Preference Shares – Advantages and Disadvantages
What are Preference Shares?
Preference shares, also commonly known as preferred stock, are generally those shares in a Company which rank ahead either as to dividends or capital or both. Preference shares are usually fixed-income shares and do not participate in the success of the Company and are generally a less risky form of investment than ordinary shares.
What’s the benefit of Preference Shares?
Holders of Preference Shares will have a first claim on the profits of the Company and also any potential proceeds from the sale of an asset of the Company, if the Company was to enter bankruptcy.
Preference Shareholders will have a priority over ordinary shareholders and they must be paid in full before ordinary shareholders can receive any dividends from the Company. However, this does not mean that they are guaranteed to receive annual dividends from the Company, as the financial position of the Company may not allow dividends to be paid every year.
There is a certain security for the holders of Preference Shares in that they are given a consistent schedule as when they will receive interest payments from the Company. This will provide the holder of the Preference Share with consistent cash flow.
A very big benefit of Preference Shares is normally experienced by the Company itself. It is a great way for them to raise capital and it will ensure that they are able to decide for themselves the level of interest that is to be paid for the capital, as opposed to when borrowing from the bank and a rate is forced upon them. As well as controlling the amount of interest that is to be charged, it will also allow the management and current shareholders of the Company to retain control as they will not be selling off voting rights with the Preference Shares.
What are the disadvantages of Preference Shares?
The main disadvantage of Preference Shares compared to Ordinary Shares is that the return is limited. Even if the Company expands exponentially and becomes the next Apple Inc. the returns for the Preference Shareholders will be fixed to what was agreed. This makes Preference Shares a very low risk investment, with no unseen up-side.
This will often lead to a situation whereby an Ordinary Shareholder in a Company will receive highly inflated returns compared to the Preference Shareholder and when you consider that the Company is under no contractual obligation to repay the debt to the Preference Shareholder by a specific date, it is understandable why this is not the most sought after investment.
As discussed above, Preference Shareholders will not have a vote in the Company which may put off certain investors as this will severely limit the amount of control they have in the Company. This means that the Company can be run in a way which is completely opposite to how the Preference Shareholder would like the Company to be run.
Overall, the major benefit to Preference Shares is the greater claim that they have on a Company’s profits and assets compared to Ordinary Shareholders, however, this is still outweighed by the Company’s creditors.
Investors will have to outweigh this benefit against the fact that their returns are fixed and that even if there is exponential growth in the Company, there returns will be fixed at what was agreed with the Company at the outset. This can lead to Preference Shareholders often holding a low yielding investment for a long period of time, especially if the rates are trending upwards and no on wants to buy the lower yielding Preference Shares.
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