Preference shares, which are issued by companies seeking to raise capital, combine the characteristics of debt and equity investments, and are consequently considered to be hybrid securities. Preference shareholders experience both advantages and disadvantages. On the upside, they collect dividend payments before common stock shareholders receive such income. But on the downside, they do not enjoy the voting rights that common shareholders typically do.
- Preference shareholders receive dividend payments before common shareholders.
- Preference shareholders do not enjoy voting rights like their common shareholder counterparts do.
- Companies incur higher issuing costs with preferred shares than they do when issuing debt.
Advantages of Preference Shares
Owners of preference shares receive fixed dividends, well before common shareholders see any money. In either case, dividends are only paid if the company turns a profit. But there is a wrinkle to this situation because a type of preference shares known as cumulative shares allow for the accumulation of unpaid dividends that must be paid out at a later date. So, once a struggling business finally rebounds and is back in the black, those unpaid dividends are remitted to preferred shareholders before any dividends can be paid to common shareholders.
Higher Claim on Company Assets
In the event that a company experiences a bankruptcy and subsequent liquidation, preferred shareholders have a higher claim on company assets than common shareholders do. Not surprisingly, preference shares attract conservative investors, who enjoy the comfort of the downside risk protection baked into these investments.
Additional Investor Benefits
A subcategory of preference shares known as convertible shares lets investors trade in these types of preference shares for a fixed number of common shares, which can be lucrative if the value of common shares begins climbing. Such participating shares let investors reap additional dividends that are above the fixed rate if the company meets certain predetermined profit targets.
Disadvantages of Preference Shares
The main disadvantage of owning preference shares is that the investors in these vehicles don't enjoy the same voting rights as common shareholders. This means that the company is not beholden to preferred shareholders the way it is to traditional equity shareholders. Although the guaranteed return on investment makes up for this shortcoming, if interest rates rise, the fixed dividend that once seemed so lucrative can dwindle. This could cause buyer's remorse with preference shareholder investors, who may realize that they would have fared better with higher interest fixed-income securities.
Financing through shareholder equity, either with common or preferred shares, lowers a company's debt-to-equity ratio, which is a sign of a well-managed business.
Preference shares benefit issuing companies in several ways. The aforementioned lack of voter rights for preference shareholders places the company in a strength position by letting it retain more control. Furthermore, companies can issue callable preference shares, which affords them the right to repurchase shares at their discretion. This means that if callable shares are issued with a 6% dividend but interest rates fall to 4%, then a company can purchase any outstanding shares at the market price, then reissue those shares with a lower dividend rate. This ultimately reduces the cost of capital. Of course, this same flexibility is a disadvantage to shareholders.