There are a number of different types of shares that companies offer their investors: preference shares being one of them. In the event of insolvency – where a company can no longer service its financial obligations – preference shares are given preferential treatment, i.e. they are paid out before ordinary shares. Preference shares vary and, depending on their structure, can be classified as ‘hybrid’ or ‘convertible’ securities, taking 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’. Like ordinary shares, preference shares provide income payments in the form of dividends. The rate at which preference share dividends are paid is either fixed or floating.
What are the different types of preference shares?
There are a number of different types of preference shares to consider, including:
Convertible: Convertible preference shares start off by paying fixed dividends at regular intervals, and then 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, one year, the company is not able to pay its dividends owing to its shareholders, the dividends simply accrue and are paid out when the company is more profitable and financially stable. Only once these dividends are paid to the cumulative preference shareholders will the ordinary shareholders be paid.
Redeemable: Shareholders with redeemable preference shares may redeem these for cash at the discretion of the company.
Do 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 that of other ordinary shareholders. Remember, however, that creditors will still take priority.
In terms of the distribution of dividend payments, preference shareholders will also take priority over ordinary shareholders. These dividends are based on the profits of the company.
Can preference shares be converted?
Most types of preference shares are ‘convertible’ because they can, and usually will, turn into ordinary shares at a certain stage. The amount of ordinary shares you receive when your preference shares convert will depend on which method of conversion is used. The method of conversion is defined in the prospectus when the shares are initially issued. 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.
If your preference shares are listed on the ASX, you can sell them before they convert. To sell your unlisted preference shares, you will need to consult the company’s by-laws or articles of association.
What should I consider when buying preference shares?
If you’re investing in preference shares, there are several important considerations:
- Check the dividend rate and whether it is floating or fixed;
- Check whether the dividend is franked. This means that the company (issuing the dividend) pays a portion of the tax on the dividend; and
- Finally, you will want to know when and how the preference shares convert into ordinary shares.
Preference shares are potentially less profitable than ordinary shares, although they offer more stability because the guaranteed dividends that are paid at regular intervals are not directly tied to the financial ebbs and flows of the market. They are also an attractive investment because they are prioritised over ordinary shares when dividends are paid and during liquidation. And finally, if the company goes into bankruptcy, holders of preference shares enjoy priority distribution (after creditors) of the company’s assets, something ordinary shareholders only benefit from once the preference shareholders have been compensated.
In you are looking to raise funding for your startup and wish to issue preference shares to potential investors, contact LegalVision for assistance in structuring your share holding.