Preference share can be defined as those shares that carry preferential right with regard to the dividend as well as repayment of capital in case of winding up of the company. In order to understand it in simple terms consider the example of apple farm suppose the farm owner in lieu of your investment of $100 in the farm gives you 2 options that either you will get 5 apples if production is above 100 apples or you will get 5 percent apples above 100 apples and if you select the first option then it is equivalent to preferred stock and if you select other option then it is equivalent to equity shares. There are many types of preference shares which company can issue; here are some of them –
- Cumulative and Non-cumulative Preference Shares – Cumulative preference shares give the right to the preference shareholders to receive arrears of dividend which were not paid in previous years due to company making loss. While Non- cumulative Preference shareholders do not have right like Cumulative preference shareholders and therefore they cannot demand any arrears of dividend which were not paid during previous years by the company. So for example if a preference shareholder holds 100 preference shares of $100 dollars face value carrying a dividend of 10 percent and due to some reason company has made loss and not paid dividend for last 3 years then in case of cumulative preference shares the shareholders will have right to receive $30 per share as dividend for past 3 years whereas non-cumulative preference shareholders will not receive the $30 per share dividend.
- Participating and Non Participating Preference Shares – Participating Preference shareholders have the right to receive any remaining profit which is left after payment of dividend to the equity shareholders, while Non Participating Preference shareholders do not have such rights. So for example if the company makes the profit after tax of $20000 and out of which company pays $5000 to preference shareholders and $10000 to equity shareholders, now in the remaining $5000 participating preference shareholder will also get a share with equity shareholders.
- Convertible and Non-Convertible Preference Shares – Convertible Preference shares can be converted into equity shares if preference shareholder decides to do so while Non-Convertible Preference shares do not have any such right. So in the case of apples if the owner gives you the option to switch from 5 apples per day to 5 percent of production then it is an example of a convertible option given by the owner. As far as shareholders are concerned they prefer to have convertible preference shares because that give them the flexibility to convert their holdings into equity whenever they want.
- Redeemable and Non-Redeemable Preference Shares – Redeemable Preference shares are those shares which have to be repaid by the company after a fixed period of time from the date of issue of such shares while Non-Redeemable Preference shares cannot be redeemed by the company except on winding up of the company.
As one can see from the above that preferred stock or preference shares are of many types and investors should look carefully and then decide in which type of preferred stock the investor wants to invest his or her money as each type has its own feature.