What Do Preference Shares Mean?

When companies need to raise capital, they have various options at their disposal. One popular method is issuing shares, which represent possession in the firm. While ordinary shares are the most familiar, there is another type of shares known as preference shares or preferred stock. Preference shares possess unique features that set them apart from ordinary ones, offering investors a different set of advantages and disadvantages.

What Are the Features of Preference Shares?

In South Africa, preference shares have several distinctive characteristics that set them apart from other types of securities. The features of preference shares comprise:

a) Priority in Assets upon Liquidation: Preference shareowners have a higher priority claim over ordinary shareowners in the event of a firm’s liquidation. They have the right to obtain their share of the firm’s assets before ordinary shareowners.

b) Dividend Payments: Preference shares grant dividend payments to shareowners. These dividends can be fixed or floating, often based on an interest rate benchmark such as SABOR.

c) Preference in Dividends: Preference shareowners have a priority in dividend payments over ordinary shareowners. They obtain their dividends before ordinary shareowners are paid.

d) Non-Voting: Preference shares do not carry voting rights. However, some types of preference shares can provide voting rights to their holders for extraordinary events.

e) Convertibility to Common Stock: Several preference shares have the option to be converted into a predefined number of ordinary stocks. The conversion can be subject to specified conditions or require approval from the board of directors.

f) Callability: Preference shares can be repurchased by the issuer at specified dates. The issuer has the right to call in or buy back the shares from the shareholders.

However, it's important to know that the specific terms and conditions of preference stocks can vary depending on the issuing company and the terms set for each share issuance.

Who Uses Preference Shares?

In South Africa, preference shares are utilised by different entities and individuals for different purposes. The following are examples of entities and individuals who commonly utilise preference stocks:

a) Companies: Private and public companies can issue preference stocks as a means of raising capital for expansion, new projects, or other financing needs. Preference stocks offer firms the advantage of accessing long-term funding while providing investors with fixed dividend payments and probable tax benefits.

b) Banks and Financial Institutions: Banks and financial institutions frequently invest in preference stocks as part of their investment portfolios. These institutions appreciate the stable income and priority in assets that preference stocks may grant, which makes them an attractive investment option.

c) Income-Oriented Investors: Individual investors seeking a stable income stream frequently invest in preference stocks. Preference shares' fixed or floating dividend payments make them appealing to income-oriented investors who prioritise regular income generation.

d) Risk-Averse Investors: Risk-averse investors who prefer more stability in their investment portfolios can invest in preference stocks. The fixed income and priority claim on assets in case of a firm's liquidation make preference stocks a relatively safer investment option in comparison with ordinary ones.

e) Employees: Some firms offer preference stocks as part of employee share ownership plans or employee incentive schemes. Employees can obtain preference stocks as part of their compensation or as a chance to take part in the firm’s growth and advance.

The utilisation of preference stocks is not limited to the entities and individuals mentioned above. Different market participants can have distinct reasons for utilising preference stocks, and their usage can vary based on specific financial objectives, risk tolerance, and investment strategies.

What are the Types of Preferred Stock?

Preferred stocks come in various forms, each with its own set of features. The most ordinary types of preference shares comprise:

a) Cumulative Preference Stock: Cumulative preferred stock ensures that if the firm fails to pay dividends in a given year, the unpaid dividends accumulate and must be paid in future years before ordinary shareowners obtain any dividends. This type of preference stock provides a higher level of security to investors as it ensures the eventual payment of dividends.

b) Non-Cumulative Preferred Stock: Non-cumulative preferred shares don’t accumulate unpaid dividends. If the firm fails to pay dividends in a particular year, shareowners of this type of stock do not have the right to claim those unpaid dividends in the future. However, they still maintain priority over common shareholders in the distribution of dividends.

c) Convertible Preferred Stock: Convertible preferred stock offers the flexibility of conversion into common shares. This means that preference shareholders have the option to convert their preferred stock into common stock at a predetermined conversion ratio. This feature allows investors to benefit from any potential increase in the company's share price and participate in its growth.

d) Participating Preferred Stock: Participating preferred stock enables shareholders to receive additional dividends beyond their fixed dividend if the company achieves a certain level of profitability. This type of preference share grants investors the opportunity to share in the company's success and enjoy higher returns.

What Are the Benefits of Preference Shares?

Preference shares offer several advantages to both companies and investors. Let's explore some of the benefits:

a) Steady Dividend Income: One of the primary advantages of preference shares is the assurance of a fixed dividend payment. This regular income stream can be appealing to investors seeking stable returns.

b) Priority in Asset Distribution: In the unfortunate event of a company's liquidation, preference shareholders hold priority in the distribution of remaining assets. This preferential treatment enhances their chances of recouping their investment compared to common shareholders.

c) Lower Risk Profile: Preference shares are often considered less risky than common shares. The fixed dividend and higher claim on assets provide a level of security to investors, particularly those who prioritise stability and income generation.

What Are the Drawbacks of Preference Shares?

While preference shares offer several advantages, they also come with certain drawbacks that investors should consider:

a) Limited Voting Rights: Preference shareholders typically have limited or no voting rights. This means they have little influence over the company's decision-making process compared to common shareholders. If active participation in corporate governance is important to an investor, preference shares may not be the ideal choice.

b) Lower Potential for Capital Appreciation: Unlike common shares, preference shares often have limited potential for capital appreciation. The fixed dividend structure and priority in asset distribution mean that preference shareholders may not fully benefit from the company's growth and increasing share prices.

c) Susceptibility to Interest Rate Changes: Preference shares are sensitive to interest rate fluctuations. If interest rates rise, the value of preference shares may decline, impacting their market price. Investors should be aware of this potential risk and monitor interest rate movements.

How to Get Preference Shares? 

In South Africa, individuals can acquire preference shares through various methods:

a) Initial Public Offerings (IPOs): Companies may offer preference shares to the public through IPOs. During an IPO, shares are made available for purchase by individual investors through the Johannesburg Stock Exchange (JSE). Interested individuals can participate in the IPO by opening brokerage accounts with licensed stockbrokers and subscribing to the offering.

b) Private Placements: Companies may also issue preference shares through private placements. In private placements, shares are offered directly to institutional investors, high-net-worth individuals, or qualified buyers. Individual investors can access these shares indirectly by investing in funds that hold preference shares.

c) Secondary Market Purchases: After the initial offering, preference shares may be traded on the JSE's secondary market. Interested individuals can purchase preference shares from existing shareholders through a licensed stockbroker. They can place buy orders for specific preference shares listed on the JSE and execute the transaction once the order is filled.

d) Participation in Employee Share Schemes: Some companies offer preference shares as part of their employee share schemes or employee share ownership plans (ESOPs). Eligible employees may have the opportunity to acquire preference shares at a predetermined price or through stock options provided by the company.

It's important for individuals to consult with a financial advisor or licensed stockbroker to explore the available options for acquiring preference shares in South Africa. The specific process may vary depending on the company issuing the shares, market conditions, and regulatory requirements.

Bottom Line and Key Takeaways

Preference shares offer investors a different set of advantages and disadvantages compared to common shares. The fixed dividend, priority in asset distribution, and lower risk profile make them an attractive option for those seeking stable income and protection of their investment. However, limited voting rights, lower potential for capital appreciation, and susceptibility to interest rate changes should also be considered.

It's important for investors to thoroughly analyse their investment goals, risk tolerance, and the specific terms and conditions of preference shares before making any investment decisions. Consulting with a financial advisor can provide valuable insights and guidance tailored to individual circumstances.

FAQ

1. Can preference shareholders convert their shares into common shares?

Yes, certain types of preference shares, such as convertible preferred stock, can be converted into common shares based on predetermined conversion ratios.

2. Do preference shareholders have voting rights?

Preference shareholders generally have limited or no voting rights. Their influence on company decisions is typically less significant compared to common shareholders.

3. Are preference shares less risky than common shares?

Preference shares are often considered less risky due to their fixed dividend payments and higher priority in asset distribution. However, they may have limited potential for capital appreciation.

4. What happens if a company fails to pay dividends on preference shares?

The consequences vary based on the type of preference shares. Cumulative preferred stock allows unpaid dividends to accumulate and must be paid in the future. Non-cumulative preferred stock does not accumulate unpaid dividends.

5. Can preference shareholders receive additional dividends?

Yes, participating preferred stock provides the opportunity for preference shareholders to receive additional dividends if the company achieves a certain level of profitability.