Advantages and Risks Associated with Preference Shares

Introduction: What are Preference Shares?

There are two types of shares that are allowed investors to invest in – equity shares and preference shares. Equity and preference shares have some distinct differences and they appeal to different categories of investors. Although equity shares are more common in financial terminologies, preference shares are also liked by many investors. Preference shares are instruments that combine the characteristics of equity shares and debt securities. Like equity shares, they represent ownership of the issuing company and are traded in the stock market.

On the other hand, they offer fixed dividends over a certain period of time like debt securities. That is why these shares, also known as preferred stock are called hybrid securities.

Features of Preference Shares

• Preferential treatment − Preference shares get preference over common or equity shares in payment and repayment of dividends. This means that the preferred stock owners must get the dividends before the common equity shareholders. Moreover, in the time of liquidation, the preference shareholders must be paid before equity shareholders.

• Dividend Payout − Preference shares get fixed dividends at certain intervals, such as yearly or monthly irrespective of whether the equity shareholders are paid or not. Therefore, the preference shareholder can remain sure about assured returns from their investment. This is a reason why preference shares are favored by some investors.

• Voting Rights − Preference shareholders do not possess voting rights. So, they cannot have their concerns subjected to discussion most of the time.

Types of Preference Shares

There are many types of preference shares depending on their nature. The following are the types of preference shares.

Cumulative Preference Shares

In the case of cumulative preference shares, the dividends accumulate over the years in which the company fails to make a profit. In the case of startups, they may take some time to turn profitable. In such cases, dividends are not paid in the years when there is no profit made by the company. However, the dividends are cumulated over the years and they are paid as a lump sum in the year when the company makes a profit.

Non-cumulative preference shares

In the case of non-cumulative preference shares, the dividends do not accumulate in the years when the company does not record a profit. So, the non-cumulative shareholders do not get any dividends in the years when the issuing company does not register a profit. They only get dividends only when the company turns profitable.

Convertible Preference Shares

Convertible preference shares can be converted to equity shares after a certain period of time. This means that after a given time period mentioned in the memorandum, the preferential shareholders become equity owners who can participate in voting but they are not treated as preference owners who will get more benefits as compared to other shareholders of the company.

Non-convertible Preference Shares

In the case of non-convertible preference shares, the preference shares cannot be converted to equity shares at any point in time. In other words, the shares remain preferential and the shareholders get preferential treatment throughout the tenure of shareholding.

Participating Preference Shares

Participating preference shares offer additional benefits to the owners. In case the issuing company of participating preference shares earns more profits than usual, these shareholders are offered additional dividends after other shareholders are paid. This means that participating preference shareholders get more dividends if the issuing company earns more in profits. This is applicable in the case of company liquidation as well. Participating shareholders can get the right to earn more during liquidation after all other shareholders are paid.

Non-participating Preference Shares

Non-participating preference shareholders do not get any other extra benefit than preferential treatment. They are not paid any extra amount depending on the extra income of the issuing company. They just get the benefit of getting dividends before equity shareholders.

Advantages of Preference Shares

Investors’ advantages

• As mentioned above preference shares are treated before equity shares. So, preference shareholders can expect preferential treatment in comparison to equity shareholders.

• Preference shareholders get dividends before equity shareholders. So, investors having preference shares can be assured of dividend payments before all other investors.

• Preference shareholders have the upper hand in claiming the company’s assets before all other shareholders in case of liquidation of the issuing company.

• Preference shares are a less risky investment than equity shares because of the preferential treatment. During dividend distribution and asset distribution (in case of liquidation) preference shareholders get the first preference.

Issuing Company’s Advantages

• The cost of preference shares is often less than equity shares. So, the companies may save money by issuing preference shares.

• Companies may keep voting rights in their hands by issuing preference shares.

Risks Associated with Preference Shares

• The risk of liquidity is still present in the case of preference shares. Although preference shareholders can claim the assets in the case of liquidation, they can do so after the creditors and debtors are paid. So, even when the risk is somewhat reduced, it is still present.

• When the interest rate in the market increases, the prices of shares may go down. So, the value of preference shares may nosedive when the interest rates go up. So, there is an interest risk associated with preference shares.

• There is also a market risk associated with preference shares. When the condition of the market is unfavorable, the prices of preference shares go down.

Whether to Buy Preference Shares or Not

Buying preference shares is a decision related to the objective of the investor. These shares are a less risky option in comparison to equity shares. They also provide consistent returns for a considerable period of time. So, if the risk appetite of the investor is low and they want to derive returns in a less aggressive manner, preference shares are the right option.

However, if the risk appetite is more and the investor wants to earn more from their investment, equity shares are a better option than preferred stock. Moreover, since equity shares offer voting rights, investors may consider buying equity stocks if they are interested in controlling the behavior of the management of issuing company.

Conclusion

Preference shares are a tool to avail preferential treatment from the issuing company. It is a less risky option for investors. That is why investors with a less risk appetite prefer investing in preference shares. These shares are different from equity shares and it is important for investors to learn about both of them to make informed decisions while investing in shares.

FAQs

Qns 1. Why are preference shares called hybrid securities?

Ans. Preference shares are instruments that combine the characteristics of equity shares and debt securities. Like equity shares, they represent ownership of the issuing company and are traded in the stock market. On the other hand, they offer fixed dividends over a certain period of time like debt securities. That is why these shares, also known as preferred stock are called hybrid securities.

Qns 2. Which is a less risky investment - equity or preference shares?

Ans. Preference shares are a less risky investment for investors.

Qns 3. Do preference shareholders get voting rights in the issuing company?

Ans. Preference shareholders do not have voting rights in the issuing company.