When purchasing shares in a company, it’s vital to know what types of shares best fit your needs. Popular belief tends to paint all shares with the same brush, ignoring any nuance between types of share. One such share that has distinct properties is preference shares, also known as preferred stock or preferred shares. In this article, we will break down preference shares, explain the differences between them and other shares, and detail their advantages and disadvantages.
As the name implies, preference shares provide investors with a priority claim when it comes to payouts and dividends. Compared to common stock, preference shares take priority. However, they are junior to bonds. In practice, this means that owners of preference shares take priority for payouts over owners of common stocks, but bond owners take precedence over both.
Preference shares have a number of features that set them apart from other types of shares. They provide holders with dividend payments and, as mentioned earlier, priority over common stockholders. These payments can be fixed or floating, depending on interest rates. Similarly, preference shares provide holders with priority over common stockholders in the event a company liquidates its assets. However, they do not provide holders with voting rights, though some exceptions can be made in highly unusual circumstances. For that reason, holders of preference shares may wish to convert their shares into common stock, which confers those rights. This most often requires approval from the board of directors.
There are several types. Though they are broadly similar, certain features may make one preferable over another. Preference shares can be:
- Perpetual preference shares – This type of preference share has no fixed date for investors to receive their investment. As the name suggests, it will continue in perpetuity.
- Cumulative preference shares – With this type of preference share, any dividend payments missed by the issuer will be rolled over into the next payment term. The investor will then receive both at once.
- Convertible preference shares – This type allows investors to convert their shares into common stock. This confers voting rights, but must be approved by the board of directors, and must not exceed a set amount.
- Exchangeable preference shares – This type can also be converted, but rather than be limited to only common stock, it can instead be exchanged for any other type of security.
As you can doubtless tell, preference shares have their advantages and useful applications. However, as with anything, they are not without disadvantages. Let’s take a look at the good and the bad.
Preference shares offer advantages to both investors and issuers. For investors they:
- Provide a reliable income – Preference shares grant their owners dividend payments, which are a reliable source of income. Moreover, they tend to offer higher rates than other forms of investment, such as bonds.
- Priority treatment – Holders of preference shares will receive payouts before common stock owners. This is true for both dividend payments and asset liquidation.
- Lower risk – Due to the above reason, preference shares are a low-risk investment opportunity. If the company in question goes bankrupt, you will be first in line when payments are made.
Preference shares are also beneficial to companies. These advantages are:
- Retain control over voting rights – As preference shares do not confer voting rights to their holders, the company directors do not stand to lose any control over the company. This is often termed a dilution of control.
- Term flexibility – Preference shares offer a great deal of flexibility to issuers. Within reason, a company can include near any term they wish in their issuing of preference shares.
- No obligation to pay dividends – In cases where a company does not bring in sufficient profits, there is no obligation to pay dividends. The one exception to this is cumulative preference shares, where the company must roll the payment over into the next term.
Equally, there are disadvantages for both investors and issuers. For investors, these disadvantages are:
- Preference shares do not confer voting rights – We’ve mentioned this throughout this article, but it does warrant stressing. Where other types of investment allow you to exert some control over the company’s direction, preference shares do not. This means that in the event the company takes a sharp turn, you are powerless to affect that decision, and thus protect your investment.
- Preference shares are not as accessible – Common stock is precisely that, common. They are relatively easy to buy and sell, but the same isn’t true for preference shares. Acquiring them can be difficult, as can converting or selling them.
- Dividends are fixed – Preference shareholders are not paid a percentage of company profits; they are paid a fixed dividend. While this does mean a reliable income, it also means you won’t receive a bonus during a particularly good month.
Disadvantages for issuers are:
- Financial pressure – Issuing preference shares will place a degree of financial pressure on your company, as dividends must be paid when the company is turning a sufficient profit. Issuing too many can greatly reduce income once dividends are paid.
- Preference shares have a set repayment date – With the exception of perpetual preference shares, a company must repay their investors after a period of time. This is often around twenty years, requiring a considerable sum of money from the issuer.
- Dividend rates are higher – Adding to further financial pressure, preference shares require companies to pay higher rates than other types of shares. Naturally, this makes them more expensive than other shares.
Of course, there are reasons to use either option. Equally, there are reasons not to. It depends on your situation and what you’d like from your investment. Preference shares, for example, carry considerable benefits in terms of dividend payouts, but do not allow shareholders to exercise any control over the company and its direction. That benefit is provided by common stock.
For investors that prefer a steady income, preference shares are likely the best option. Conversely, for investors that would rather have a say in the company in the form of voting rights, common stock is the better choice.
In a company facing liquidation, ownership of preference shares is highly beneficial. Owners will receive their payment before owners of common stock, though any secured, unsecured, and preferential creditors will be prioritised over both. This process tends to go smoothest during a Members’ Voluntary Liquidation (MVL). When a company closes due to insolvency, however, the process can be complicated due to the lack of money left in the company’s coffers.
If you operate a company that is feeling the financial strain paying dividends causes, it might be time to look at other options. If you decide that liquidation is an option, Clarke Bell is here to help. To find out what we can do for you, contact us today.
