Preference Shares : Features, Types, Merits and Demerits

What are Preference Shares?

Preference shares are those shares that are issued with features like preferential claim to dividends and capital repayment with a fixed rate of return. Preference share capital is the capital acquired through the issuance of preferred shares. There are two ways in which preference shareholders are in a better position than equity shareholders :

1. Receiving a fixed rate of dividend before any dividend is paid to equity shareholders out of the company’s net profits.
2. Receiving their capital at the time of the company’s liquidation after the debts of its creditors have been settled.

In comparison to equity shareholders, preference shareholders have a preferential claim to dividends and capital repayment. Preference shares are similar to debentures in that they have a fixed rate of return. Furthermore, As the dividend is paid only at the discretion of the directors and only from profit after tax, these are similar to equity shares in that context. As a result, preference shares share some characteristics of both equity and debentures.

Features of Preference Shares

1. Fixed Rate of Dividend: Preference shareholders get dividends before equity shareholders at a fixed rate.

2. No Security: The preference shareholders do not get any security from the company against their shares. Besides, preference share capital is a part of the owner’s fund capital of the company.

3. Hybrid Security: As preference shares consist of the features of both equity shares and debentures, they are known as Hybrid Securties. Just like equity shares, the preference shareholders get dividends only when the company earns a profit, and just like debentures, preference shareholders get a fixed rate of return.

4. Voting Rights: Under general conditions, the preference shareholders do not have voting rights. However, if the dividends are not paid for two years or more, the preference shareholders get voting rights.

5. Help to Collect Large Amount of Funds: As cautious investors and financial institutions prefer to invest in preference shares of a company, it helps them collect a huge amount of funds. Besides, preference shares attract more public because of their fixed rate of return.

6. No Fixed Liability: Preference shareholders get dividend only when the company earns profit. Therefore, in case of losses, the company is not obliged to pay dividend to the preference shareholders.

Types of Preference Shares

Preference Shares are of the following types:

1. Cumulative Preference Shares: Cumulative Preference Shares are those that have the right to accumulate unpaid dividends in future years if they are not paid during the current year.

2. Non-Cumulative Preference Shares:  Non-cumulative Preference Shares are those on which dividends do not accumulate. It means that if a company does not declare dividends for any year, the right of dividend of such shareholders for that year will be lost.

3. Participating Preference Shares:  Participating preference shares are preference shares that have the right to participate in the additional surplus of a company’s shares after a dividend at a certain rate has been paid on equity shares.

4. Non-Participating Preference Shares:  Non-participating preferences are those who do not have the right to participate in the company’s profits.

5. Convertible Preference Shares: Convertible preference shares are preference shares that can be converted into equity shares within a certain time frame. 

6. Non-Convertible Preference Shares: Non-convertible shares are those that cannot be converted into equity shares.

Merits of Preference Shares

The merits of raising funds through preference shares are:

1. Consistent Income: Preference shares provide reasonably consistent income in the form of a fixed rate of return and investment safety.

2. Reasonable Safety of Returns: Preference shares are useful for investors seeking a fixed rate of return with low risk.

3. No Interference in Management: It has no effect on equity shareholders’ control over management because preference shareholders do not have voting rights.

4. Trading on Equity: Paying a fixed dividend rate to preference shares may enable a company to declare higher dividend rates to equity shareholders in good times.

5. Repayment of Principal Amount: In the event of a company’s liquidation, preference shareholders have a preferential repayment right over equity shareholders.

6. No Charge on Assets: Preference capital does not impose any kind of charge on a company’s assets.

Demerits of Preference Share

The demerits of raising funds through preference shares are:

1. Limites Appeal: Preference shares are not suitable for investors who are willing to take risks in exchange for higher returns.

2. Dilutes Claim of Equity Shareholders: Preference capital dilutes equity shareholders’ claims towards the company’s assets.

3.  Unreliable and Low Returns: As the dividend on these shares is only paid when the company makes a profit, there is no guaranteed return for investors. As a result, these shares may not be very appealing to investors.

4. No Tax Benefits: The dividend is not deductible as an expense from profits. As a result, there is no tax savings, as in the case of interest on loans.