According to Sec. 85 of the Act, preference shares are those shares on which there is preference right to claim dividend during the life time of the company, and to claim repayment of capital on the winding up.
The percentage of dividend is fixed in preference shares. The holders of preference shares get the fixed dividend before any dividend is paid to other classes of shareholders. At the time of winding up of the company, the preference shareholders can get back their capital before any other classes of shareholders can get back their money.
There are different types of preference shares according to the clause contained in the agreement at the time of their issue. The following are some important kinds of preference shares.
There are different classes of preference shares. They are as follows:
- Cumulative Preference Shares.
- Non-cumulative Preference Shares.
- Participating Preference Shares.
- Non-participating Preference Shares.
- Convertible Preference Shares.
- Non-convertible Preference Shares.
- Redeemable Preference Shares.
- Guaranteed Preference Shares.
Shares which have the right of dividend of a company even in those years in which it makes no profit are called cumulative preference share. The company must pay the unpaid dividends on preference shares before the payment of dividends to equity shareholders.
If in any gear the company does not earn adequate profit, dividends on preference shares may not be paid for that year. In case of cumulative preference shares, such unpaid dividend is treated as arrears. The arrears will accumulate and they will be payable out of the profits of the subsequent years. Dividend on other classes of shares can be paid only after the payment of such arrears. If the Articles are silent, all preference shares are assumed to be cumulative preference shares.
Non-cumulative preference shares are in contrast to Cumulative preference shares. Non-cumulative dividends do not accumulate if they are not paid when due.
The dividend on these shares are payable only out of the profits of the current year. If in any year the company does not earn adequate profit, the holders get no dividend or partial dividend. In that case, the unpaid dividend will not be carried forward to subsequent years. The holder cannot claim arrears of dividend.
The holders of Participating preference share receive stipulated rate of dividend and also participate in the additional earnings of the company along with the equity shareholders.
During the lifetime of the company in addition to the fixed dividend, the shareholders of this kind of shares have a right to participate in the surplus of profits, which remains after payment to the equity shareholders. At the time of winding up in addition to their shares, the shareholders have a right to participate in the surplus of assets, which remains after payment to the equity shareholders. The surplus will be distributed between the participating preference shareholders and equity shareholders in an agreed ratio.
In practice, most preference shares are non-participating in nature. It means that preference shareholders receive only stated dividend and no more. This is based on the fact that the preference shareholders surrender their claim to extra earnings in lieu of their right to receive the stated dividend.
The holders of non-participating preference shares have no right either to participate in the surplus of profits, which remains after payment to equity shareholders (during the lifetime) or to participate in the surplus of assets, which remains after payment to equity shareholders (at the time of winding up).
If the Articles are silent, all preference shares are treated as nonparticipating preference shares.
According to Sec. 80 of the Companies Act, the preference shares, which can be redeemed after a specified period or at the discretion of the company, are called redeemable preference shares.
Non-redeemable preference share is permanent in nature and its shareholding is continuous till the company goes into liquidation. In this sense, the preference share resembles the equity share. So, in order to attract the investor, a clause is included in the agreement for redeeming the preference share after the expiry of a specified period.
The redemption of preference share is advantageous for the company. It acts as a hedge against inflation. When the money rate declines, the company may redeem the shares and refinance it at a lower dividend rate.
Redeemable preference shares are also called, at the option of the company. If this call is exercised by the company, the investor must find alternative form of investment for investing the sum he gets on the retirement of the shares. Investment in equity share is more profitable than that of preference share.
Preference share holders do not participate, in the extra earnings of the company, except in the case of participating preference shares.
Convertible preference shares are those which are converted into equity shares at a specified rate on the expiry of a stated period. The holders of this kind of shares have a right to convert their shares into equity shares within a specified period.
For example, a 100 Rupee preference share may become convertible into 10 equity shares of Rs.10 each.
Convertible preference share may also have cumulative or participating rights. This kind of preferred stock is ideal from the view point of the investor. Non-convertible preference shares are not converted into equity stock. Non-convertible preference shares may also be redeemable.
The holders of this kind of shares have no right to convert their preference shares into equity shares.