Preferred Stock Definition
Those shares which are given priority in terms of dividend payouts over other equity shares are called preferred shares. Preferred stock or preference shares are given to certain shareholders who will be the first to get dividend payouts if the company decides to pay dividends. Another manner in which one can define preferred shares is that they are those holdings whose shareholders possess the right to claim dividends during the lifespan of the company. In case the said company underperforms and liquidates, the same preference shareholders are also eligible to claim repayment of capital in case the company liquidates.
Preferred Stock Example
We can also define preferred stock through an illustration of how they work. As an example, suppose that a Company ‘C’ has a total of 10,000 preference shares to distribute among its investors. These shares are priced at ₹100 earning interest at 8% per annum. For the years of 2018 and 2019, C company has not paid dividends to its preference shareholders.
Before the company can pay its regular shareholders in 2020, the preference shareholders are eligible to receive ₹2,40,000 by the time 2020 rolls around. This amount is the cumulative dividend earned after 3 years for all shareholders. Preference shareholders will get priority before other shareholders when the company starts paying its dividends.
Preference Shares Benefits
Preference stock offers advantages to both its stockholders and the issuer. These advantages are divided into both these categories.
When it comes to the benefits afforded to an investor, preferred stock helps as follows:
Secured position: When compared to common shareholders, those with preferred stock have a significantly more secure position. They can claim the company’s assets first in case of the company’s liquidation.
Fixed income: Depending upon the company one can be bought stocks in and the type of preference share chosen, investors are eligible to receive a fixed passive income through dividend payouts.
Preferred stocks afford the issuer the following benefits:
Flexibility: The management and board of directors of a company also enjoy flexibility in setting up the use of preferred stock in the way in which they see fit. They can allocate the ratio of preference shares most suited to their company to attract investors.
No dividend obligation: A certain type of preferred stock known as cumulative preferred stock affords the issuer the freedom to defer investors’ dividend payouts. This helps the investor when they lack sufficient dividend funds. This policy allows them to not be responsible to pay every month but defer payments once funds are available.
Preferred Shares Features
Preference shares differ from common equity or debt along the following lines.
Dividend Preference: With preference share, shareholders get the benefit of receiving the dividend payment on priority relative to non-preference stockholders.
Voting Rights: Generally, one does not get voting rights in the company’s management when they buy stock in the company. However, in certain extraordinary cases, preference shareholders can receive the right to vote.
Preference in assets: In case the company liquidates, preference shareholders also get priority over a company’s assets and can claim them over non-preference shareholders.
Convertibility: Preference shares have the option of being converted into a predetermined number of non-preference shares. If an investor wishes to alter their holding position, they have this option. Depending upon the company, preferred stock has the option to be converted prior to a specific date or might require the permission of the board of directors.
Callability: At some point in the foreseeable future, an issuer can repurchase their preference shares through a callback. This scalability is similar to being converted into a non-preference share. However, when the preference share is repurchased by the company itself, the company’s ownership is increasing as opposed to third party investors.
One helpful strategy to somewhat reduce one’s risk when they become a shareholder in a company is to be a preference shareholder. One is eligible to claim both dividends and company assets over and above non-preference shareholders in case of company liquidation. There are a slew of preferred shares to choose from and one can convert their preference shares into non-preference shares if they wish to change their holding in the company. Some types of preference shares payouts can be deferred by a company until they have the funds to pay dividends.