Definition of Preferred Shares
Preferred shares are a mixture of both equity and debt. Like equity, it doesn’t have any maturity and like debt the dividend percentage is fixed. The payment to preferred shareholders come before common shareholders, so they have a priority claim on dividends and distribution of assets in case of liquidation.
Issuing preferred shares are a way of raising money from public. The preferred shareholders usually have no voting rights or limited voting rights in the company. The claim on the company’s assets for a preferred shareholder comes below the debt holder. Preferred shares are generally less risky as compared to common shares.
Features of Preferred Shares
Some of the features of preferred shares are:
1. Preference Over Dividend Distribution
Preferred shares are paid dividend prior to common shareholders. So if the company has not earned enough profit in any year, then it may happen that only preferred shareholders will receive dividend and common shareholders will not receive anything.
2. Priority During Liquidation Distribution
When the company files for bankruptcy, then the valuation of the company is done and assets are liquidated. Proceeds from the liquidation are paid first to the preferred shareholders as compared to the common shareholders. Whatever proceed is left after payment to preferred shareholders, will be distributed to common shareholders.
3. Lack of Voting Rights
Preferred shareholders usually doesn’t have voting rights, it means that the preferred shareholders can’t participate in the decision making process of the company.
4. Dividend Yields are High
Preferred shares are issued at a higher dividend yield as compared to common shares dividend yield. The fixed dividend payment makes preferred shares attractive in the market.
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5. Convertibility Option
Some preferred shares have the option to convert themselves to common stocks. If the common stock performs well in the market, then preferred shareholders can convert their preferred shares into common shares.
6. Callability Option in Preferred Shares
Like many callable bonds, many preferred shares also have a callability option in them. The option lies in the hand of the company. They may call the preferred share whenever they want to.
Types of Preferred Shares
Types of preferred shares are given below:
1. Callable Preferred Shares
The callable feature allows the company to call the preferred shares when the price of preferred shares breaches a certain mark in the market. Say the company has issued a callable preferred share which allows the company to call the preferred shares @$25. So whenever the price of preferred shares crosses this mark, then the company can call it.
2. Cumulative Preferred Shares
Here the dividends that must be paid to the preferred shareholders get accumulated. If in any year, the company doesn’t pay a dividend to the preferred shares, due to lack of profit, then the company will have to keep a record of the unpaid dividends and clear the cumulative dividends with the next period’s profit.
3. Participatory Preferred Shares
Participatory preferred shares give extra rights to the preferred shareholders. If in any year the company reaches a desired level of profitability, then the preferred shareholders will participate in the profit sharing and will get extra dividends on top of the fixed dividend that they are supposed to receive.
4. Convertible Preferred Shares
This is an option given to the preferred shareholders. Preferred shareholders can buy common stocks at a predefined price. So if the common stock price increases in the market, then preferred shareholders can convert their preferred shares into common shares and enjoy the increase in price.
Why are They Preferred
Preferred stockholders enjoy a variety of preferences. Preferred shares have a higher claim on dividend than common stocks. Unlike a bond, there is no maturity for preferred shares, so preferred shareholders can enjoy high yield for a considerable amount of time.
Advantages of Preferred Shares
The following are the advantages are given below:
- Preferred shares have a higher claim over dividend as compared to common shareholders. So if the company makes a limited profit, then out of that limited profit, preferred shares will be paid first, if anything is left, then that will go to the common shareholders.
- There is no maturity for preferred shares. So unlike debt holders, preferred shareholders will not have to worry about the maturity of their fixed income source
- Higher claim during liquidation. Preferred shares will receive the proceeds from liquidation prior to common shareholders. So once the claim of preferred shareholders are completely settled, then common shareholders will get a chance to settle a claim from the remaining proceeds
- Preferred shares have additional features like conversion options, accumulation, etc. All these add to the advantages being enjoyed by the preferred shares in a company
Disadvantages of Preferred Shares
The following are the disadvantages are given below:
- Preferred shares doesn’t enjoy voting rights. So the preferred shareholders can’t take part in the decision making process of a company.
- As the rate of dividend payment is fixed, so if the interest rate in the market increases then the preferred share will be less attractive to investors as the fixed dividend rate is lower than what other fixed income securities are offering in the market.
Preferred Shares vs Common Shares
Preferred shares and common shares are both issued by companies in order to raise capital. In the case of common shares, there are voting rights assigned to shares. So common shareholders will take part in the decision making process of the company. These voting rights lack in the preferred shares of the company. There is a fixed percentage of dividend payment for preferred shares. In the case of common shares, the dividend payment is optional.
Conclusion
Preferred shares are important for companies in order to raise capital. As preferred shares doesn’t have voting rights, so ownership dilution will not happen. In the case of debt, the company needs to give back the principal due, but in case of preferred shares, there is no need for principal repayment as there is no maturity for preferred shares. An investor should judge the interest rate that is prevailing in the market and take a decision regarding the correct preferred shares to be purchased.
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