Preference shares—commonly referred to as preferred stock—have a number of benefits and drawbacks for both issuing companies and investors.
Preference Shares: An Overview
A benefit for investors who hold preference shares is that they receive dividend payments before common stock shareholders. A drawback is that they have no voting rights as common shareholders typically do.
Companies that issue preferred stock also face a number of pros and cons.
Advantages of Preference Shares
The advantages of preference shares for investors include:
Paid Dividends First
As mentioned, the chief benefit for shareholders is that preference shares have a fixed dividend that must be paid before any dividends can be paid to common shareholders. While dividends are only paid if the company turns a profit, some types of preference shares (called cumulative shares) allow for the accumulation of unpaid dividends. Once the business is back in the black, all unpaid dividends must be remitted to preferred shareholders before any dividends can be paid to common shareholders.
Higher Claim on Company Assets
In addition, in the event of bankruptcy and liquidation, preferred shareholders have a higher claim on company assets than common shareholders do. This makes preference shares particularly enticing to investors with low risk tolerance. The company guarantees a dividend each year, but if it fails to turn a profit and must shut down, preference shareholders are compensated for their investments sooner.
Additional Investor Benefits
Other types of preference shares carry additional benefits. Convertible shares allow the shareholder to trade in preference shares for a fixed number of common shares. This can be a lucrative option if the value of common shares begins to climb. Participating shares offer the shareholder the opportunity to enjoy additional dividends above the fixed rate if the company meets certain predetermined profit targets. The variety of preference shares available and their attendant benefits means that this type of investment can be a relatively low-risk way to generate long-term income.
Preference shares also have a number of advantages for the issuing company, including:
Lack of Shareholder Voting Rights
The lack of shareholder voting rights that may seem like a drawback to investors is beneficial to the business because it means ownership is not diluted by selling preference shares the way it is when ordinary shares are issued. The lower risk to investors also means the cost of raising capital for issuing preference shares is lower than that of issuing common shares.
Right to Repurchase Shares
Companies can also issue callable preference shares, which afford 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%, the company can purchase any outstanding shares at the market price and then reissue shares with a lower dividend rate, thereby reducing the cost of capital. Of course, this same flexibility is a disadvantage to shareholders.
[Important: Financing through shareholder equity, either common or preferred, lowers a company's debt-to-equity ratio, which is considered by both investors and lenders to be a sign of a well-managed business.]
Disadvantages of Preference Shares
Preferred shares also present disadvantages for investors and shareholders.
Investors Can't Vote
From the investor's perspective, the main disadvantage of preference shares is that preferred shareholders do not have the same ownership rights in the company as common shareholders. The lack of voting rights means the company is not beholden to preferred shareholders the way it is to equity shareholders, though the guaranteed return on investment largely makes up for this shortcoming. However, if interest rates rise, the fixed dividend that seemed so lucrative can quickly look like less of a bargain as other fixed-income securities emerge with higher rates.
Higher Cost Than Debt for Issuing Company
The chief disadvantage to companies is the higher cost of this type of equity capital relative to debt.
- The chief benefit of preferred shares for investors who hold them is that they get paid dividends before common shareholders.
- Among the benefits for companies is a lack of shareholder voting rights, which is a drawback for investors.
- Issuing companies face a higher cost for this type of equity when compared to debt.