All Types of Preference Shares Explained
Do you remember how many types of preference shares there are? No? Don’t worry! We are here to help you.
Let’s start from the beginning.
Preference shares, also known as preferred stock, represent a class of ownership in a corporation that has a higher claim on assets and earnings than common shares.
These shares are termed “preference” because they have preferential rights over ordinary shares. These rights can pertain to dividends, repayment of capital, or other features. Here are nine different types of preference shares:
Cumulative preference shares:
Definition: If a company fails to pay dividends in one year, the holders of cumulative preference shares have the right to be paid their omitted dividends in subsequent years.
Features: These shareholders are in a priority position to receive missed dividends before any dividend is paid to ordinary shareholders.
Example: If a company couldn’t pay dividends for 2 years but makes a profit in the third year, the cumulative preference shareholders would first receive their dividends for the past two missed years before any dividends are distributed to other shareholders.
Non-cumulative preference shares:
Definition: Unlike cumulative preference shares, these shareholders do not have the right to receive dividends that were omitted in previous years.
Features: If the company skips a dividend payment in any year, these shareholders lose their right to that dividend permanently.
Example: If a dividend isn’t declared in a year, non-cumulative preference shareholders will not receive it in subsequent years, even if the company returns to profitability.
Participating and non-participating preference shares:
Definition: These shareholders not only receive a fixed dividend but also have the right to participate in surplus profits after all dividends are paid to other shareholders.
Features: They allow shareholders to benefit from both the stability of fixed dividends and the potential upside of a company’s success.
Example: After paying dividends to all shareholders, if there’s any profit left, participating preference shareholders will receive an additional portion of the profit.
Definition: Shareholders receive only a fixed dividend and don’t get to participate in any extra dividends that might be available after all other dividends are paid.
Features: They offer stability with their fixed dividends, but no additional benefits from surplus profits.
Example: Even if the company has surplus profits after distributing dividends, non-participating preference shareholders won’t receive a part of it.
What about other types of preference shares?
Convertible preference shares and non-convertible preference shares:
Definition: Shareholders have the option to convert their preference shares into ordinary shares after a specified period.
Features: Offers a blend of the safety of preference shares and the potential upside of ordinary shares.
Example: A holder of convertible preference shares might decide to convert them into ordinary shares to capitalize on the company’s growth and potentially higher dividends in the future.
Non-convertible preference shares:
Definition: These shares cannot be converted into ordinary shares.
Features: They remain preference shares for their entire existence, offering a fixed dividend but no potential conversion upside.
Example: These are suitable for investors looking for a steady income without the volatility associated with ordinary shares.
Redeemable preference shares and irredeemable preference shares:
Definition: These shares are issued with the understanding that the company will redeem them after a certain period.
Features: They provide fixed dividends and are returned for a fixed price after the tenure is over.
Example: An investor might purchase redeemable preference shares that promise to pay back the principal amount after 10 years.
Irredeemable preference shares (or perpetual preference shares):
Definition: These shares have no specific maturity date and the company is not obligated to redeem them.
Features: They can remain in existence for as long as the company is operational, providing a continuous source of fixed dividend income.
Example: Suitable for investors seeking a perpetual income without a focus on capital return.
Adjustable-Rate Preference Shares:
Definition: The dividend yield on these shares is tied to a benchmark interest rate, like the prime rate.
Features: The dividend can go up or down based on the movements of the referenced rate, offering a variable return.
Example: If the benchmark interest rate rises, the dividend on these shares might increase, offering higher returns to the shareholders.
Adjustable preference shares
We can’t forget about adjustable preference shares, when it comes to all types of preference shares.
In the case of adjustable preference shares, the dividend rate is not fixed and is influenced by current market rates.
To sum up, preference shares represent a class of ownership that combines features of both debt and equity, offering advantages to both corporations and investors.
Diversified financing: Preference shares provide an alternative source of funding beyond common equity and debt. This flexibility can be crucial during periods when one source of financing becomes too expensive or unavailable.
No obligation for dividends: Unlike bonds, where interest payments are mandatory, companies are not obligated to pay dividends on preference shares. However, if skipped, they might have to pay it later for cumulative preference shares.
Strengthening balance sheet: As they don’t necessitate fixed payments like debt, they can be viewed more favorably by lenders and rating agencies, potentially improving credit ratings.
Higher claim: Preference shareholders have a higher claim on assets and earnings than ordinary shareholders. If a company goes bankrupt, preferred shareholders are paid before common shareholders during asset liquidation.
Dividend advantage: They typically receive dividends before common shareholders and often at a fixed rate, making it a more predictable income source.
Convertible features: Some preference shares offer the option to convert into ordinary shares, allowing investors to potentially benefit from a company’s growth.
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