What Are Preference Shares?

Definition and Core Features

Preference shares are a class of share capital that gives holders certain preferential rights over ordinary shareholders. The most significant right is priority in receiving dividends. When a company declares dividends, preference shareholders typically receive their fixed payment before any distribution reaches ordinary shareholders.

Unlike ordinary shares, preference shares usually carry a fixed dividend rate. This rate is expressed as a percentage of the nominal value of the share. For example, a 6% preference share with a nominal value of £1 would entitle the holder to £0.06 per share annually, provided the company declares a dividend.

The key features of preference shares include:

• Priority over ordinary shares for dividend payments

• A fixed dividend rate, set at issue

• Limited or no voting rights in most circumstances

• Priority over ordinary shares for capital repayment if the company is wound up

• No automatic right to share in additional profits beyond the fixed dividend

It is important to understand that holding preference shares does not guarantee you will receive dividends. The board must still declare them. If the company lacks sufficient profits or chooses not to pay, preference shareholders may receive nothing in a given period. Capital is also at risk; if the company fails, you could lose some or all of your investment.

How Preference Share Dividends Work

Preference share dividends operate on a fixed basis. The rate is determined when the shares are issued and remains constant throughout the life of the share. This contrasts with ordinary share dividends, which fluctuate based on company performance and board decisions.

The payment process works as follows: the company generates profits, and the board decides whether to distribute dividends. If it does, preference shareholders receive their fixed amount first. Only after this obligation is met can ordinary shareholders receive any dividend.

However, preference share dividends are not guaranteed. They depend on:

• The company having distributable profits

• The board deciding to declare a dividend

• The terms set out in the company’s articles of association

If the company suspends dividends, preference shareholders have no legal recourse to demand payment, unless the shares carry specific cumulative rights (explained later). This uncertainty represents a material risk that investors should weigh carefully.

Preference Shares vs Ordinary Shares: Key Differences

Dividend Priority and Voting Rights

The difference between preference shares and ordinary shares centres on two main areas: dividend treatment and voting rights.

Ordinary shareholders sit at the back of the dividend queue. They receive whatever remains after preference shareholders have been paid. In good years, this could be substantial. In difficult years, they may receive nothing. However, ordinary shareholders typically enjoy full voting rights, giving them a say in company decisions such as electing directors or approving major transactions.

Preference shareholders trade voting power for income priority. Most preference shares carry no voting rights unless dividends are in arrears for a specified period. Even then, voting rights may be limited to matters directly affecting their class of shares.

*but dividends are not guaranteed and market prices can fall

This trade-off suits different investor needs. Those seeking predictable income may prefer the fixed dividend. Those seeking growth and influence may prefer ordinary shares.

Capital Repayment on Liquidation

If a company enters liquidation, the order in which stakeholders receive repayment matters significantly. Secured creditors are repaid first, followed by unsecured creditors. Only then do shareholders receive anything.

Among shareholders, preference shareholders rank ahead of ordinary shareholders. This means preference shareholders have a better chance of recovering some capital if assets remain after creditors are satisfied.

However, this ranking provides limited comfort in practice. By the time a company reaches liquidation, assets are often insufficient to repay even creditors in full. Shareholders of both classes frequently receive nothing. The preferential ranking should not be mistaken for security.

Types of Preference Shares

Cumulative Preference Shares

Cumulative preference shares carry an important protection. If the company skips a dividend payment, the unpaid amount accumulates. The company must pay all accumulated arrears before any dividend can be paid to ordinary shareholders.

Consider an example. A company issues 5% cumulative preference shares. In Year 1, it pays the dividend. In Years 2 and 3, it suspends payments due to poor trading. In Year 4, before ordinary shareholders can receive anything, the company must first pay the preference shareholders for Years 2, 3 and 4 combined.

This feature provides some safeguard against temporary dividend suspensions. However, if the company never returns to profitability or enters insolvency, the accumulated dividends may never be paid. Cumulative rights do not convert missed payments into guaranteed payments; they merely establish a priority queue.

Redeemable Preference Shares

Redeemable preference shares include a provision allowing the company to buy them back at a future date. The redemption terms, including the price and timing, are specified when the shares are issued.

From the company’s perspective, redeemable preference shares offer flexibility. The company can raise capital now and return it later when circumstances change, such as when it can refinance at a lower cost.

From the investor’s perspective, redemption introduces timing uncertainty. You may receive the redemption price if and when the company redeems the shares in line with the terms and remains able to do so, but this may come at an inconvenient moment. If prevailing interest rates have fallen, you might struggle to find a comparable income-producing investment when the shares are redeemed.

Redeemable preference shares may also be non-redeemable at the holder’s option. This means you cannot force the company to buy them back; you must wait for the company to exercise its redemption right or find a buyer in the secondary market.

Participating Preference Shares

Participating preference shares offer something beyond the fixed dividend. After receiving their fixed payment, holders may participate in additional profits alongside ordinary shareholders. The participation terms vary by issue.

For instance, a participating preference share might entitle the holder to the fixed 5% dividend plus a further share of profits exceeding a certain threshold. This structure provides some upside potential while maintaining the priority dividend.

These shares are less common than standard preference shares. The participation feature makes them more attractive to investors but more expensive for companies to issue. Terms can be complex, so careful reading of the share prospectus is essential.

Convertible Preference Shares

Convertible preference shares give holders the option to convert their preference shares into ordinary shares at a predetermined ratio and within a specified timeframe.

This conversion feature allows investors to benefit from growth in the company’s ordinary share price. If the ordinary shares perform well, converting may prove profitable. If they underperform, the holder can retain the preference shares and continue receiving the fixed dividend.

The conversion ratio and window are fixed at issue. Once the conversion period expires, unconverted preference shares typically remain as standard preference shares. The decision to convert is usually irreversible, so timing and valuation analysis matter.

Are Preference Shares Debt or Equity?

The question of whether preference shares are debt or equity lacks a simple answer. They share characteristics with both.

From a legal standpoint, preference shares are equity. Holders are shareholders, not creditors. They own part of the company and bear the risks of ownership. If the company fails, preference shareholders rank behind all creditors.

From an economic standpoint, preference shares behave somewhat like debt. The fixed dividend resembles interest payments. The redemption feature on some preference shares mimics bond maturity. For investors, the income profile may feel more like holding a bond than owning a growth-oriented equity stake.

For accounting purposes, classification depends on the specific terms. Some preference shares are classified as liabilities on the balance sheet, particularly if redemption is mandatory. Others appear within equity. The International Financial Reporting Standards provide detailed guidance, but the practical outcome varies by instrument.

Investors should not assume preference shares carry the safety characteristics of bonds simply because they share some features. They remain equity instruments with equity risks.

Potential Benefits and Risks of Preference Shares

Potential Benefits

Preference shares may offer certain advantages depending on individual circumstances:

• Dividend priority: Payments come before ordinary shareholders receive anything.

• Predictable income: Potentially more predictable income (if dividends are paid). Fixed dividend rates allow for better income planning.

• Lower volatility: Price movements may be less volatile than ordinary shares in some cases.

• Liquidation preference: Better ranking than ordinary shareholders if the company is wound up.

• Cumulative features: Some shares accumulate unpaid dividends for later payment.

These characteristics may appeal to investors who prioritise income stability over capital growth. However, benefits are not guaranteed, and individual outcomes depend on company performance and broader market conditions.

Potential Risks

Preference shares carry material risks that investors must consider:

• Dividend suspension: Companies can stop paying dividends at any time if profits are insufficient or the board decides against payment.

• Capital loss: If the company fails, preference shareholders may lose their entire investment.

• Limited liquidity: Some preference shares trade infrequently, making them difficult to sell at a fair price.

• Interest rate sensitivity: When market interest rates rise, the fixed dividend becomes less attractive, and the share price may fall.

• Inflation erosion: Fixed payments lose purchasing power over time if inflation rises

• No voting rights: Limited ability to influence company decisions.

• Redemption risk: The company may redeem shares at an inconvenient time for the investor.

These risks mean preference shares are not suitable for everyone. The fixed dividend does not compensate for all the risks involved.

Who Might Consider Preference Shares?

Preference shares may suit investors who:

• Prioritise regular income over capital growth

• Accept that dividends can be suspended and capital is at risk

• Understand the hybrid nature of the instrument

• Have other investments providing diversification

• Do not require immediate liquidity from this portion of their portfolio

They may be less suitable for investors who:

• Need guaranteed income payments

• Cannot afford to lose their invested capital

• Require frequent access to their funds

• Seek voting rights and active participation in company governance

• Are primarily focused on capital appreciation

Each investor’s circumstances differ. Before investing in preference shares, consider whether they align with your financial goals, risk tolerance and overall portfolio strategy. If you are unsure whether preference shares are appropriate for your circumstances, seek independent financial advice.

Summary

Preference shares sit between ordinary shares and bonds in the capital structure. They offer dividend priority and a fixed income rate but typically carry no voting rights. The main types include cumulative, redeemable, participating and convertible preference shares, each with distinct features.

Understanding the difference between preference shares and ordinary shares is fundamental. Preference shareholders gain income priority but forfeit voting power and unlimited profit participation. They rank ahead of ordinary shareholders in liquidation but remain behind all creditors.

Whether classified as debt or equity, preference shares carry genuine risks. Dividends can be suspended. Capital can be lost. Prices can fall when interest rates rise. These risks deserve equal weight alongside any potential benefits.

Preference shares are not a guaranteed income product. They are an equity instrument with a fixed income characteristic. Approaching them with clear expectations and appropriate risk awareness is essential for any investor considering this asset class.

This article is for educational purposes only. It does not constitute personal investment, legal or tax advice. If you are unsure whether preference shares are suitable for your circumstances, please seek independent professional advice.