Blog

What are Preference Shares?

Preference shares, also known as preferred shares or preferred stock, are a class of shares that have certain preferential rights and privileges compared to ordinary shares. These shares are typically issued by corporations to attract investors who desire a fixed income stream and priority treatment in the event of liquidation or dividend payments.

Features of Preference Shares

Here are some key features of preference shares:

1. Claims on Income and Assets
2. Fixed Dividend
3. Cumulative Dividends
4. Redemption
5. Sinking Fund
6. Call Feature
7. Participation Feature
8. Voting Rights
9. Convertibility

Claims on Income and Assets

A preference share is a senior security as compared to an ordinary share. It has a prior claim on the company’s income in the sense that the company must first pay a preference dividend before paying an ordinary dividend. It also has a prior claim on the company’s assets in the event of liquidation.

The preference share claim is honored after that of a debenture and before that of an ordinary share. Thus, in terms of risk, the preference share is less risky than the ordinary share. There is a cost involved for the relative safety of preference investment.

Preference shareholders generally do not have voting rights and they cannot participate in extraordinary profits earned by the company. However, a company can issue preference shares with voting rights (called participative preference shares).

Fixed Dividend

The dividend rate is fixed in the case of preference shares, and preference dividends are not tax deductible. The preference dividend rate is expressed as a percentage of the par value. The amount of preference dividend will thus be equal to the dividend rate multiplied by the par value.

A preference share is called fixed-income security because it provides a constant income to investors. The payment of preference dividends is not a legal obligation. Usually, a profitable company will honor its commitment to paying preference dividends.

Cumulative Dividends

Most preference shares in India carry a cumulative dividend feature, requiring that all past unpaid preference dividends be paid before any ordinary dividends are paid. This feature is a protective device for preference shareholders.

The preference dividends could be omitted or passed without the cumulative feature. Preference shareholders do not have the power to force the company to pay dividends; non-payment of preference dividends also does not result in insolvency. Since preference share does not have dividend enforcement power, the cumulative feature is necessary to protect the rights of preference shareholders.

Redemption

As per the provisions of the Company’s Act, now a company is not allowed to issue irredeemable preference shares. The preference shares are legally required to be redeemable and that too with a maximum maturity period of 20 years.

Perpetual or irredeemable preference share does not have a maturity date. Redeemable preference share has a specified maturity. In practice, redeemable preference shares in India are not often retired in accordance with the stipulation since there are no serious penalties for violation of the redemption feature.

Sinking Fund

Like in the case of debenture, a sinking fund provision may be created to redeem preference shares. The money set aside for this purpose may be used either to purchase a preference share in the open market or to buy back (call) the preference share. Sinking funds for preference shares are not common.

Call Feature

The call feature permits the company to buy back preference shares at a stipulated buy-back or call price. The call price may be higher than the par value. Usually, it decreases with the passage of time. The difference between the call price and the par value of the preference share is called call premium.

Participation Feature

Preference shares may in some cases have a participation feature that entitles preference shareholders to participate in extraordinary profit earned by the company. This means that a preference shareholder may get a dividend amount in excess of the fixed dividend. The formula for determining extra dividends would differ.

A company may provide an extra dividend to preference shareholders equal to the amount of the ordinary dividend that is in excess of the regular preference dividend.

Thus if the preference dividend rate is 10 percent and the company pays an ordinary dividend of 16 percent, then preference shareholders will receive an extra dividend at 6 percent (16 percent–10 percent). Preference shareholders may also be entitled to participate in the residual assets in the event of liquidation.

Voting Rights

Preference shareholders ordinarily do not have any voting rights. They may be entitled to contingent or conditional voting rights. In India, if a preference dividend is outstanding for two or more years in the case of cumulative preference shares, or the preference dividend is outstanding for two or more consecutive preceding years or for a period of three or more years in the preceding six years, preference shareholders can nominate a member on the board of the company.

Convertibility

Preference shares may be convertible or non-convertible. A convertible preference share allows preference shareholders to convert their preference shares, fully or partly, into ordinary shares at a specified price during a given period of time.

Preference shares, particularly when the preference dividend rate is low, may sometimes be converted into debentures.

FAQs About the Features of Preference Shares