What are Preference Shares?

Preference shares, also known as preferred shares or preferred stocks, are a distinct type of equity instrument issued by companies to raise capital. They are different from ordinary shares (also known as common stock) in several ways, offering unique features and benefits to both the issuing company and the investors. While ordinary shares represent ownership in a company and provide shareholders with voting rights, preference shares are generally structured to provide investors with more predictable returns, often in the form of fixed dividends, but with fewer rights in terms of control over the company.

One of the most notable features of preference shares is that they typically do not carry voting rights. Shareholders of ordinary shares can influence company decisions by attending general meetings and casting votes on significant matters, such as electing the board of directors or approving mergers and acquisitions. In contrast, preference shareholders do not have these rights and, as such, are excluded from participating in the corporate governance of the company. This lack of voting power is balanced by the priority that preference shareholders have over ordinary shareholders when it comes to dividend payments and the distribution of assets in the event of liquidation.

Preference shares are usually designed to provide a fixed income to investors. The company commits to paying dividends on these shares at a predetermined rate, which is typically fixed at the time of issuance. This fixed dividend is often expressed as a percentage of the par value of the shares. For example, if a company issues preference shares with a 5% dividend rate and a $100 par value, preference shareholders are entitled to receive $5 per share in dividends annually, assuming the company declares them. This fixed income characteristic of preference shares is particularly attractive to income-focused investors who prefer a steady and predictable return on their investment, making preference shares a popular option for institutional investors, pension funds, and other entities seeking stable income streams.

In addition to offering fixed dividends, preference shares have priority over ordinary shares in the payment of dividends. This means that, in the event that a company generates profits and decides to distribute dividends, the holders of preference shares will be paid before any dividends are paid to ordinary shareholders. This gives preference shareholders a greater claim to the company's earnings, offering them a more secure income stream, especially if the company is experiencing financial difficulties. If the company does not have enough profits to cover both the preference and ordinary dividends, the preference dividends must be paid in full before the ordinary shareholders receive any dividend payouts. For this reason, preference shares are considered less risky than ordinary shares, as they provide investors with more security in terms of income distribution.

However, the priority of dividend payments does not guarantee that preference shareholders will always receive their dividends. If a company does not have sufficient profits to meet its obligations, it may decide to defer or suspend dividend payments altogether, especially during times of economic downturn or financial stress. This possibility highlights the fact that preference shares, although more secure than ordinary shares in terms of dividends, still carry a level of risk. Companies in distress may delay dividend payments, and in some cases, preference shareholders may not receive their dividends if the company's financial situation worsens significantly.

Preference shares can be further classified into two primary types: cumulative and non-cumulative. These two categories differ in the way unpaid dividends are treated when the company is unable to pay them in a given period. Understanding the distinction between these two types of preference shares is crucial for investors as it can significantly impact the total return they can expect to receive from their investment.

Cumulative preference shares are the most common form of preferred stock. With cumulative shares, if the company is unable to pay dividends in one or more periods, any missed payments accumulate and must be paid in full before any dividends can be distributed to ordinary shareholders. For example, if a company declares a 5% dividend on its cumulative preference shares but does not have the funds to pay it in one year, the unpaid dividend will be carried forward to the next year. The company will then be required to pay the accumulated dividends to preference shareholders in addition to the current year’s dividend before paying anything to ordinary shareholders. This feature provides a higher level of protection for preference shareholders, ensuring that they eventually receive any dividends owed to them, even if the company experiences temporary financial difficulties. The cumulative feature offers a safety net for investors, making cumulative preference shares a more attractive option for those seeking consistent income over time.

On the other hand, non-cumulative preference shares do not carry forward any unpaid dividends from previous years. If the company is unable to pay dividends in a given year, the preference shareholders lose their right to those dividends, and the payment is not carried forward into the next period. This means that if the company is unable to pay dividends in one year, the preference shareholders will have to wait until the company is financially capable of paying dividends again in subsequent years. The non-cumulative feature is riskier for investors, as there is no guarantee that missed payments will ever be made up. However, non-cumulative preference shares may offer a higher dividend rate to compensate for this risk, making them more attractive to certain investors who are willing to take on a bit more risk in exchange for potentially higher returns.

The treatment of unpaid dividends and the different risks associated with cumulative and non-cumulative preference shares can have significant implications for investors. Cumulative preference shares offer a more secure investment, particularly for those who rely on their dividends for income. These shares provide the peace of mind that any missed dividend payments will eventually be paid out, even if it takes some time. Non-cumulative preference shares, by contrast, are better suited for investors who are looking for higher yields and are willing to accept the possibility that dividends may not be paid in some years.

Despite the priority given to preference shareholders in the payment of dividends, preference shares still come with certain limitations. One of the most notable limitations is that preference shareholders typically do not have voting rights, meaning they have no say in the management or strategic direction of the company. As a result, they are excluded from influencing decisions that could significantly affect the company’s future growth, profitability, and overall success. This lack of voting power makes preference shares less appealing to investors who are interested in playing an active role in the company's governance or those who believe in the importance of shareholder influence on company policy.

Another limitation of preference shares is that they do not typically offer the same level of capital appreciation potential as ordinary shares. While the value of ordinary shares can rise significantly in response to a company’s success, the value of preference shares tends to remain more stable, with their value primarily driven by the fixed dividend payments. This means that while preference shares can provide a reliable income stream, they offer less upside potential in terms of price appreciation.

In conclusion, preference shares are a unique type of equity instrument that provide investors with a predictable income stream through fixed dividends, with priority over ordinary shareholders in dividend payments. They are particularly attractive to income-focused investors who seek stable returns with less risk compared to ordinary shares. The distinction between cumulative and non-cumulative preference shares further allows investors to tailor their investment choices based on their preferences for security versus potential higher returns. While preference shares do not provide voting rights and offer less potential for capital appreciation, they are an important component of the investment landscape, offering a secure and reliable option for those seeking regular income and lower levels of investment risk.