Preference shares offer a distinct type of financial asset with their own benefits and drawbacks for investors and companies.
For the investor, these shares guarantee a fixed dividend and take precedence over ordinary equity shares during payouts.
Advantages of preference shares for investors
- Priority in Dividend Payment: Preference shareholders are paid dividends before ordinary shareholders.
- Stronger Asset Claims: In the unfortunate event of a company facing liquidation or bankruptcy, preference shareholders are prioritised for asset distribution.
- Additional Perks: The terms may include options for converting preference shares to ordinary shares.
Advantages of preference shares for companies
- Flexibility in Capital Structure: Issuing preference shares allows a company to raise capital without diluting control, as these shares typically don’t come with voting rights.
- Predictable Costs: The dividend rates for preference shares are fixed, allowing for easier financial planning.
- Attracting Diverse Investors: Some investors seek the predictability and lower risk associated with preference shares, diversifying the company’s investor base.
Disadvantages of preference shares for companies
- Costly Dividends: Fixed dividends often mean a higher capital cost than ordinary shares, particularly when the company is doing well.
- Reduced Borrowing Capacity: Because preference dividends must be paid before ordinary dividends, they can limit a company’s ability to take on additional debt.
- Less Attractive to Certain Investors: The lack of voting rights may make preference shares less appealing to potential investors who want to influence company operations.
What are preference shares?
A preference share is a type of share that provides the holder with priority rights in certain areas but usually comes without voting rights.
This contrasts with ordinary shares, where the shareholder may have voting rights and can influence company decisions. Preference shares are akin to bonds, offering perpetual dividends to the holders.
Calculating the dividend yield for preference shares involves dividing the annual dividend by the share’s current market price.
Unlike ordinary shares, where dividends are variable and announced by the board of directors, preference share dividends are generally fixed.
The value of preference shares can be influenced by interest rates, much like bonds. When interest rates rise, the value of preference shares typically declines.
Ordinary shares don’t follow this pattern; their value is determined by market demand and supply.
Are preference shares debt or equity?
Technically, preference shares are a form of equity, as they represent ownership in the company.
However, they share characteristics with debt, such as fixed, predetermined dividend payments, much like interest payments on a loan.
Because they straddle the line between debt and equity, preference shares can offer companies financial flexibility, but they can also complicate a firm’s capital structure.
Impact on existing shareholders
While preference shareholders may not have voting rights, their inclusion can still affect ordinary shareholders.
Introducing preference shares expands the company’s financial resources but dilutes the ownership stake of ordinary shareholders.
This dilution can be particularly detrimental during company losses or liquidation, as preference shareholders are paid out first.
Alternatives to issuing preference shares
- Debentures: Unsecured bonds offer less risk than preference shares due to their senior status in liquidation events.
- Issuing More Ordinary Shares: This negates the need for priority dividend payments and creates a more equitable distribution during liquidation.
Conclusion
Preference shares serve as a common fundraising tool for public companies.
While beneficial for raising capital and offering guaranteed dividends, they also have implications for investors and the companies that issue them.
Companies should weigh these pros and cons carefully and consider alternatives like debentures or additional ordinary shares.
