A guide to preference shares

Preference shares differ from ordinary shares in terms of dividend payments, voting rights, and other aspects. Their distinct features suit certain shareholders and companies better than ordinary shares. Below, we explain some of the key features of preference shares.

What are preference shares?

Preference shares, also known as preferred shares or ‘prefs’ provide a couple of preferential rights for their shareholders, as opposed to shareholders of ordinary shares.

These two preferential rights consist of (i) preferential dividend payments and (ii) preferential return of capital. Let’s take a look at these rights in turn.

Preferential dividend payments

Preference shares have a fixed rate of dividend which is paid out before the other types of shares.

In other words, they take precedence over ordinary shares and other share classes in terms of the payment of any dividends. This feature essentially provides a higher degree of security for shareholders of preference shares, at least in terms of receiving a return on their investment.

Any remaining profits available for distribution as dividends are shared between the holders of ordinary shares after the preference shareholders have been paid their fixed rate of dividend.

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It should be noted that preference shares do not guarantee payment of any dividend to their holders if there have not been sufficient profits. However, they are first in line if there are any profits in the relevant financial period.

The flip side of the fixed rate of dividend associated with preferential shares is that their holders will miss out if there are particularly healthy profits. Ordinary shareholders may see higher dividend payments when the company is doing well, and preferential shareholders will be excluded from these benefits.

Preferential return of capital

Another feature of preference shares is that in the event of the company being wound up, holders of this type of share are entitled to be repaid their capital contribution before ordinary shareholders.

This effectively provides preference shareholders with a higher degree of security when it comes to recouping any losses should the company get into financial difficulty.

It should be noted that priority is still given to creditors over shareholders – including holders of preference shares.

So, just as preference shares do not guarantee payment of any dividend to their holders, they do not provide a guarantee that they will be able to retrieve their initial investment in the company if things go awry.

Can holders of preferential shares still vote?

One of the downsides of preferential shares is that they do not generally provide any automatic voting rights. This sets them apart from ordinary shares which normally entitle their holders to vote on company decisions.

Types of preference shares

Cumulative

Cumulative preference shares add a unique feature to standard preference shares regarding dividend payments.

With this type of share, if the regular fixed-rate dividend is not paid for one financial period as a result of inadequate profits, the sum which has not been paid will accrue and be added to future dividend payments.

This means that when profits improve enough to allow dividend payments, holders of cumulative preference shares will receive both the new fixed dividend payments in addition to the fixed dividend payments which they previously missed out on. As such, for long-term investments, cumulative preference shares provide even greater security and improve the chances of seeing a return on investment.

Convertible

Holders of convertible preference shares have the option to convert their preference shares to ordinary shares.

This option of conversion may be set for a certain period of time, or fall on a particular date in the future.

The main benefit of this type of share is to overcome the potential downside of a fixed rate of dividend. During a particularly successful trading period, holders of non-convertible preference shares may receive a lower dividend (i.e. at the fixed rate) compared to holders of ordinary shares, whose rate is variable and linked to profits.

Redeemable

Shareholders cannot normally demand that the company returns its investment in shares. There is no automatic refund policy unless a company enters liquidation.

Similarly, the company issuing shares cannot easily forcibly buy back its shares from shareholders. But a company can issue redeemable shares, which makes it easier for the shareholder to return the shares and redeem their initial investment.

Since preference shares are often viewed purely as an investment vehicle, making them redeemable is particularly attractive. It may also be helpful to the company if they plan to buy back their shares at a future date.

Participating

As we have discussed, one of the downsides of preference shares is that as a result of their fixed rate of dividend, in a profitable trading period, holders of them may receive lower rates of dividend payment compared with ordinary shareholders.

Participating preference shares entitle their holders to both (i), the fixed rate of dividend, and (ii), a share in the surplus profits which would otherwise only be shared out amongst ordinary shareholders in a particularly lucrative year.

Attracting investment opportunities without giving up control

Preference shares are generally viewed by investors as a safer bet than ordinary shares. As such, companies that are seeking new investment may decide to offer them as an alternative to taking out a business loan.

In effect, the process of issuing preference shares to risk-averse investors may be seen in some ways as a loan arrangement, with the release of capital for fixed rate payments (i.e. dividends).

Furthermore, because preference shares do not generally come with voting rights, existing shareholders may be more comfortable since their voting rights are not being diluted. Control of the company is therefore not being given away to the new investors.

But it is important to remember that preference shares do not involve debt, and do not create a creditor-debtor relationship. Preference shareholders will not necessarily see regular payments if a company does not make profits, and therefore their investment remains more at risk compared to creditors.