Preference Shares: Meaning, Benefits, Limitations and More

When it comes to raising funds for expanding its business, a company has various options. These include borrowing from financial institutions, issuing equity shares, and issuing preference shares.

Preference shares can be described as a form of share capital in which investors are granted certain rights compared with other ordinary equity shareholders, particularly regarding dividends and repayment of capital in the event the company is liquidated.

Preference shareholders enjoy preferential treatment over other equity shareholders in various important aspects. It is not necessarily true that they have high earnings all the time. The benefits and limitations of preference shares depend on the type of preference shares issued by the company and on its performance.

This article provides a detailed look at preference shares and their associated characteristics.

Key Takeaways

• Preference shares give investors priority over equity shareholders for dividends and capital repayment, subject to the terms and applicable law.
• They usually provide a fixed or predetermined dividend, but investors should not automatically treat this as a guaranteed return.
• There are several types of preference shares, including cumulative, non-cumulative, participating, non-participating, convertible, non-convertible, and redeemable shares.
• Preference shares can be useful for both companies and investors, providing companies with another way to raise capital and investors with an alternative investment option.
• Preference shares still carry risk. Investors should examine the company's financial health and the detailed terms of the issue before investing.

What are Preference Shares?

Preference shares are shares that offer some special privileges to their shareholders over the ordinary equity shareholders.

These are the two main preferences:

• Preference in dividends: Preference shareholders are usually paid their dividends before ordinary equity shareholders.
• Preference in the repayment of capital: In the event of the company's winding up, preference shareholders are usually entitled to receive their capital back before ordinary equity shareholders.

For instance, suppose a company has both ordinary equity shareholders and preference shareholders. If the company decides to issue dividends, it will usually pay preference shareholders first. This is followed by payments to the ordinary equity shareholders. However, preference shareholders usually enjoy limited voting powers compared to ordinary equity shareholders.

How do Preference Shares Work?

A company issuing preference shares usually specifies the dividend rate and other conditions at the time of issue.

For example, ABC Ltd. issues 10,000 preference shares with a ₹100 face value and an 8% dividend. Thus, the preference dividend for the year will be:

10,000 × ₹100 × 8% = ₹80,000

This indicates that the company will have to pay ₹80,000 as a preference dividend before paying dividends to equity holders, in accordance with the terms and conditions and applicable law.

It is important to note that a preference dividend is not exactly the same as interest on a loan. Whether it must be paid when profits are unavailable depends on the type of preference shares and the terms attached to them.

Types of Preference Shares

Preference shares can be divided into different categories based on their features.

Cumulative Preference Shares

With cumulative preference shares, unpaid dividends generally accumulate and may become payable in future years when the company has sufficient distributable profits.

For example, if a company cannot pay the preference dividend for one year, the unpaid amount may be carried forward. When the company is able to pay dividends later, the accumulated amount is generally considered before dividends are paid to equity shareholders.

Non-Cumulative Preference Shares

In the case of non-cumulative preference shares, an unpaid dividend generally does not accumulate for future years.

If the company does not declare the dividend for a particular year, the investor may lose the dividend for that year, subject to the terms of the issue.

Participating Preference Shares

Participating preference shareholders may have the right to receive their fixed preference dividend and, under specified conditions, participate in additional profits along with equity shareholders.

This can provide investors with an opportunity to benefit from strong company performance.

Non-Participating Preference Shares

Non-participating preference shareholders generally receive their specified preference dividend but do not share in additional profits beyond the rights attached to their shares.

Convertible Preference Shares

Convertible preference shares can be converted into equity shares according to the terms of the issue.

This may appeal to investors who want the relative stability of preference shares initially but also want the possibility of benefiting from future growth in the company's equity value.

Non-Convertible Preference Shares

These preference shares cannot be converted into equity shares. Investors continue to hold them as preference shares according to their terms.

Redeemable Preference Shares

Redeemable preference shares are issued with terms under which the company can redeem them, subject to applicable legal requirements and the conditions of the issue. Redemption can give investors a clearer idea of how long they may hold the investment.

Benefits of Preference Shares

• Regular income: Preference shares with a fixed dividend can provide a relatively predictable source of income.
• Priority over equity shareholders: Preference shareholders generally receive dividends before equity shareholders and have priority in repayment of capital.
• Potentially lower volatility than equity: Depending on the company and market conditions, preference shares may be less sensitive to certain equity-market movements than ordinary shares. However, they are not risk-free. 
• Different investment choices: They allow investors to diversify their investments beyond ordinary equity shares and traditional debt instruments.

Limitations of Preference Shares

• Fixed cap on return upside: Unlike equity shareholders who benefit directly from a company's surging profits through higher variable dividends and share price growth, non-participating preference shareholders receive only their predetermined fixed dividend rate regardless of corporate profitability.
• Absence of operational voting control: Preference shareholders generally do not have voting rights in Annual General Meetings (AGMs). They cannot vote on key corporate governance issues, board appointments, or strategic decisions unless a resolution directly affects their rights or class of shares.
• Interest rate risk: Because preference shares pay a fixed dividend yield, their market value drops when broad market interest rates rise (similar to fixed-income bonds), as newer market instruments offer higher competing yields.
• Subordinate to debt holders: In the event of corporate insolvency or liquidation, preference shareholders are paid only after all secured and unsecured creditors, debenture holders, and lenders are fully settled.
• Dividend unpredictability in distressed years: Unlike bond interest, preference dividends depend on the availability of distributable post-tax profits and board declaration.

Difference Between Preference Shares and Equity Shares

Basis	Preference Shares	Equity Shares
Meaning	Shares that give shareholders preferential rights over equity shareholders.	Shares that represent ordinary ownership in a company.
Dividend	Usually carry a fixed or predetermined dividend rate.	The dividend is not fixed and depends on the company's profits and decisions.
Priority of Dividend	Preference shareholders generally receive dividends before equity shareholders.	Equity shareholders receive dividends after preference shareholders, subject to declaration and applicable rules.
Repayment of Capital	Preference shareholders generally have priority over equity shareholders when capital is repaid during winding up.	Equity shareholders are paid after preference shareholders and other higher-priority claims.
Voting Rights	Usually have limited voting rights, depending on applicable law and issue terms.	Generally have voting rights in company matters.
Risk	Generally considered less risky than equity shares in terms of priority, but they are not risk-free.	Usually carry higher risk because equity shareholders are the last owners to receive capital during liquidation.
Return Potential	Usually offers more predictable dividend income but may have limited upside.	Can provide higher returns when the company performs well, but losses can also be higher.
Capital Appreciation	Generally more limited, especially for fixed-rate preference shares.	Greater potential for capital appreciation as the company's value grows.
Participation in Profits	Usually limited to the specified dividend unless the shares are participating preference shares.	Can benefit from higher profits through increased dividends and share price appreciation.
Convertibility	Some preference shares can be converted into equity shares.	Equity shares normally remain equity shares unless converted or reorganised under specific conditions.
Suitability	May suit investors looking for preferential treatment and relatively predictable income.	May suit investors seeking long-term growth and willing to accept greater market risk.
Ownership Position	Have preferential rights but generally limited control over company decisions.	Represent the residual ownership of the company and generally provide greater control through voting rights.