There are various ways for a company to raise funds. Few companies issue bonds while few issue equity shares.
Stocks provide dividends and capital appreciation to investors. They carry medium to high risk and are suitable for aggressive investors. Bonds provide regular returns in the form of interest. They are less risky than equity. And hence suitable for conservative investors.
But what about investors who want to invest in a combination of both equity shares and bonds?
Such investors can invest in preferred stocks also known as preference shares. This investment option provides a steady source of income in form of fixed dividends.
In this article we will learn:
- What are preference shares?
- Why does a company issue preference shares?
- What are the types of preference shares?
- Advantages of preference shares
- Disadvantages of preference shares
- How does a company issue preference shares?
- Who can buy preference shares?
- What are the key differences between equity shares, preference shares and debt instruments?
- Recent preference shares issued in India
What are Preference Shares?
Preference shares are a special type of shares. They promise the preference shareholder to have preference in sharing profits over equity shareholders. Preference shareholders are paid dividends before equity shareholders.
Similar to debt instruments, they provide fixed payment in the form of preference dividends. Whereas, like equity shares they carry risk as the capital amount is not secured.
Why Does a Company Issue Preference Shares?
Companies avoid excess debt on their balance sheet. Both analysts and investors monitor a company’s Debt to Equity ratio. Too much debt on the balance sheet can lead to a reduced rating of bonds. And can be a red flag for equity shareholders too. To avoid all this, companies prefer issuing preference shares instead of adding debt.
Hence, preference shares are a great alternative to borrowing debt and are considered the fastest ways to raise capital.
What are the Types of Preference Shares?
On the basis of dividend
1. Cumulative preference shares
This is the most common type of preference shares. These shares have an added advantage over ordinary preference shares. Here, shareholders have the right to earn dividends even when the company makes no profit. This due dividend keeps on accumulating. So if the company does not declare dividend in a particular year they are treated as arrears and are carried forward.
2. Non cumulative preference shares
A non cumulative preference share is opposite to a cumulative preference share. It does not accumulate any dividend. In case the company does not pay dividends for a few years then amount overdue cannot be claimed for those years.
On the basis of redeemability
1. Redeemable preference shares
The issuing company can purchase the preference shares back before maturity. This is known as a redeemable preference share. However, the company has to provide prior notice to its shareholders.
2. Irredeemable preference shares
These preference shares can only be redeemed if the company shuts its operations or liquidates itself.
On the basis of participation
1. Participating preference shares
Usually dividends are paid out at a fixed rate. But if equity shareholders get a higher dividend, then participating preference shareholders can get a chance to earn higher dividend too. This is usually done when the company earns a huge profit in a particular year.
2. Non participating preference shares
In non participating preference shares, the dividend payout rate is fixed. So even if the company earns huge profits, the preference shareholder will be paid as per the stated dividend.
On the basis of convertibility
1. Convertible preference shares
Here shareholders are allowed to convert their shares into equities. This could be done after a certain time and at a certain ratio.
For example, if you have a conversion ratio of 2:1. Then you will get two equity shares in exchange for one preference share.
2. Non convertible preference shares
These shareholders do not have the right to convert preference shares into equity shares.
Advantages of preference shares
Advantages to investors
- If you hold preference shares of a company, you are entitled to earn fixed dividends as per predefined rates.
- Preference shares provide higher rate of returns than bonds.
- These shares have lower risk than equity shares and are suitable for medium risk investors.
- If the company goes bankrupt, preference shareholders are paid before equity shareholders.
- As per the Income Tax Act 1961, dividends earned from preference shares are tax free up to Rs 10 lakh.
Advantages to issuing company
- The cost of raising capital from preference shares is less than equity shares.
- The company is not bound to pay dividend if its profits in a particular year are insufficient. Except for cumulative preference shares.
- Preference shareholders do not get any voting rights. Hence it does not lead to dilution of management’s control on a company.
Disadvantages of preference shares
Disadvantage to investors
- Preference shares do not have voting rights. Hence, they cannot raise issues to the management or control the decision making of the company.
- Preference shareholders are only paid fixed dividend. Hence they do not enjoy the excess profits of the company. Except for participating preference shares.
- Preference shares cannot be easily bought and sold as equity shares.
- Dividend income more than Rs 10 lakhs will be taxed at 10%.
Disadvantage to issuing company
- Paying yearly dividend can be a financial burden to the company.
- Unlike equity capital, a company cannot use preference capital permanently. It has to be repaid.
- Preference shares are to be redeemed compulsorily within 20 years. Hence the company would require huge cash for this purpose.
- Investors who have high risk appetite prefer investing in stocks. Whereas, conservative investors invest in debentures. Hence to attract investors, the company has to offer a high rate of dividend.
How does a company issue preference shares?
- The company needs to ensure if issuing preference shares are authorised under the Articles of Association (AOA) of the company.
- Later in an Annual General Meeting (AGM) with the help of an explanatory statement relevant facts are discussed such as:
- Size of the issue, number of preference shares, nominal value of the shares
- Nature of the shares
- Objective of the issue.
- Terms of issue, rate of dividend and tenure of redemption.
- Current shareholding pattern of the company
- Expected dilution of equity shares upon conversion (in case the nature of shares is convertible)
- After the resolution is passed the company files a statement with the Registrars of Companies (ROC) within 30 days.
Here are a few key points to note before issuing preference shares.
- A company shall redeem its preference shares within 20 years from the date of issue.
- The minimum application size for each investor should not be less than Rs 10 lakh.
- Issuing companies must obtain at least AA or AAA ratings from a credit rating agency.
Who can buy preference shares?
Preference shares are not traded on the stock exchanges. Hence they are not available for retail investors. Usually companies issue these shares under private placement. These are issued to financial institutions, Hindu Undivided Family (HUF) and other lending firms. Retail investors are rarely offered preference shares.
What are the key differences between equity shares, preference shares and debt instruments?
|Source of Division||Equity Shares||Preference Shares||Debt instruments|
|Brief||Equity shares are one of the most popular sources of raising funds. They signify your ownership in the company.||Preference shares is an equity vehicle but has few qualities of bonds. They guarantee shareholders a fixed rate of dividend.||Debt is another popular investment option. Here the company borrows money and is obliged to pay back at a future date with interest.
They are lenders of capital.
|Dividend and interest||Equity shareholders receive dividend at a fluctuating rate. They are the last ones to get paid.||Preference shareholders have fixed dividend rates. They are always paid before equity shareholders.||Interest on debt is paid before preference and equity shareholders.|
|Voting Authority||Equity shareholders have voting rights.||Preference shareholders do not carry the voting rights. But in rare cases, they get voting rights.||Debt holders do not have any right on the company’s management or management decisions.|
|Convertibility||Equity shares cannot be converted.||Only convertible preference shares can be converted into equity shares.||N/A|
|Dividend Overdue||Equity shareholders do not get outstanding payment of dividends.||Cumulative Preference shareholders get unpaid dividends as arrears.||N/A|
|Risk||Risk associated with equity shares is high.||Risk associated with a preference share is less than an equity share.||Debt instruments which are AAA rated are considered less risky as there is low to no risk of defaults.|
|Who should invest?||Investors who are ready to take risk should invest in equity shares.||Medium risk investors who wish to earn fixed returns can invest in preference shares.||Investors who wish to invest in safe investments should opt for debt instruments such as AAA rated bonds|
Recent Preference Shares Issued in India
In the past years many reputed companies such as Tata Capital, L&T Finance Holding company, IL&FS transportation networks ltd, have issued preference shares under private placement. Dividend rates of these securities are very lucrative and tax free up to Rs 10 lakh.
|Security||Issue date||Maturity||Type of issue||Dividend rate||Dividend payment date||Tax free returns|
|Tata capital preference shares||22/04/2015||21/04/2022||Fully Paid up Non Convertible Cumulative Redeemable Non Participating Preference Shares||8.33%||30th June annually||8.25%|
|L&T finance holdings ltd.||12/10/2018||12/10/2021||Non convertible cumulative redeemable preference shares||9%||26th March annually||8.95%|
|IL&FS transportation networks ltd.||16/05/2014||16/05/2021||Non-convertible Redeemable Cumulative Preference Shares||16%||30th May annually||15.99%|
While lucrative, preference shares are not 100% risk-free. In the case of IL&FS, the company had huge debt on its balance sheet. And they chose to pay its long-term debt by borrowing short term debt. All this lead the company towards bankruptcy. On 7th October 2018 IL&FS Transportation Networks Ltd. declared that they had defaulted on redemption of preference shares worth Rs 39.5 crore.
So, it is safe to say that preference shares have their own unique risk and reward potential.
Hence, you must carefully study about the past performance, growth potentials and analyse the fundamentals and management of the company by reading the balance sheet. You can also check Samco’s stock ratings and analyse how the company has been performing so far. It will help you make an informed investment decision.
To get started with your stock market investment journey open a Demat account with Samco today.