Preference shares

Preference shares are company shares that usually offer a fixed dividend rate. Preference shareholders receive dividends before equity shareholders when the company declares a dividend.

• They have priority over equity shareholders for dividend payments.
• They also have a higher claim on capital if the company is liquidated.
• Most preference shareholders have limited voting rights.
• Cumulative preference shares carry forward unpaid dividends.
• Convertible preference shares can be converted into equity shares.
• Redeemable preference shares are repaid by the company on agreed terms.
• Dividends are not guaranteed and may be delayed or skipped.

• Their market value and purchasing power can still fall.

  
  
  

Preference shares are company shares that give their holders certain rights before equity shareholders. These rights mainly relate to dividend payments and repayment of capital.
For example, suppose a company decides to distribute dividends to both preference and equity shareholders. It must first pay the dividend due to preference shareholders. It can then pay equity shareholders.
Preference shareholders also receive priority if the company closes and its assets are distributed. However, creditors and other lenders are generally paid before shareholders.
Preference shares usually carry a fixed dividend rate. However, this does not mean that the income is guaranteed. The payment depends on the type of preference share, its terms and the company’s financial position.
These shares combine some features of equity and debt. They represent share capital, but their fixed dividend structure can make them appear similar to fixed-income instruments.
 

Preference shares have the following main features.

1. Priority in dividend payments

Preference shareholders receive dividends before equity shareholders when a company declares a dividend.
For example, suppose a company has both preference shares and equity shares. If it declares a dividend, it must first pay the preference dividend. It can distribute the remaining amount to equity shareholders afterwards.
With cumulative preference shares, unpaid dividends are carried forward. The company must clear these pending dividends before paying dividends to equity shareholders.

2. Limited voting rights

Preference shareholders usually cannot vote on every business decision. However, this does not mean that they never have voting rights.
They may vote on matters that directly affect the rights attached to their preference shares. They may also vote on matters such as winding up, repayment or reduction of share capital.
Under Indian company law, a class of preference shareholders may gain voting rights on all resolutions if its dividend remains unpaid for two years or more.

3. Predetermined dividend rate

Preference shares commonly carry a dividend rate decided when the shares are issued. This can make their income more predictable than the dividend from equity shares.
However, the payment is not guaranteed monthly income. The company may delay or skip dividends depending on its financial position and the terms of the shares.
For example, if a cumulative preference dividend is missed, it is carried forward. If a non-cumulative preference dividend is missed, the shareholder usually cannot claim it in a later year.

4. Redemption and call options

A company may issue redeemable preference shares. These shares are repaid or bought back according to the redemption date and conditions set at the time of issue.
Some preference shares may also have a callable option. This allows the company to repurchase them at an agreed price after a specified date.
Investors should check the issue terms carefully. The terms explain when the shares may be redeemed, the applicable price and the conditions that the company must follow.
 

Investors may consider preference shares for regular dividend income and priority over equity shareholders. However, the actual benefit depends on the type and terms of the shares.

• They may provide regular returns

  
  

  Preference shares commonly carry a predetermined dividend rate. This may provide a more predictable source of income than ordinary equity dividends.

  
  

  However, the payment is not assured. Its continuity depends on factors such as the company’s financial condition and whether the shares are cumulative or non-cumulative.

  
  

• They carry priority over equity shares

  
  

  Preference shareholders have a higher claim than equity shareholders on dividend payments and repayment of capital.

  
  

  If a company closes, creditors are paid first. Preference shareholders then receive repayment before equity shareholders, subject to the money and assets available.

  
  

  This priority may reduce some risk compared with equity shares. It does not remove the possibility of losing part or all of the investment.

  
  

• They may offer limited growth

  
  

  Most preference shareholders receive only the agreed dividend rate. They may not benefit fully when the company’s profits increase.

  
  

  Preference shares can also have less scope for capital appreciation than equity shares. Investors should consider this limitation before investing.

  
  
  

Preference shares can be grouped according to their dividend, redemption, participation and conversion terms.

1. Cumulative preference shares

Cumulative preference shares allow unpaid dividends to build up.

If the company does not pay the dividend in a particular year, the missed amount is carried forward. The company must pay these pending dividends before paying dividends to equity shareholders.

For example, suppose the annual dividend is ₹8 per share, and the company misses it for two years. The accumulated amount would be ₹16 per share, subject to the issue terms.

2. Non-cumulative preference shares

Non-cumulative preference shareholders receive dividend priority over equity shareholders. However, a dividend missed in one year does not normally carry forward.

For example, suppose the company does not pay the dividend for a financial year. The shareholder cannot usually demand that missed payment in a later year.

These shares therefore carry more dividend uncertainty than cumulative preference shares.

3. Redeemable preference shares

Redeemable preference shares are repaid by the issuing company after a specified period or on an agreed date.

The redemption price, date and other conditions are generally decided when the shares are issued.

For example, a company may issue preference shares that are redeemable after five years. Until redemption, the shareholder may receive dividends according to the issue terms.

4. Irredeemable preference shares

Irredeemable or perpetual preference shares do not have a fixed redemption date.

However, companies limited by shares in India cannot issue new irredeemable preference shares under the Companies Act, 2013. Preference shares issued by such companies generally need to be redeemable within the period permitted by law.

5. Participating preference shares

Participating preference shares may allow shareholders to receive an additional share of profits after receiving their fixed dividend.

The additional payment depends on the conditions set when the shares are issued. It may apply when the company earns profits above a stated level.

Some participating preference shares may also provide a right to share in surplus assets during liquidation. This right depends on the specific terms of the issue.

6. Non-participating preference shares

Non-participating preference shares do not give shareholders a right to additional profits beyond the agreed dividend.

For example, even if the company earns much higher profits, the shareholder normally receives only the dividend specified in the issue terms.

These shares may offer more predictable income, but they provide less opportunity to benefit from increased profits.

7. Convertible preference shares

Convertible preference shares can be converted into equity shares according to agreed conditions.

Before conversion, holders may receive preference dividends. After conversion, they become equity shareholders and their returns depend more directly on the company’s share price and performance.

For example, the terms may allow one preference share to be converted into a stated number of equity shares after a certain period.

8. Non-convertible preference shares

Non-convertible preference shares cannot be converted into equity shares.

Their returns mainly come from dividend payments and any redemption amount available under the issue terms. They do not provide an opportunity to gain equity ownership through conversion.

However, their market price may still change before redemption.

9. Preference shares with a callable option

Callable preference shares give the issuing company the right to repurchase the shares after a specified date and at a predetermined price.

The call date and call price are stated in the issue terms or prospectus.

For example, if market interest rates fall, a company may call shares carrying a relatively high dividend rate. The investor may then need to reinvest the amount at a lower available rate.

10. Adjustable-rate preference shares

Adjustable-rate preference shares carry a dividend rate that changes according to a stated benchmark or market rate.

When the linked rate increases, the dividend rate may also rise. When it falls, the dividend payment may decrease.

For example, the dividend rate may be reset periodically using a benchmark specified in the issue terms. This can reduce some interest-rate risk, but it does not guarantee protection against inflation or loss.

Preference shares may offer the following advantages.

• More predictable dividend income

  
  

  Preference shares usually carry a predetermined dividend rate. This may make the expected income easier to estimate than dividends from equity shares.

  
  

  However, these dividends are not guaranteed. The company’s financial position and the terms of the shares affect whether and when payments are made.

  
  

• Priority in dividend payments

  
  

  Preference shareholders receive their applicable dividend before equity shareholders when a company distributes dividends.

  
  

  This priority is useful when the amount available for distribution is limited. It does not mean that the company must pay a dividend in every situation.

  
  

• Higher claim during liquidation

  
  

  Preference shareholders have priority over equity shareholders when the company repays share capital during liquidation.

  
  

  For example, if money remains after creditors and other senior claims are paid, preference shareholders are generally paid before equity shareholders.

  
  

  The amount recovered still depends on the assets available. Priority does not ensure full repayment.

  
  

• Conversion opportunity

  
  

  Convertible preference shares allow holders to convert their shares into equity shares under specified conditions.

  
  

  This structure may let investors receive preference dividends before conversion and participate in possible share-price growth after conversion.

  
  

  The conversion ratio, date and other conditions should be checked before investing.

Preference shares also have several limitations and risks.

• Limited voting rights
  Preference shareholders usually cannot vote on all company decisions. Their voting rights are generally limited to matters affecting their rights and certain other situations covered by law.
  This means they may have less influence over the company’s management than equity shareholders.
• Limited dividend growth
  Most preference shareholders receive only the dividend rate mentioned in the issue terms.
  If the company’s profits increase sharply, equity shareholders may receive higher dividends or benefit from share-price growth. Non-participating preference shareholders may not receive the same benefit.
• Call risk
  Callable preference shares may be repurchased by the company after the call date.
  A company may use this option when market rates fall and its existing preference shares carry a higher dividend rate. Investors may then have to reinvest the money at a lower rate.
• Inflation risk
  A fixed dividend may lose purchasing power when prices rise.
  For example, a dividend that covers a certain level of expenses today may buy fewer goods and services after several years of inflation.
  Adjustable-rate preference shares may reduce some of this risk, but their dividend rate can also fall when the linked benchmark decreases.
• Dividend risk
  Preference dividends are not the same as interest payments on a loan. The company may not pay them if its financial condition or the terms of the shares do not permit payment.
  Cumulative shares carry forward unpaid dividends. Non-cumulative shares generally do not.
• Market and liquidity risk
  The market price of preference shares may rise or fall before redemption. Changes in interest rates, the company’s financial position and market demand can affect their value.
  Some preference shares may also have fewer buyers and sellers than widely traded equity shares. This can make them harder to sell quickly at the expected price.
   

Preference shares give shareholders priority over equity shareholders for dividends and repayment of capital. They may suit investors looking for comparatively predictable dividend income.
However, dividends are not guaranteed, and preference shares still carry company, market, liquidity, inflation and call risks. Investors should read the issue terms carefully and understand the dividend, redemption, conversion and voting conditions before making a decision.