There are a number of key differences between ordinary shares and preference shares. This article aims to highlight the key elements that an investor should keep in mind when dealing with preference shares.
Preference shareholders are NOT the owner of the company. By analogy, the investor is giving a loan to the company and the company issue preference shares to the investor giving him certain preferential rights. For example:
Generally, the investor’s objective is to make a decent profit when he exits the investment in a few years’ time.
In the unfortunate event of liquidation, winding up, dissolution, cessation of business of the company or return of capital, preference shareholders shall be paid out of the proceeds in priority to any amount payable in respect of the ordinary shares.
This characteristic is important to ensure that preference shareholders have priority of claim against the company for the dividends and redemption sum payable in respect of the preference shares. On that basis, preference shares are more secured because ordinary shareholders will only be entitled to claim the remaining proceeds after preference shareholders are duly paid of the dividends and redemption sums.
In some cases, the investors can also require the promoters to provide a personal guarantee to guarantee the payment by the company of dividends and redemption sums in respect of the preference shares. The personal guarantee further lowers the default risks and hence making the preference shares more attractive for investors.
For ordinary shareholders, they can only wait and hope that the company will make enough profit and declare a dividend (at the discretion of the board), which can be regular or irregular. It is important to bear in mind that the board does not have any statutory obligation to declare and pay the dividend, and can opt to keep all the profit for working capital purposes. If there is no payment of dividend, ordinary shareholders can only expect financial gains when he exits the investment by selling off his shares.
A cumulative dividend means the type of dividend which if it is accrued but unpaid in respect of the preference shares, it will be treated as arrears and will be carried forward to subsequent years and accumulated until it is fully paid.
A non-cumulative dividend means the type of dividend which if it is accrued but unpaid in respect of the preference shares, the preference shareholders do not have the rights to claim any of the unpaid dividends in the future. The unpaid dividend will not be accumulated.
If the company does not have sufficient profit (either from profit or retained earnings), the company is not legally able to declare and pay the dividend, even if it is fixed and agreed under the terms of preference shares.
Fixed and cumulative dividends can be attractive for some investors who prefer more certainty of returns in their investment.
Some investors expect to exit their investment with a 2x-5x return, especially for investment into start-ups or technology firms.
Conversion rights allow preference shareholders to convert their preference shares into ordinary shares based on an agreed conversion formula. Once converted, they become ordinary shareholders. Meaning they also become co-owner of the business who can enjoy the potential appreciation in the value of the business.
For example, instead of accepting cash from the preference shareholders upon exercising the conversion rights, the company accepts the preference shares as issue price/consideration for the issuance of the new ordinary shares. The number of new ordinary shares to be issued will depend on the then market value or fair value of the business. The valuation of the business is best conducted by an independent valuer, whether appointed by the board or jointly by the board and the investors.
Of course, the business founders may not like the idea that preference shareholders can also become co-owners just because of the “loan” given to the company. Hence, preference share with conversion rights may have a lower dividend rate. This is as some founders would argue that the preference shareholders have had the benefit of the conversion rights. Such commercial terms are entirely subject to the negotiation of the parties.
Save for very limited types of resolutions (e.g. winding-up resolution or resolution which adversely affect or alter the rights of preference shareholders), preference shareholders do not have voting rights at any general meeting of the company.
Investors are only entitled to the agreed dividends and redemption sum – i.e. principal investment sum – if the preference shares do not come with conversion rights. They will not be able to benefit from the appreciation in value of the business. In other words, there will be no upside in terms of return of investment.
Having said that, such an investment instrument could be suitable for more conservative investors. Those who prefer higher dividend yields with certainty in repayment despite that return of investment may not be fantastic.
Preference shares can be the right investment instrument for risk-takers or risk-averse investors. But this depends on the terms of the preference shares. Again, there is no one size fits all terms that are suitable for every type of investor.
If you intend to invest in preference shares, you better educate yourself of the above.