What differences between ordinary and preference shares?
Contributor: CISI |
The capital of a company is made up of a combination of borrowing and the money invested by its owners. The long-term borrowings, or debt, of a company are usually referred to as bonds, and the money invested by its owners as shares, stocks or equity. Shares are the equity capital of a company, hence the reason they are referred to as equities. They may comprise ordinary shares and preference shares.
Ordinary shares carry the full risk and reward of investing in a company. If a company does well, its ordinary shareholders should do well. As the shareholders of the company, it is the ordinary shareholders who vote ‘yes’ or ‘no’ to each resolution put forward by the company directors at company meetings. For example, an offer to take over a company may be made and the directors may propose that it is accepted but this will be subject to a vote by shareholders. If the shareholders vote ‘no’, then the directors will have to think again.
Ordinary shareholders share in the profits of the company by receiving dividends declared by the company, which tend to be paid half-yearly or even quarterly. With the final dividend for the financial year, the company directors will propose a dividend which will need to be ratified by the ordinary shareholders before it is formally declared as payable. The amount of dividend paid will depend on how well the company is doing. However, some companies pay large dividends and others none as they plough all profits made back into their future growth.
If the company does badly, it is the ordinary shareholders that will suffer. If the company closes down, often described as the company being ‘wound up’, the ordinary shareholders are paid last, after everybody else. If there is nothing left, then the ordinary shareholders get nothing. If there is money left after all creditors and preference shareholders have been paid, it all belongs to the ordinary shareholders.
Some ordinary shares may be referred to as partly paid or contributing shares. This means that only part of their nominal value has been paid up. For example, if a new company is established with an initial capital of £100, this capital may be made up of 100 ordinary £1 shares. If the shareholders to whom these shares are allocated have paid £1 per share in full, then the shares are termed fully paid. Alternatively, the shareholders may contribute only half of the initial capital, say £50 in total, which would require a payment of 50p per share, ie, one-half of the amount due. The shares would then be termed partly paid, but the shareholder has an obligation to pay the remaining amount when called upon to do so by the company.
Some companies have preference shares as well as ordinary shares. The company’s internal rules (its Articles of Association) set out the specific ways in which the preference shares differ from the ordinary shares.
Preference shares are a hybrid security with elements of both debt and equity. Although they are technically a form of equity investment, they also have characteristics of debt, particularly in that they pay a fixed income. Preference shareholders have legal priority (known as seniority) over ordinary shareholders in respect of earnings and, in the event of bankruptcy, in respect of assets.
Normally, preference shares:
- are non-voting, except in certain special circumstances, such as when their dividends have not been paid
- pay a fixed dividend each year, the amount being set when they are first issued and which has to be paid before dividends on ordinary shares can be paid
- rank ahead of ordinary shares in terms of being paid back if the company is wound up.
Preference shares may be cumulative, non-cumulative, and/or participating.
If dividends cannot be paid in a particular year, perhaps because the company has insufficient profits, preference shareholders would receive no dividend. However, if they were cumulative preference shareholders then the dividend entitlement accumulates. Assuming sufficient profits, the cumulative preference shareholders will have the arrears of dividend paid in the subsequent year. If the shares were non-cumulative, the dividend from the first year would be lost.
Participating preference shares entitle the holder to a basic dividend of, say, 3p a year, but the directors can award a bigger dividend in a year when the profits exceed a certain level. In other words, the preference shareholder can ‘participate’ in bumper profits.
Preference shares may also be convertible or redeemable. Convertible preference shares carry an option to convert into the ordinary shares of the company at set intervals and on pre-set terms.
Redeemable shares, as the name implies, have a date on which they may be redeemed; that is, the nominal value of the shares will be paid back to the preference shareholder and the shares cancelled.