There are a number of different types of shares that companies offer their investors. One of these is preference shares. If you are looking to make an investment but are unsure about the future of a company, becoming a preference shareholder may be the right decision for your finances. This article will explain how preference shares work so you can decide if they may be the best option for your future investments.
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What are Preference Shares?
Where a company can no longer meet its financial obligations and falls into insolvency, preference shares receive preferential treatment. This means that holders of preference shares are paid out before holders of ordinary shares. Preference shares vary and, depending on their structure, can be classified as ‘hybrid’ or ‘convertible’ securities. This means that they take on characteristics of both debt and equity.
Preference shares can be unlisted (for private companies) or listed (for public companies) on the Australian Stock Exchange (ASX). They are similar to bonds in that they typically have a fixed maturity date. Meaning there is a fixed date for when you will receive the money that you had invested.
Like ordinary shares, preference shares provide income payments in the form of dividends. A company will pay preference share dividends at either a fixed or floating rate.
What Are the Different Types of Preference Shares?
There are a number of different types of preference shares to consider.
| Type | Description |
| Convertible | Convertible preference shares start off by paying fixed dividends at regular intervals. Then, they convert to ordinary shares or become redeemable for cash at a specified rate and time. |
| Converting | Unlike convertible preference shares, these shares must convert to ordinary shares and usually do so at a fixed-dollar amount. |
| Cumulative | If a company cannot pay the dividends they owe to shareholders, the dividends simply accrue. Likewise, the company pays them when they are financially stable. Only after the cumulative preference shareholders receive their dividends will the ordinary shareholders also receive payment. |
| Redeemable | Shareholders with redeemable preference shares may redeem these for cash at the company’s discretion. |
Will I Have Preference Over Other Shareholders?
As a preference shareholder, you rank ahead of ordinary shareholders if the company goes into liquidation. Liquidation occurs when the company is no longer able to meet its financial obligations and cannot pay off its debts. When this happens, your claim to the company’s assets is prioritised over other ordinary shareholders. Remember, however, that paying off the debts will still take priority.
An Example
Typically, where the company has enough funds on liquidation, each preference shareholder will be entitled to be paid out the full amount they initially invested to receive the preference shares.
Investor A paid $100,000 to receive 100,000 preference shares and Investor B paid $50,000 to receive 50,000 preference shares. After paying creditors, the company has $150,000. Accordingly, Investor A and Investor B will be entitled to receive each of their initial investment sums.
Where the company does not have enough to return all preference shareholders’ initial investment sums, preference shareholders will typically be entitled to an amount proportionate to their initial investment when all preference shareholders’ investment sums are added together.
Where the company only has $75,000 after paying creditors, Investor A will receive $50,000 (as they hold 66.66% of the total investment sum on preference shares). Investor B will receive $25,000 (as they hold 33.33% of the total investment sum on preference shares).
Regarding the distribution of dividend payments, preference shareholders will also take priority over ordinary shareholders. Any dividends declared must be declared on preference shares before being declared before other classes of shares. You would pay dividends from the company’s profit, but this must not prevent the company from paying its debts when they fall due. In other words, declaring a dividend must not make the company insolvent.
Can You Convert Preference Shares?
Most types of preference shares are ‘convertible’ because they can, and usually will, turn into ordinary shares at some stage. The amount of ordinary shares you receive when your preference shares convert will depend on the conversion method you use. The company should outline the method of conversion in the legal documents that you receive during the initial issuing of the shares.
You will usually receive the fixed dollar value of preference shares in ordinary shares at their present market value. This means that you will receive fewer shares if the market value of ordinary shares, at the time of conversion, is higher.
What Should I Consider When Buying Preference Shares?
If you are investing in preference shares, you should check:
- the dividend rate and whether it is floating or fixed;
- whether the dividend is franked. This means that the company (issuing the dividend) pays a portion of the tax on the dividend; and
- when and how the preference shares convert into ordinary shares.
Anti-Dilution Rights
Preference shares typically have anti-dilution rights. Such rights protect the shareholder from dilution, where the company issues new shares at a price less than what the existing preference shareholders initially paid.
Key Takeaways
Preference shares are potentially less profitable than ordinary shares. However, they offer more stability because the guaranteed dividends that the company pays at regular intervals are not tied to the financial pressures of the market. They are also an attractive investment because they are prioritised over ordinary shares when dividends are paid or during liquidation.
For more information about how preference shares work, our experienced capital raising lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to solicitors to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
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