Preference shares are most often issued to investors, while ordinary shares are often given out to startup business founders. Preference shares give shareholders a priority when it comes to being paid company dividends, but they have less input into the strategy of the business.
Why does it matter?
Shareholders have acquired shares in a business to get a cut of the profits. When purchasing equity shares in a company, you may have the option of buying them in two different ways: ordinary shares and preference shares.
There are pros and cons to both.
What are ordinary shares?
Ordinary shares, also known as common stock, are equity ownership units that a COMPANY issues to its founders. These shares have additional rights compared to preferred shares but are paid last in the case of liquidation and dividend distribution. Ordinary shares may be fully or partly paid.
Ordinary shares allow investors to vote at meetings and receive dividends from the company's earnings. Voting rights give you a voice in issues like pay and company strategy.
When dividends are paid, you have the right to receive them, but if a decision is made to the contrary, companies aren't required to distribute them. This might be due to lower-than-expected earnings or because it has been decided that these profits should, instead, be reinvested into the company for future expansion.
The disadvantages to ordinary shareholders vs preference shareholders include:
(1) Priority distribution of dividends: Priority would be given to preference shareholders when the dividends are distributed; and
(2) No guaranteed right to receive dividends: The company can make a decision not to distribute the dividends depending upon the situation.
What are preference shares?
Preference shares are usually shares that rank above other shares in terms of dividends or capital, but have restricted voting rights. They are almost always fixed-income securities; because of this, they do not usually participate in the company's success and are therefore typically a less risky form of investment than ordinary shares.
The specifics of preference shares are usually set out in the company's articles of association or shareholder agreements.
What’s the difference?
Preference shares usually come with no voting rights at meetings but they provide an advantage over ordinary shareholders when it comes to receiving dividends, as preference shareholders get preference over dividends whether the business is operating or enters into liquidation in future.
Preference shareholders generally receive predetermined dividends on a monthly, quarterly or yearly basis and as such, preference shares are considered a less risky investment than ordinary shares.
The downside to this is that should a business see a significant period of growth, this will often not be reflected in the preference shareholders dividend payments.
Preference shareholders are paid a fixed percentage of yearly dividends, which is decided during the signing of the share certificates, while ordinary shareholders are compensated varying amounts of dividends each year.
Types of preference shares
Other types of preference shares that you might come across include cumulative preference shares, which entitle the holder to receive dividends only in the event that they haven't previously been paid out; and convertible preference shares, which give investors the option to convert their preferred shareholder interests into ordinary share stakes.
Cumulative preference shares
When you don't receive a dividend payment, the remainder will roll over to the next dividend date. If dividends are paid at this time, you'll get both amounts; if dividend payments are prohibited again, both amounts will roll over to the next date and so on.
Noncumulative preference shares
If a company decides not to pay dividends for an extended period, it will not pay out this sum at any time in the future; effectively, the shareholder loses his or her dividend payment permanently.
Convertible preference shares
Shareholders may exchange their shares for ordinary shares at specified intervals, depending on the terms agreed. This implies that when they convert their shares to common stock, they start to have a more significant input into the direction of the company.
Participatory preference shares
These shares give holders the right to a set amount of dividends each year as well as additional payments when the company achieves specific objectives. This means that whenever the company's performance surpasses a certain level, they share in the profits.
Redeemable preference shares
The shares are repossessed after a certain amount of time has elapsed, usually determined by the company. The company will repossess the shares and return them to the shareholders at some point in the future. The owner will be compensated based on the value of redeemed shares at that point. This means that the owner will no longer be a shareholder.
Who issues preference shares?
Typically, high-ranking members or owners of a business issue preference shares when they want to raise capital without giving up any control over their company. The disadvantage for this strategy is that any significant growth in earnings won't be visible in dividend payments until all ordinary capital has been paid back.
Details of share distribution can be found in the partnership agreement.
Who invests in preference shares?
Unlike ordinary equity investment instruments such as stocks and bonds, where people can invest regardless of what stage the company is in, preference shares are usually bought by investors who are looking for a more secure investment with a fixed income. This generally limits the number of people who invest in them and can make it difficult for companies to raise large sums of money through this means.
Preference shares vs ordinary shares: which is better?
There isn't a definitive answer as to whether preference shares are better than ordinary shares – it depends on the individual company and what their specific articles of association state. From a dividends perspective, preference shareholders usually receive payments before ordinary shareholders but this isn't always the case.