What are Preference Shares?

Preference shares occupy an important position in the corporate financing structure of companies in India. They represent a class of share capital that combines features of both equity and debt instruments. While they form part of the ownership capital of a company, they also provide fixed returns similar to debt, making them a hybrid financial instrument.

The Companies Act, 2013 recognises preference shares as a distinct category of share capital and lays down specific provisions governing their issue, rights, and redemption. Understanding preference shares is essential for law students, professionals, and anyone studying corporate law and finance.

Meaning of Preference Shares

Preference shares, also known as preferred stock, are a class of shares that provide certain preferential rights over equity shares. The primary preference relates to the payment of dividends and repayment of capital.

Preference shareholders are entitled to receive dividends at a fixed rate before any dividend is paid to equity shareholders. Further, in the event of winding up of a company, preference shareholders have a priority claim over the company’s assets compared to equity shareholders.

Despite these advantages, preference shareholders generally do not enjoy voting rights in the management of the company, except in specific circumstances provided under law.

Legal Framework under Companies Act, 2013

The Companies Act, 2013 provides a structured framework for the issue and regulation of preference shares, primarily under Sections 43, 47, and 55.

Section 43 – Kinds of Share Capital

Section 43 classifies share capital into two types:

• Equity share capital
• Preference share capital

This statutory recognition establishes preference shares as a separate and important component of a company’s capital structure.

Section 55 – Issue and Redemption of Preference Shares

Section 55 governs the issue and redemption of preference shares and lays down several key conditions:

• A company cannot issue irredeemable preference shares.
• Preference shares must be redeemable within a period not exceeding 20 years from the date of issue.
• An exception is provided for companies engaged in infrastructure projects. Such companies may issue preference shares redeemable beyond 20 years, subject to conditions:
  • Redemption must begin from the 21st year
  • At least 10% of such shares must be redeemed annually
  • Full redemption must be completed within 30 years

Further, any premium payable on redemption must be provided out of the profits of the company or, in certain cases, from the securities premium account.

Section 47 – Voting Rights of Preference Shareholders

Preference shareholders generally do not have voting rights. However, an important exception exists:

• If dividends on preference shares remain unpaid for a period of two years or more, preference shareholders acquire the right to vote on all resolutions placed before the company.

This provision ensures protection of their financial interests in situations of prolonged default.

Features of Preference Shares

Preference shares possess distinct characteristics that differentiate them from equity shares.

Priority in Dividend Payment

Preference shareholders receive dividends before equity shareholders. The dividend rate is usually fixed and predetermined, ensuring predictability of returns. This priority makes preference shares relatively stable compared to equity investments.

Priority in Repayment of Capital

In the event of liquidation, preference shareholders have a superior claim over the assets of the company. Their capital is repaid before any distribution is made to equity shareholders.

Fixed Income Nature

Preference shares often provide fixed dividend payments at regular intervals. This feature makes them similar to fixed-income instruments, offering steady returns to investors.

Limited or No Voting Rights

Preference shareholders generally do not participate in the management of the company through voting. This limitation allows companies to raise capital without diluting control.

Redemption Requirement

Unlike equity shares, preference shares must be redeemed within a specified period. This feature introduces an element of repayment obligation on the company.

Hybrid Nature

Preference shares combine elements of both equity and debt. They represent ownership in the company but also carry fixed returns and redemption obligations, similar to debt instruments.

Types of Preference Shares

Preference shares can be classified into various types based on their features. Each type serves a different financial and strategic purpose.

Cumulative Preference Shares

Cumulative preference shares provide that unpaid dividends accumulate over time. If a company is unable to pay dividends in a particular year due to insufficient profits, the unpaid amount is carried forward.

These accumulated dividends must be paid before any dividend is declared for equity shareholders. This feature offers greater security to investors.

Non-Cumulative Preference Shares

Non-cumulative preference shares do not carry forward unpaid dividends. If a company does not declare dividends in a particular year, shareholders lose the right to claim those dividends in the future.

This type of share involves relatively higher risk compared to cumulative preference shares.

Redeemable Preference Shares

Redeemable preference shares are those which the company agrees to repay after a specified period or on a specific date. These shares must be redeemed in accordance with the provisions of Section 55.

They provide clarity regarding the time frame within which the investment will be returned.

Irredeemable Preference Shares

Irredeemable preference shares are those which do not have a fixed redemption period. However, such shares are not permitted under the Companies Act, 2013.

This prohibition ensures that companies do not carry perpetual financial obligations towards preference shareholders.

Participating Preference Shares

Participating preference shares allow shareholders to receive additional dividends beyond the fixed rate. This additional participation is usually linked to excess profits earned by the company.

In some cases, these shareholders may also participate in surplus assets during liquidation.

Non-Participating Preference Shares

Non-participating preference shares entitle shareholders only to fixed dividends. They do not have the right to share in surplus profits or additional distributions.

This type offers stability but limits the scope for higher returns.

Convertible Preference Shares

Convertible preference shares provide the option to convert preference shares into equity shares after a specified period or upon fulfilment of certain conditions.

This feature allows investors to benefit from potential capital appreciation while initially enjoying fixed dividends.

Non-Convertible Preference Shares

Non-convertible preference shares do not offer any option of conversion into equity shares. They remain as preference shares throughout their tenure and provide fixed returns.

Callable Preference Shares

Callable preference shares give the company the right to repurchase or redeem the shares at a predetermined price and date. The terms of such redemption are specified in the issue conditions.

This feature introduces flexibility for the company but also involves certain risks for investors.

Adjustable Rate Preference Shares

In adjustable rate preference shares, the dividend rate is not fixed and varies according to prevailing market conditions or interest rates.

This feature helps in addressing fluctuations in interest rates and inflation.

Difference Between Preference Shares and Equity Shares

Preference shares differ significantly from equity shares in terms of rights and features.

• Dividend: Preference shares provide fixed dividends with priority, whereas equity dividends are variable and paid after preference shareholders.
• Voting Rights: Preference shareholders generally do not have voting rights, while equity shareholders actively participate in management decisions.
• Capital Repayment: Preference shareholders are repaid before equity shareholders in case of liquidation.
• Redemption: Preference shares are redeemable, whereas equity shares are generally not redeemable.
• Risk and Return: Preference shares offer lower risk and stable returns, while equity shares carry higher risk but greater potential for capital appreciation.

Advantages of Preference Shares

Preference shares offer several benefits in the corporate and investment context.

Stable and Predictable Returns

The fixed dividend structure provides a steady source of income, making preference shares suitable for those seeking financial stability.

Priority Rights

Preference shareholders enjoy priority in both dividend distribution and repayment of capital, reducing the risk of loss.

Flexibility in Structure

The availability of various types such as convertible and participating preference shares allows companies to design instruments suited to their financial needs.

Lower Risk Compared to Equity

Due to priority rights and fixed returns, preference shares are generally less risky than equity shares.

Disadvantages of Preference Shares

Despite their advantages, preference shares have certain limitations.

Absence of Control

The lack of voting rights restricts the ability of preference shareholders to influence company decisions.

Limited Upside Potential

Preference shareholders typically receive fixed returns and do not benefit from higher profits unless the shares are participating or convertible.

Dividend Uncertainty in Some Cases

Although dividends are fixed, payment depends on the availability of profits in certain types of shares, especially non-cumulative ones.

Call and Inflation Risks

Callable preference shares may be redeemed early, affecting expected returns. Additionally, fixed dividends may lose value due to inflation over time.

Nature of Preference Shares: Debt or Equity

Preference shares possess characteristics of both debt and equity.

They resemble debt because they provide fixed returns and are redeemable after a certain period. At the same time, they represent ownership in the company, similar to equity shares.

This dual nature makes them an important instrument in corporate finance.

Conclusion

Preference shares play a significant role in the capital structure of companies under the Companies Act, 2013. They offer a balance between risk and return by combining stability with limited participation in ownership.

The legal framework ensures proper regulation of their issue and redemption, safeguarding the interests of both companies and investors. With various types such as cumulative, convertible, and participating preference shares, companies can tailor financial instruments to meet diverse objectives.