Preference shares as the term implies are the shares that rank at a priority above the equity shares. These shares contain a preferential right to receive the dividend as are declared by the company on first priority order. During the course of dividend declaration, these shareholders are entitled to receive the dividend first as against the normal equity shareholder.
The preference shareholders not only have a preferential right to receive a dividend on the preliminary basis but they also have preferential right to receive the proceeds that are realized from the sale of the company’s assets during the course of liquidation of the company after payments having been made to the secured creditors of the company.
As per Explanation(ii) to section 42 of the Companies Act, 2013, the term preference shares mean and includes that part of the share capital the holders of which have a preferential right overpayment of dividend (fixed amount or rate) and repayment of share capital in the event of winding up of the company.
In other words, preference shares are the shares that carry or would carry a preferential right with respect to:
- Payment of dividend, either fixed or an amount calculated at a fixed rate
- Repayment of the amount of paid-up capital share capital paid up or deemed to have been paid up, in the scenario of winding up of the company or repayment of capital.
Preference shares generally pay a higher rate of dividend however at a fixed rate or a fixed amount as a dividend. The preference shareholders are also privileged and entitled to receive all dividends i.e. current as well as an accrued dividend at priority before equity shareholders.
It is evident to highlight that a company can issue preference shares only if these shares form part of the authorized share capital of the company as per the Memorandum of Association. It is important to verify the Articles of Association as to whether they grant authorization to issue preference shares.
In the scenario where the Memorandum of Association or the Articles of Association of the company do not bestow the requisite power to issue preference share then in such a state, necessary amendments would be required to be made in these documents prior to issuing such preference shares.
It is widely known that the equity shareholders are regarded as the owners of the company. The equity holders have the major decision-making power in their hands while granting limited decision-making power to the preference shareholders. On this note if a company which has equity shareholders is in need of additional funds may fulfill its additional fund requirement by opting for either of the below-mentioned alternatives :
- By issuing more shares: this is an easy alternative but it ultimately leads to the dilution in the value of equity shares as held by existing equity shareholders.
- By taking Loans: This is a cumbersome option as it means paying back the money borrowed along with interest irrespective of the fact that the venture for which extra funds were required is making profits or not.
- By issuing preference shares: This alternative is a mixture of the above-mentioned two alternatives. Vide this alternative the shareholders are granted preferential right to receive dividends as well their share in the assets of the company in the event of liquidation of the company.
The choice of an above-discussed alternative depends on the fund needs and size of the company.
Having gained an insight into the preference shares let’s head towards a detailed analysis of the preference shares.
Preference shares are a safe and lucrative alternative to raising additional capital requirements. On this note, it is crucial to analyze the pros and cons of preference shares.
Pros of preference shares
The advantages of preference shares are as follows:
From a company’s point of view:
- The dividend payable on preference shares is fixed that is usually lower than that payable on equity shares. Thus they help the company in maximizing the profits available for the dividend to equity shareholders.
No voting Right:
- Preference shareholders have no voting right on matters not directly affecting their rights hence promoters or management can retain control over the affairs of the company.
Flexibility in Capital Structure:
- The company can maintain flexibility in its capital structure by issuing redeemable preference shares as they can be redeemed under terms of issue.
No burden of Finance:
- Issue of preference shares does not prove a burden on the finance of the company because dividends are paid only if profits are available, otherwise, no dividend has to be paid.
No charge on assets:
- Non-payment of dividends on preference shares does not create a charge on the assets of the company as is in the case of debentures.
Widens Capital Market:
- The issue of preference shares widens the scope of the capital market as they provide safety to the investors as well as a fixed rate of return. If the company does not issue preference shares, it will not be able to attract capital from such a moderate type of investor.
From an Investor’s point of view;
Regular Fixed Income:
- Investors in cumulative preference shares get a fixed rate of dividend on preference share regularly even if there is no profit. Arrears of dividends, if any, are paid in the years of profits.
- Preference shares carry preferential rights as regard to payment of dividend and as regards repayment of capital in case of winding up of the company. Thus they enjoy the minimum risk.
Voting Rights for Safety of Interest:
- Preference shareholders are given voting rights in matters directly affecting their interest. It means their interest is safeguarded.
Lesser Capital Losses:
- As the preference shareholders enjoy the preferential right of repayment of their capital in case of winding up of company, it saves them from capital losses.
- Preference shares are fair securities for the shareholders during cyclic market corrections and depression periods when the profits of the company are down. Also, in the case of startup companies, preference shares are the first choice of investors, and usually, the dividend payment is allowed to accumulate until the company becomes profitable. This is done in order to reduce the already high risk that investors take when they invest in early-stage companies.
Preference shares often pay a higher rate of dividend as against other categories of shares. The preference shareholders are also entitled and empowered to receive their accrued as well as accumulated dividends. Preference shareholders also have the privilege to enjoy the surplus profits of the company which are left over after payment of dividend to the equity shareholders.
Cons of preference shares
The main drawback of preference share is as follows:
From Companies’ point of view
Higher Rate of Dividend:
- Companies pay a higher dividend on these shares than the prevailing rate of interest on debentures of bonds. Thus, it usually increases the cost of capital for the company and debt may be preferred.
- Most of the preference shares are issued cumulative which means that all the arrears of preference dividend must be paid before anything can be paid to equity shareholders. The company is under an obligation to pay dividends on such shares. It thus reduces the profits for equity shareholders.
Dilution of Claim over Assets:
- The issue of preference shares involves dilution of equity shareholders’ claim over the assets of the company because preference shareholders have the preferential right on the assets of the company in case of winding up.
Adverse effects on creditworthiness:
- The creditworthiness of the company is seriously affected by the issue of preference shares. The creditors may anticipate that the continuance of dividend on preference shares and suspension of dividend on equity capital may deprive them of the chance of getting back their principal in full in the event of dissolution of the company because preference capital has the preference right over the assets of the company.
- The taxable income is not reduced by the amount of preference dividend while in the case of debentures or bonds, the interest paid to them is deductible in full.
From Investors’ point of view:
No Voting Rights:
- The preference shareholders do not enjoy any voting right except in matters directed affecting their interest.
- The dividend on preference shares other than participating preference shares is fixed even if the company earns higher profits.
No claim over surplus:
- The preferential shareholders have no claim over the surplus. They can only ask for the return of their capital investment in the company.
No Guarantee of Assets:
- The company provides no security to the preference capital as is made in the case of debentures. Thus their interests are not protected by the assets of the company.
Commonly the equity shareholders are conferred with the right to vote on all resolutions that require the approval of shareholders. Also, the equity shareholders have the privilege to appoint and remove the directors and auditors and also to approve the company’s financial statements. Majorly, the control of the company is in the hands of the equity shareholders.
The preference shareholders possess limited voting rights which can be utilized only in situations which significantly affect the rights of preference shareholders. Hence the preference shareholders have minimal control over the affairs of the company.
After having discussed the pros and cons of preference shares, let’s gain an overview of the target audience for preference shares.
Preference shares are suitable for which type of investors?
Preference shares are a viable and suitable option for risk-averse equity investors. These are less volatile than normal shares. The best distinguishing factor for preference shares is that they offer a steadier flow of dividends. Also, the preference shares are redeemable i.e. they can be called back at any time. Therefore to sum up the preference shares are a lucrative option against the equity shares.
Abhishek Jain at MUDS suggests that
“Investment in preference shares will not only grow your wealth but you will also enjoy fixed regular income. As proactive investor, next time when you plan to buy a share don’t forget to consider preference share for your portfolio inorder to seek benefit of both equity and debt instrument.”
Hope that this article was informative, interesting in providing an in-depth insight about the preference shares. Stay connected with MUDS for updates.