Preference shares are shares which are preferred over common or equity shares in payment of surplus or dividend i.e preference shareholders are the first to get dividends in case the company decides to pay out dividends. Owners of preference shares gets fixed dividend. However, in the event of liquidation of the company they are paid after bond holders and creditors, but before equity holders.
To simplify, when you buy shares from the company you become part-owner of the company, you are common shareholder or equity shareholder. One cannot directly own preference shares as it is for only Board of Directors, promoters of the company or financial institutions. They are still not offered to retail-investors
Also referred to as preferred stock or preferred shares, these may have any combination of attributes i.e features of both equity and debt and so is considered a hybrid instrument in general. The articles of association lays down the terms of the preferred stock.
Other than the preference in respect of dividend and asset payout in case of liquidation, preference shares can also be converted into common stock. Further, at the discretion of the company, these shares can be redeemed before maturity.
Preference shares are not liquid shares as they are not traded on stock exchanges. The other disadvantage is they don't have voting rights.
For example, if the company ABC declares extra dividend common shareholders are eligible to receive such dividends. Whereas, preference shareholders are entitled for fixed dividends.
In another scenario, if the company ABC is under liquidation, preference shareholders would enjoy priority over common shareholders in terms of payments.
Different types of Preference Shares are as follows:
1) Cumulative Preference Share
In case where a company does not declare dividends for a particular year, they are carried to next year. They are treated as arrears.And a preference share is said to be cumulative in a case when the arrears pertaining to dividend are cumulative in nature and such arrears are cleared before any dividend payment to equity shareholders.
2) Non- Cumulative Preference shares:
As the name suggests, it does not accumulate dividends. Dividend skipped by the company are not paid, which means they have the right to avail dividend from the profits earned from that particular year.Notably, dividends are only payable from net profits of each year. So, in case where there are no profits for a particular year, the arrears of dividend cannot be claimed in subsequent years. Preference shares are cumulative in nature unless explicitly described as otherwise.
3) Redeemable Preference shares:
These are shares which can be redeemed or repaid after the fixed period as issued by the company or even before at the option of the company.
These shares cannot be redeemed during the life of the company.
5) Convertible Shares
Shares can be converted into equity at the option of the holder after the stated tenure.
6) Non-convertible shares
Shares which cannot be converted to equity are called non convertible shares.
7) Participating shares
Such shares have the right to participate in surplus profits of the company at the time of liquidation after the company had paid to other holders.
8) Non-participating Preference Shares
Preference shares, which have no right to participate in the surplus profits or in any surplus on liquidation of the company, are called non-participating preference shares.