What are Preference Shares? How do they work?

A preference share is a type of equity that gives the holder preferential treatment in dividend payments and assets in the event of liquidation. This is in comparison to common shareholders. Preference shares typically do not confer voting rights, but they may have other features such as callability or cumulativeness. Preference stocks are a way for companies to raise capital without giving up control of the business. They are also a way for investors to get a higher return than they would from a bond, with less risk than they would from a common stock. In this article, we will explore what preference shares are, how they work, and the benefits associated with them.

What are Preference Shares?

Preference shares, also known as preferred stock, are a type of stock that give shareholders preferential treatment in terms of dividends and asset liquidation.

Holders of preference stocks typically have priority over common shareholders when it comes to receiving dividends. They may also have the right to be paid back first in the event that the company is liquidated.

Preference stocks usually don’t come with voting rights. This means that holders of preferred stock don’t have a say in how the company is run. However, some preference stocks do come with voting rights. In some cases, holders of preference stocks may even have veto power over certain decisions made by the company’s board of directors.

How do Preference Shares work?

A business might decide to issue preferreds for a few reasons:

  • In the event of corporate cash flow issues, preferred dividends may be halted.
  • The fact that institutional investors frequently purchase and hold preferred stock may make it simpler to market during an IPO.
  • Because preferred stock typically pays higher fixed-income payments than bonds while requiring a smaller investment per share, it is appealing. In addition, preferred stockholders are entitled to dividends and liquidation proceeds before common stockholders. As opposed to common stock, its price is typically more steady. Additionally, compared to corporate bonds of same quality, it is more liquid.
  • A callable characteristic of preferred stock permits the issuing company to forcibly cancel the outstanding shares for cash. This prevents the investor from taking advantage of any potential price growth in the future. Additionally, the maturity date is not stated, which raises doubts about the possibility of recovering the principle invested. It has little potential for appreciation, no voting privileges, and is interest rate sensitive.

What are the types of Preference Shares?

Preference stocks come in four basic varieties: participatory preferred, non-cumulative preferred, cumulative preferred, and convertible preferred. In contrast to non-cumulative preferred shares, holders of cumulative preferred shares are entitled to dividends retrospectively for any dividends that were not paid in earlier periods. Because of this, cumulative preferred shares will often cost more than non-cumulative preferred shares. Similar to participating common shares, participating preferred shares provide the benefit of increased dividends if specific performance goals are met, such as when corporate profits surpass a predetermined level. Similar to convertible bonds, convertible preferreds permit the holder to exchange their preference stocks for common shares at a predetermined exercise price.

Preference stocks may also be participating or non-participating. Participating preference stocks entitle the shareholder to participate in any increase in dividends paid on ordinary shares above the rate paid on preference shares. Non-participating preference stocks do not have this entitlement.

Preference Shares or Preference Stocks
Preference Shares or Preference Stocks

What is the difference between Preference Stocks and Ordinary Stocks?

Preference stocks may also be participating or non-participating. Participating in preference stocks entitles the shareholder to participate in any increase in dividends paid on ordinary shares above the rate paid on preference stocks. Non-participating preference stocks do not have this entitlement.

Preference shares typically have a fixed dividend, which is paid before any dividends are paid on ordinary shares. However, some preference share issues may have a variable dividend that is linked to the profitability of the company.

Unlike ordinary shares, preference shares usually have a redemption date, after which the company has the right to buy back the preference shares at a predetermined price.

What are the advantages of Preference Stocks?

Preference stocks offer a number of advantages over other types of equity investment. They typically offer a higher dividend yield than ordinary shares, and they also offer a greater degree of capital stability as the preference shareholder has priority over the ordinary shareholder in the event of a liquidation.

Preference stocks can also offer a degree of flexibility. Since they can be structured to provide either cumulative or non-cumulative dividends, they can be redeemable or non-redeemable. This flexibility means that preference stocks can be tailored to meet the specific needs of the investor.