Preference Share Definition & Examples

Published Sep 8, 2024

Definition of Preference Share

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. Preference shares typically receive dividends before common shareholders and have a fixed dividend rate, making them similar to debt securities while retaining equity characteristics.

Example

Consider a company named Tech Innovators Inc.

Common Shares: These are the regular shares issued to the owners of the company. Shareholders of common stock participate in the company’s growth and bear the brunt of its risks.
Preference Shares: Tech Innovators Inc. decides to issue preference shares to attract investors who desire a steady income with less risk. They offer these shares with a fixed annual dividend of 5% of the share’s face value, which is paid out before any dividends on common shares.

Now, suppose Tech Innovators Inc. has a limited profit in a given year, only enough to pay the fixed 5% dividend to preference shareholders. In this scenario:

Preference shareholders receive their fixed dividends.
Common shareholders receive dividends only if there’s any remaining profit after the preference dividends are paid.

Additionally, preference shareholders often have a claim on the company’s assets before common shareholders if the company is liquidated. However, they typically do not have voting rights, unlike common shareholders.

Why Preference Shares Matter

Preference shares offer a blend of equity and debt features, making them attractive for both companies and investors.

For Companies:
- Issuing preference shares can be a way to raise capital without diluting the power of existing common shareholders since preference shareholders usually do not have voting rights.
- The fixed dividend payments are often lower than interest rates on debt, making this a cheaper financing option.
For Investors:
- Preference shares provide a fixed dividend, offering more stable income compared to the variable dividends of common shares.
- They have a higher claim on assets and earnings, giving investors a cushion against company insolvency.

Frequently Asked Questions (FAQ)

What are the main types of preference shares?

There are several types of preference shares, each with distinct features:

Cumulative Preference Shares: These shares accumulate unpaid dividends. If a company misses a dividend payment, it must pay the accumulated dividends to preference shareholders before any dividends can be paid to common shareholders.
Non-Cumulative Preference Shares: These shares do not accumulate unpaid dividends. If a dividend is missed, preference shareholders lose that dividend, and the company is not obligated to pay it in the future.
Convertible Preference Shares: These can be converted into a specified number of common shares after a predetermined date or under certain conditions, allowing investors to benefit from the company’s growth.
Redeemable Preference Shares: These shares can be bought back by the issuing company after a certain period or under specific conditions, providing a potential exit strategy for shareholders.

How do preference shares compare with bonds as an investment option?

Both preference shares and bonds offer fixed returns, but they differ in several key aspects:

Risk and Return: Bonds typically are less risky than preference shares because they are debt instruments and have a higher claim on assets in the event of liquidation. Preference shares, being a form of equity, are riskier but offer potentially higher returns through fixed dividends.
Income Stability: Bonds offer guaranteed interest payments, whereas preference share dividends depend on the availability of the company’s profits.
Claim on Assets: In case of company liquidation, bondholders are paid before preference shareholders, making bonds a safer investment in this regard.

Can preference shares influence corporate decisions?

Generally, preference shareholders do not have voting rights and hence do not influence corporate decisions to the same extent as common shareholders. However, under certain conditions (e.g., unpaid dividends for a specified period), preference shareholders may be granted voting rights, allowing them to participate in critical decisions, thus providing some level of control and influence within the company.

What are the tax implications of investing in preference shares?

Tax treatment of preference shares can vary based on jurisdiction, but generally:

Dividends from preference shares might be taxed differently than interest income from bonds.
In some regions, there’s a preferential tax rate for dividends, making the after-tax return on preference shares potentially more attractive compared to bonds.
Investors should consult with tax professionals to understand local tax obligations and benefits related to preference shares.

Preference shares can be a versatile investment vehicle offering a blend of fixed income and equity benefits, making them an important tool for both company financing strategies and investor portfolios.