Types of Preference Shares
Preference shares (or preferred stocks) are a class of ownership in a corporation that has a higher claim on assets and earnings than common stock. Preference shares typically get dividends before common shareholders and have priority in the event of a liquidation. They come in various types, each with distinct features:
- Cumulative Preference Shares:
- If the company fails to pay a dividend in any year, the dividend will accumulate and must be paid out to cumulative preference shareholders first, before any dividends are paid to common shareholders.
- Example: If a company skips a dividend payment in Year 1, the cumulative preferred shareholders would receive dividends for both Year 1 and Year 2 in the next payment period.
- Non-Cumulative Preference Shares:
- Holders of these shares only receive dividends if the company decides to pay them. If the company skips a dividend in a particular year, these shareholders have no rights to claim any missed payments.
- Example: If no dividend is declared in a given year, non-cumulative preference shareholders won’t receive a payment and won’t be compensated for the missed payment later.
- Participating Preference Shares:
- Apart from receiving a fixed dividend, holders of these shares might also get a share of surplus profits after all dividends are paid to common shareholders.
- Example: If a company has a particularly profitable year, participating preference shareholders might receive their standard dividend plus an additional percentage of the excess profits.
- Non-Participating Preference Shares:
- Shareholders receive a fixed dividend and nothing more, regardless of the company’s profit levels.
- Example: If the fixed dividend is 5%, that’s all the non-participating preference shareholders will get, even if the company has an exceptionally profitable year.
- Convertible Preference Shares:
- These shares can be converted into common stock after a specified period.
- Example: An investor might buy convertible preference shares that can be converted into common stock after three years at a predetermined conversion ratio.
- Non-Convertible Preference Shares:
- These shares cannot be converted into common stock.
- Example: An investor holding non-convertible preference shares will only receive the benefits associated with those shares and won’t have the option to convert them into common shares.
- Redeemable Preference Shares:
- These shares can be redeemed (bought back) by the company after a certain period or on a specific date.
- Example: A company might issue redeemable preference shares that they commit to buying back after 10 years at a set price.
- Irredeemable Preference Shares (or Perpetual Preferred Stock):
- These shares don’t have a redemption date. They remain in existence for an indefinite period until the company winds up or chooses to redeem them.
- Example: A company could issue irredeemable preference shares with a fixed dividend of 6% indefinitely, with no set redemption date.
When issuing preference shares, a company can combine features from different types. For instance, a company might issue cumulative, participating, convertible preference shares. Investors should always read the terms associated with any preferred stock offering to understand the exact features and benefits.
Example of Types of Preference Shares
Let’s delve into a hypothetical scenario to better understand two different types of preference shares:
Company Alpha’s Preference Share Issuance:
Background: Company Alpha, a growing technology firm, decides to raise capital without diluting the voting power of its existing common shareholders. They decide to issue preference shares. To appeal to a broader base of investors, they issue two types of preference shares: Cumulative Convertible Preference Shares and Redeemable Non-Participating Preference Shares.
- Cumulative Convertible Preference Shares:
- Details: These shares offer a fixed annual dividend of 4%. If Company Alpha doesn’t distribute dividends in any given year, the dividend accumulates and is paid out in the subsequent years before any dividend is given to common shareholders. After five years, shareholders have the option to convert these preference shares into common stock at a 1:2 ratio (one preference share converts to two common shares).
- Example Scenario: Suppose an investor, Mr. Smith, buys 100 of these shares. If Company Alpha skips dividends in Year 1 and 2 due to reinvesting profits, by Year 3, Mr. Smith is owed dividends for all three years. In Year 6, seeing the company’s strong growth, he decides to convert his 100 preference shares into 200 common shares.
- Redeemable Non-Participating Preference Shares:
- Details: These shares offer a fixed annual dividend of 5%. They do not have the right to participate in any surplus profits beyond this dividend rate. Company Alpha can redeem (buy back) these shares at a 10% premium after seven years.
- Example Scenario: Mrs. Johnson buys 100 of these shares. She receives a consistent 5% dividend each year, irrespective of how well the company performs. After seven years, Company Alpha decides to redeem these shares. Mrs. Johnson receives her initial investment back along with a 10% premium.
Outcome: Through this issuance, Company Alpha successfully raises capital, offering different benefits to cater to varied investor preferences. Mr. Smith, believing in the company’s long-term prospects, opts for cumulative dividends and later conversion into common stock. In contrast, Mrs. Johnson prefers a consistent dividend and the option for a premium upon redemption.
Both types of shares serve the company’s goal of raising funds without diluting voting rights immediately, and they cater to investors with different risk appetites and investment horizons.
