Preference shares, also known as preferred stock, are company shares that entitle holders to receive dividends before common shareholders receive any dividends. This preferential treatment gives preference shareholders priority in dividend payments and, often, in assets upon liquidation of the company.
Characteristics of Preference Shares
Preference shares come with several distinct characteristics that differentiate them from common shares:
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Dividend Priority: Preference shares provide holders with dividends ahead of common shareholders.
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Fixed Dividends: Typically, preference shares offer a fixed dividend rate.
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Liquidation Preference: In the event of company liquidation, preference shareholders have a higher claim on assets than common shareholders.
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Non-Voting Rights: Generally, preference shareholders do not have voting rights in company decisions, unlike common shareholders.
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Convertibility: Some preferred stocks can be converted into a predetermined number of common shares.
Types of Preferred Stock
1. Cumulative Preference Shares
Cumulative preference shares accumulate unpaid dividends. If a company skips dividend payments, these unpaid dividends must be paid out to cumulative preference shareholders before any dividends are distributed to common shareholders.
2. Non-Cumulative Preference Shares
Non-cumulative preference shares do not have the right to claim unpaid or omitted dividends in the future. If the company decides not to pay dividends in a particular year, shareholders of these stocks cannot demand those dividends later.
3. Participating Preference Shares
Participating preference shares offer the potential for additional dividends beyond the fixed rate. These shareholders can receive dividends that common shareholders get if profits exceed a certain level, and they often have a preferential claim in liquidation.
4. Convertible Preference Shares
Convertible preference shares can be converted into a specified number of common shares after a predetermined period or under specific conditions, enabling holders to potentially benefit from the upside in common stock.
5. Redeemable Preference Shares
Redeemable preference shares can be bought back by the issuing company at a future date and at a predetermined price. This feature provides additional flexibility to the issuing company.
Example of Preference Shares
Imagine a company, XYZ Corp, issues 1,000 cumulative preference shares at $100 each with an annual dividend rate of 6%. If XYZ fails to declare a dividend in one year, the unpaid $6 per share must be paid in the subsequent years before any dividend can be given to common shareholders.
Historical Context and Use Cases
Historical Context: Preference shares have a long history, dating back to the early 19th century, and have been used by companies as a way to raise capital without diluting the voting power of common shareholders.
Use Cases: Preference shares are commonly used in financial structuring, such as mergers and acquisitions, venture capital financing, and in situations where companies aim to attract investors seeking a fixed income stream with lower risk compared to common stock investments.
Related Terms
- Common Stock: Shares that represent ownership in a company, typically providing voting rights and dividends that are not fixed.
- Dividends: Payments made by a corporation to its shareholders, usually in the form of a distribution of profits.
- Equity Financing: Raising capital through the sale of shares in a company.
- Liquidation: The process of bringing a business to an end and distributing its assets to claimants.
FAQs
What Are the Advantages of Investing in Preference Shares?
Can Preference Shares Be Converted Into Common Shares?
Do Preference Shareholders Have Voting Rights?
References
- Damodaran, Aswath. Corporate Finance: Theory and Practice. Wiley, 2001.
- Bodie, Zvi, et al. Investments. McGraw-Hill Education, 2013.
Summary
Preference shares provide investors with fixed dividends and priority over common shareholders for dividend payments and asset claims. They come in various types, each catering to different investment needs and financial strategies. Understanding these types and their characteristics helps investors make informed decisions in the stock market.
By exploring preference shares and their different forms, one gains a broader perspective on investment opportunities and the ways companies structure their equity to meet both their own needs and those of their investors.
