years.
Participating Preference Shares
Participating preference shares provide the shareholders the right to receive additional dividends based on certain conditions, such as a specified profit threshold, beyond the fixed dividend.
Convertible Preference Shares
Convertible preference shares can be converted into common shares at a predetermined rate after a specified period.
Special Considerations
- Risk Factors: Although preference shares have priority over common shares regarding dividends and assets in liquidation, they are subordinate to debts.
- Market Performance: Preference shares typically do not benefit from capital appreciation in the same way common shares do. Investors seeking growth may prefer common shares.
- Non-voting Rights: The lack of voting rights can be a disadvantage for investors who wish to have a say in the company’s governance.
Examples of Preference Shares
Example 1: Dividend Preference
A company issues preference shares with a 5% annual dividend rate. If the company earns sufficient profit to declare dividends, preference shareholders will receive their fixed 5% dividend before any dividends are paid to common shareholders.
Example 2: Liquidation Preference
If a company goes into liquidation, preference shareholders are entitled to be paid their initial investment back before any assets are distributed to common shareholders, after all debts have been settled.
Historical Context
Preference shares have been part of the financial ecosystem for centuries, providing a hybrid instrument that balances equity and debt features. They gained popularity during periods of economic uncertainty as companies looked to attract investment without diluting control among common shareholders.
Applicability
Preference shares are utilized by companies looking to raise capital without giving up control. They are particularly favored by investors seeking stable income and relatively lower risk compared to common stocks.
Comparisons
Preference Shares vs. Common Shares
- Priority in Dividends: Preference shares have priority over common shares for dividend payments.
- Capital Appreciation: Common shares typically offer higher potential for capital appreciation.
- Voting Rights: Common shareholders usually have voting rights, while preference shareholders usually do not.
Preference Shares vs. Bonds
- Ownership: Preference shares represent ownership in the company, whereas bonds are debt instruments.
- Dividends vs. Interest: Preference shares pay dividends, which can be cut or suspended, while bonds pay fixed interest, which must be paid before dividends.
- Liquidation Priority: Bondholders are paid before preference and common shareholders in the event of liquidation.
Related Terms
- Equity: Denotes ownership in an asset or company.
- Dividend: A payment made by a corporation to its shareholders, usually as a distribution of profits.
- Convertible Securities: Financial instruments, like convertible preference shares, that can be converted into another form of security.
FAQs
What are the benefits of preference shares for companies?
Can preference shareholders vote in shareholder meetings?
Are preference shares a safe investment?
References
- “Investing in Preferred Stocks,” The Balance. Retrieved from The Balance.
- Ross, S. A., Westerfield, R. W., & Jaffe, J. (2002). Corporate Finance. McGraw-Hill.
Summary
Preference shares offer a blend of equity and fixed-income features, providing priority in dividends and liquidation over common shares, but usually without voting rights. They come in various types, including cumulative, non-cumulative, participating, and convertible preference shares. While preference shares appeal to income-focused investors, they also bring considerations such as lack of voting rights and lesser capital appreciation potential compared to common shares.
This structured and comprehensive definition allows readers to gain a robust understanding of preference shares, their characteristics, types, special considerations, and applicability, supplemented with historical context and comparisons to related financial instruments.
