Features of Preference Shares

Preference shares, also known as preferred stocks, are a distinctive class of equity securities that companies issue to raise capital. Unlike ordinary shares (common stock), preference shares carry certain privileges that set them apart. These privileges often make preference shares an attractive investment for those seeking stable income with less risk. However, despite their advantages, preference shares also come with limitations, particularly in terms of ownership rights and the potential for capital appreciation. The primary objective behind the issuance of preference shares is to offer an investment vehicle that provides more security to investors compared to ordinary shares, while still allowing companies to raise funds without diluting ownership control or taking on more debt.

There are several key features that define preference shares, and understanding these features is essential for investors who wish to make informed decisions. Preference shares come with distinct rights and benefits that make them an appealing choice for risk-averse investors. In this essay, we will discuss the three main features of preference shares, including their fixed dividend rate, lower risk compared to ordinary shares, and preferential treatment in the event of liquidation or winding up of the company.

One of the most important characteristics of preference shares is their entitlement to a fixed rate of dividend. Preference shares are often referred to as fixed-income securities because the dividend paid to preference shareholders is fixed at the time of issuance. This fixed dividend is usually specified as a percentage of the nominal value of the share or as a fixed amount. For example, a company may issue preference shares with a 5% dividend rate, which means that for each share with a nominal value of $100, the shareholder will receive a fixed dividend of $5 annually.

This feature distinguishes preference shares from ordinary shares, as the dividends paid to ordinary shareholders are not fixed. The dividend paid to ordinary shareholders is typically based on the company’s profitability and declared at the discretion of the board of directors. If the company performs well and generates profits, ordinary shareholders may receive dividends; however, if the company experiences losses or chooses to reinvest profits back into the business, ordinary shareholders may not receive any dividends. In contrast, preference shareholders are entitled to receive their fixed dividends regardless of the company’s financial performance, as long as the company has enough profits or reserves to pay these dividends.

The fixed-rate dividend makes preference shares an attractive option for investors who seek a predictable and stable income. Preference shares are particularly appealing to income-focused investors, such as pension funds, insurance companies, and retirees, who rely on steady cash flow from their investments. Moreover, because the dividend is fixed, it provides investors with a higher degree of certainty compared to ordinary shares, which may experience fluctuations in dividend payouts depending on the company’s performance.

Another key feature of preference shares is that they are comparatively less risky for investors. This lower level of risk is due to the priority given to preference shareholders in the payment of dividends and the distribution of assets in case the company faces financial difficulties. Preference shareholders are typically paid their dividends before ordinary shareholders, which gives them a more secure income stream, even during times of financial stress. If a company faces a downturn or financial instability, it will first honor its obligations to pay dividends to preference shareholders, and only after those obligations are met will the remaining profits be distributed to ordinary shareholders.

Additionally, preference shares are considered less risky than ordinary shares because they generally offer more stability in terms of income and return on investment. While the value of ordinary shares can fluctuate widely due to changes in the company’s performance or market conditions, the value of preference shares tends to be more stable. This is because the dividends are fixed and not dependent on the company’s profits, providing preference shareholders with a more predictable return. Furthermore, in the event of liquidation or bankruptcy, preference shareholders have a higher claim on the company’s assets than ordinary shareholders, making their investments less vulnerable to loss.

However, preference shares are not entirely risk-free. While the risk of non-payment of dividends is lower for preference shareholders compared to ordinary shareholders, it still exists. In cases where the company faces severe financial difficulties or is unable to generate sufficient profits, it may be unable to meet its dividend obligations to preference shareholders. Despite this, preference shares still offer a lower level of risk than ordinary shares, as their fixed dividends are prioritized over the more variable dividends of ordinary shares.

The third key feature of preference shares is that preference shareholders are given preferential treatment in the event of the company’s liquidation or winding up. In the event that a company is dissolved, liquidated, or declared bankrupt, the preference shareholders have a priority claim on the company’s assets before the ordinary shareholders. This means that preference shareholders will be paid any outstanding dividends and may receive a portion of the company’s remaining assets before ordinary shareholders are entitled to anything. This priority over ordinary shareholders makes preference shares a safer investment in terms of capital recovery during times of financial distress or when the company is undergoing liquidation.

In the event of liquidation, the process of asset distribution follows a hierarchy of claims. Creditors, such as bondholders and lenders, are typically paid first, followed by preference shareholders who are entitled to receive the amount due to them based on their fixed dividend entitlements. Only after the preference shareholders have been fully compensated do ordinary shareholders have a claim to any remaining assets. This hierarchy ensures that preference shareholders have a greater likelihood of recovering their investment in the event of the company’s failure, whereas ordinary shareholders may lose all of their capital if the company’s assets are insufficient to cover its debts and obligations.

While the priority in liquidation makes preference shares attractive from a safety standpoint, it is important to note that preference shareholders do not have the same level of ownership control as ordinary shareholders. Preference shares do not usually carry voting rights, meaning preference shareholders cannot participate in corporate governance decisions or influence the management of the company. This lack of control is a significant disadvantage for some investors, as it means they cannot vote on important matters, such as the election of directors, mergers and acquisitions, or changes in the company’s strategy.

In summary, preference shares are an important class of equity securities that offer investors a fixed dividend rate, lower risk compared to ordinary shares, and preferential treatment in the event of liquidation. These characteristics make preference shares an appealing choice for investors seeking stability, predictability, and income. The fixed dividend provides a reliable income stream, while the priority in dividend payments and asset distribution offers additional security for investors. However, preference shares come with limitations, including the lack of voting rights and the potential for dividend payments to be missed in times of financial difficulty. Despite these limitations, preference shares remain a popular investment choice, particularly for those seeking to balance risk and return in their portfolios.