This article has been written by Ms. Preksha Bothra, a 4th year BA LLB student from BMS College of Law, Bengaluru

Introduction:

Preference share capital is a type of equity capital that combines elements of both equity and debt financing. Preference shares are issued by a company to investors, who receive a fixed dividend payment that is typically higher than the dividend paid on common shares. In exchange for this higher dividend, preference shareholders do not have voting rights and are not entitled to participate in the company’s profits beyond the fixed dividend payment.

Preference shares are an important source of capital for companies, especially those that are looking to raise capital without diluting ownership or control. In this article, we will explore what preference share capital is, how it works, and why companies might choose to issue preference shares.

What is Preference Share Capital?

Preference share capital is a form of equity financing that allows companies to raise capital without issuing additional common shares. Preference shares are issued to investors, who receive a fixed dividend payment that is typically higher than the dividend paid on common shares. In exchange for this higher dividend, preference shareholders do not have voting rights and are not entitled to participate in the company’s profits beyond the fixed dividend payment.

Preference shares are called “preference” shares because they have priority over common shares in the event of liquidation. If a company goes bankrupt and is liquidated, preference shareholders will receive their fixed dividend payments before any payments are made to common shareholders.

How Do Preference Shares Work?

Preference shares work by giving investors a fixed dividend payment that is paid out before any dividends are paid to common shareholders. This fixed dividend payment is usually a percentage of the face value of the preference shares. For example, if a company issues preference shares with a face value of $100 and a fixed dividend rate of 5%, the preference shareholders would receive a fixed dividend payment of $5 per share per year.

In addition to the fixed dividend payment, preference shares may also have other features that make them more attractive to investors. For example, some preference shares may have a cumulative dividend feature, which means that if the company fails to pay the fixed dividend in any given year, the unpaid dividends will accumulate and be paid out in future years before any dividends are paid to common shareholders. Other preference shares may have a convertible feature, which allows investors to convert their preference shares into common shares at a predetermined price.

Unlike common shares, preference shares do not give investors voting rights in the company. This means that preference shareholders do not have a say in the management of the company or in the election of the board of directors. However, some preference shares may have a special voting right that is triggered if the company fails to pay the fixed dividend for a certain number of years.

Types of Preference Shares

There are several different types of preference shares, each with its own unique features and characteristics. Some of the most common types of preference shares include:

1. Cumulative Preference Shares: As mentioned earlier, cumulative preference shares have a feature where if the company fails to pay the fixed dividend in any given year, the unpaid dividends will accumulate and be paid out in future years before any dividends are paid to common shareholders.
2. Non-cumulative Preference Shares: Non-cumulative preference shares, on the other hand, do not have this feature. If the company fails to pay the fixed dividend in any given year, the preference shareholders will not receive the unpaid dividends in future years.
3. Convertible Preference Shares: Convertible preference shares have a feature that allows investors to convert their preference shares into common shares at a predetermined price. This can be an attractive feature for investors who want the potential for capital appreciation in addition to the fixed dividend payment.
4. Participating Preference Shares: Participating preference shares have a feature that allows investors to participate in the company’s profits beyond the fixed dividend payment. If the company exceeds a certain level of profitability, the preference shareholders may receive an additional dividend payment.
5. Redeemable Preference Shares: Redeemable preference shares have a feature that allows the company to buy back the shares at a predetermined price after a certain period of time. This can be an attractive feature for companies that want to limit their long-term capital commitments.

Advantages of Preference Share Capital

There are several advantages to using preference share capital as a financing tool for companies. Some of the most significant advantages include:

1. No Dilution of Ownership: One of the most significant advantages of preference share capital is that it allows companies to raise capital without diluting ownership or control. This can be especially important for founders or existing shareholders who want to maintain control of the company.
2. Fixed Income Stream: Another advantage of preference share capital is that it offers investors a fixed income stream that is typically higher than the dividend paid on common shares. This can be an attractive feature for investors who are looking for a stable income stream.
3. Tax Benefits: In some countries, the tax treatment of preference shares may be more favorable than that of common shares. For example, in some countries, the dividend paid on preference shares may be deductible for tax purposes, while the dividend paid on common shares may not be deductible.
4. Attractive to Certain Investors: Preference shares may be more attractive to certain types of investors, such as those who are looking for a lower level of risk or a stable income stream. By offering preference shares, companies can attract a broader range of investors than they might with common shares alone.
5. Priority in Liquidation: In the event of liquidation, preference shareholders have priority over common shareholders in terms of receiving payment. This can be an important feature for investors who are concerned about the risk of the company going bankrupt.

Disadvantages of Preference Share Capital

While there are several advantages to using preference share capital as a financing tool, there are also some disadvantages to consider. Some of the most significant disadvantages include:

1. Higher Cost: Preference shares may be more expensive for companies to issue than common shares, due to the higher fixed dividend rate.
2. Limited Upside Potential: Preference shareholders do not participate in the company’s profits beyond the fixed dividend payment. This means that they do not benefit from any potential increases in the company’s share price or profitability.
3. No Voting Rights: Preference shareholders do not have voting rights in the company, which means that they do not have a say in the management of the company or in the election of the board of directors.
4. Limited Flexibility: Companies that issue preference shares may be limited in their ability to raise additional capital in the future. Because preference shareholders have a fixed income stream, the company may have difficulty convincing them to accept a lower dividend rate in the future.
5. Risk of Default: In the event that a company is unable to pay the fixed dividend on its preference shares, it may be considered a default, which could lead to a decrease in the company’s credit rating and an increase in its cost of borrowing.
6. Potential for Conflict: There is a potential for conflict between common shareholders and preference shareholders, particularly in situations where the company is struggling financially. Common shareholders may feel that the fixed dividend payment to preference shareholders is limiting the company’s ability to invest in growth or pay dividends to common shareholders.

Why Do Companies Issue Preference Shares?

There are several reasons why a company might choose to issue preference shares. One of the main reasons is to raise capital without diluting ownership or control. By issuing preference shares, a company can raise capital without giving up voting rights or control of the company. This can be especially attractive to founders or existing shareholders who want to maintain control of the company.

Another reason why companies might issue preference shares is to take advantage of tax benefits. In some countries, the tax treatment of preference shares may be more favorable than that of common shares. For example, in some countries, the dividend paid on preference shares may be deductible for tax purposes, while the dividend paid on common shares may not be deductible.

Finally, companies may choose to issue preference shares because they are more attractive to certain types of investors. For example, investors who are looking for a fixed income stream may prefer preference shares over common shares, which have a more variable dividend payment. Similarly, investors who are looking for a lower level of risk may prefer preference shares, which have priority over common shares in the event of liquidation.

Conclusion

Preference share capital is a financing tool that can be attractive to both companies and investors. For companies, preference shares allow them to raise capital without diluting ownership or control, while offering investors a fixed income stream that is typically higher than the dividend paid on common shares. However, preference shares also come with some disadvantages, such as a higher cost of issuance, limited upside potential, and the potential for conflict with common shareholders.

Before deciding whether to issue preference shares, companies should carefully consider the costs and benefits of this financing tool, as well as the specific needs of their business. They should also consider the different types of preference shares available, and choose the one that best fits their needs and goals.

For investors, preference shares can be an attractive investment option, particularly for those who are looking for a stable income stream or a lower level of risk. However, investors should also be aware of the potential disadvantages of preference shares, such as limited upside potential and the risk of default.

In conclusion, preference share capital is a useful financing tool that can be used by companies to raise capital while maintaining ownership and control. While it may not be the right choice for every company, preference shares can be an attractive investment option for certain types of investors. Companies and investors should carefully consider the costs and benefits of preference share capital before making any decisions.