Equity vs Preference shares

We keep hearing the term ‘shares’ or ‘stock’ nowadays as it is a common topic of discussion. However, it is essential to know the different types of shares available in the market to be aware of our options as investors and also to determine which type suits the objectives of the investor better.

According to section 86 of the companies act, a company can issue only two types of shares:
(a) Preference shares
(b) Equity shares

PREFERENCE SHARES

As the name suggests, a preference share gives a preferential right to its shareholder, to get a fixed rate of dividend over other types of shares. This implies that preference shareholders are entitled to receive their dividends BEFORE any dividend is paid to equity shareholders from the profits.

Preference shareholders are also entitled to return of share capital before equity shareholders when the company is winding up. This implies, that after the company has paid off its debts to outsiders, the surplus and remaining assets are used to return the share capital to preference shareholders before equity shareholders. The remaining assets and surplus, if any, is distributed among the equity shareholders.

However, Preference shareholders don’t get to enjoy voting rights. They are only allowed to vote on

a) Any resolution affecting their rights

b) All resolutions when dividend has not been paid to them for the time period mentioned in the Act.

Types of Preference shares

Different kinds of shares have different rights associated with them.

• Cumulative Preference Shares– Dividends not declared and paid in the current year (due to loss or inadequate profit), is accumulated and can be paid out of profits of subsequent years before dividend is paid to equity shareholders. Preference shares are always cumulative, unless the contrary is expressly stated in the Articles of Association.
• Non-Cumulative Preference Shares- In the case of non-cumulative preference shares if dividend is not paid in any particular year, it lapses. It does not accumulate. Hence, it is not paid in the subsequent years.
• Participating Preference Shares- In addition to the fixed rate of dividend, these shares carry a further right to participate with the equity shareholders in the surplus profits which remain after paying a certain rate of dividend to equity shareholders. Thus, they get two kinds of dividend, one fixed rate and the other changing every year depending on the level of excess profits. Similarly, such preference shares have a right to participate in the surplus assets of the company on its winding up after paying in full the preference and equity share capital.
• Non-Participating Preference Shares– These shares are entitled to only a fixed rate of dividend. They do not participate either in the surplus or in the surplus assets on winding up after paying in full the preference and equity share capital. Preference shares are presumed to be non-participating unless specifically stated otherwise in the articles.
• Convertible Preference Shares– These shares can be converted into equity shares within a specified time period.
• Non-Convertible Preference Shares- These shares cannot be converted into equity shares. Preference shares are presumed to be non-convertible unless specifically stated otherwise in the articles.
• Redeemable Preference Shares- Capital raised by means of these shares can be returned after a specified period or at any time at its options after giving notice as per terms of issue. These shares can be redeemed either out of profits or out of the proceeds of a fresh issue of shares.
• Irredeemable Preference Shares- Any preference share that cannot be redeemed during the lifetime of the company is known as irredeemable preference Shares. Such shares are not offered anymore.

EQUITY SHARES

Equity shareholders are entitled to get dividend only after the fixed rate of dividend is paid to preference shareholders. Similarly, at the time of winding up of the company, only after returning preference share capital in full, and if there is any surplus, it will be paid to equity shareholders.

The rate of dividend is not fixed as it varies from year to year and depends on the profit earned every year. Higher the profits, higher the dividends of equity shareholders. However, in case of loss or inadequate profits, equity shareholders often do not get dividends for that year. Moreover, even in case of profits, the company can choose to retain the surplus in the business instead of paying dividends to equity shareholders. Hence, dividends for equity shareholders are not assured.

However, equity shareholders are considered as the owners of the company and hence, get voting rights on all resolutions.

To conclude, equity shares are quite risky since dividends and return of capital when the company is winding up is not assured. However, if the company is reputed and does well, equity shareholders dividends are usually more than fixed dividends of preference shareholders. Moreover, equity shareholders enjoy voting rights and are more involved in the management of the company as they are the owners.

On the other hand, for investors looking for fixed rate of return (dividends) and assured return of capital invested, preference shares should be a good investment.