Preference shares are a popular investment option for those who want steady returns without taking on the full risk of equity. While they represent ownership in a company, preference shares behave more like income-generating tools, offering fixed dividends and payout priority over regular shareholders.
This makes them especially attractive during uncertain market phases or for investors who want exposure to equity without its volatility. Read along to know more!
Preference Shares: Definition and Key Features
Preference shares are a class of shares that offer investors fixed dividend payouts and priority over equity shareholders when it comes to dividend distribution and capital repayment during liquidation. They are considered a hybrid instrument, combining the steady income feature of debt with the ownership rights of equity, though limited in scope.
Key Features of Preference Shares
Some key features of preference shares include:
- Fixed Dividends: Preference shareholders receive a predetermined dividend, often expressed as a percentage of the face value. This income is typically more stable than that of equity shares.
- Priority over Equity: In case of dividend payout or company liquidation, preference shareholders are paid before equity shareholders.
- No Voting Rights: Generally, preference shareholders do not have voting rights in company matters, except in rare circumstances, like when dividends are unpaid for a certain period.
- Convertible Option: Some preference shares may be convertible into equity shares at a later stage, offering potential capital appreciation.
- Limited Capital Gains: Since preference shares do not benefit directly from increases in the company’s market valuation, capital appreciation is usually limited.
- Redeemability: Redeemable preference shares come with a fixed maturity date after which the company repurchases them. Irredeemable ones stay on the books until liquidation (though rarely issued now).
Rights of Preference Shareholders
- Right to receive fixed dividends before equity shareholders.
- Priority claim on company assets in case of liquidation.
- Right to participate in surplus profits (if issued as participating shares).
- Right to convert to equity (if convertible).
Types of Preference Shares
When evaluating whether to invest in preference shares, it’s important to understand the different variations available, each designed for specific investor needs and company goals.
These shares differ based on dividend treatment, convertibility, participation in profits, and redemption terms. Below is a breakdown of the main types of preference shares, along with examples and why companies issue them.
Cumulative vs Non-Cumulative Preference Shares
| Type | Cumulative Preference Shares | Non-Cumulative Preference Shares |
| Definition | Accumulate unpaid dividends to be paid later | Do not carry forward unpaid dividends |
| Example | If the company misses dividends in 2023, it must pay both 2023 and 2024 in 2024 | If the company skips 2023 dividends, they’re permanently lost |
| Why Issued | Helps attract investors when profits may fluctuate year to year | Suitable when the company wants to limit long-term dividend obligations |
Participating vs Non-Participating Preference Shares
| Type | Participating Preference Shares | Non-Participating Preference Shares |
| Definition | Entitled to fixed dividends and an additional share of profits after equity dividends | Only entitled to fixed dividends |
| Example | Earn extra dividends in profitable years after equity holders are paid | Receive тВ╣10 dividend even if the company earns huge profits |
| Why Issued | Attracts long-term or strategic investors who benefit from strong company performance | Lets company control and cap total payouts |
Convertible vs Non-Convertible Preference Shares
| Type | Convertible Preference Shares | Non-Convertible Preference Shares |
| Definition | Can be converted into equity shares after a set period or under certain terms | Cannot be converted into equity shares |
| Example | тВ╣100 preference share may convert into 10 equity shares after 5 years | Remains a preference share until redeemed |
| Why Issued | Appeals to investors seeking both steady income now and growth later | Helps the company avoid future dilution of equity ownership |
Redeemable vs Irredeemable Preference Shares
| Type | Redeemable Preference Shares | Irredeemable Preference Shares |
| Definition | Repaid by the company after a fixed period or on a pre-decided date | No maturity date; stay active indefinitely |
| Example | Share redeemed by the company after 7 years | Pays dividends perpetually until the company liquidates |
| Why Issued | Useful for time-bound financing like infrastructure projects | Rare today; used to raise capital without repayment commitment |
How Preference Shares Differ from Equity Shares
Preference shares offer fixed dividends and limited rights, making them suitable for risk-averse investors looking for steady returns. In contrast, equity shares provide ownership with voting power and higher profit potential but carry more risk.
Here are some key differences between the two:
| Feature | Preference Shares | Equity Shares |
| Voting Rights | No voting rights in most cases | Full voting rights on company matters |
| Dividend Distribution | Fixed dividends are paid before equity dividends | Variable dividends paid after preference shareholders |
| Priority in Liquidation | Priority over equity shareholders for capital repayment | Last claim during liquidation |
| Risk Profile | Lower risk due to fixed income and priority in payouts | Higher risk due to market volatility and last claim on assets |
| Returns Potential | Limited to fixed dividend unless participating | Unlimited, based on company performance and stock appreciation |
| Convertibility | May be convertible to equity (in case of convertible preference shares) | Not applicable |
| Trading Liquidity | Less liquid; fewer listed preference shares | Highly liquid; actively traded on stock exchanges |
| Ownership | Partial ownership without control | Full ownership with control rights (via voting) |
Advantages and Disadvantages of Preference Shares
LetтАЩs discuss the key advantages and disadvantages of preference shares for both investors and companies:
Advantages of Preference Shares
For Investors
- Fixed Returns: Preference shares offer fixed dividends, providing predictable income.
- Lower Risk: In case of company liquidation, preference shareholders are paid before equity holders.
- Portfolio Stability: Ideal for conservative investors seeking steady returns without full equity exposure.
- Convertible Options: Some types can be converted into equity shares for upside potential.
For Companies
- No Dilution of Control: Since most preference shares donтАЩt carry voting rights, control remains with existing equity shareholders.
- Flexible Capital Raising: Companies can structure terms (e.g., callable, cumulative) to suit their financing needs.
- Tax Efficiency: Dividend payments are not treated as interest expense, reducing tax impact compared to debt in certain cases.
Disadvantages of Preference Shares
For Investors
- No Voting Rights: Investors usually donтАЩt get a say in company decisions.
- Limited Capital Gains: Returns are capped at fixed dividends unless shares are convertible.
- Low Liquidity: Preference shares are not widely traded, making them harder to exit.
- Dividend Risk: In non-cumulative types, missed dividends are not paid later.
For Companies
- Dividend Obligation: Even if not legally binding like debt interest, missing dividends can affect credit reputation.
- Higher Cost: Preference dividends are often higher than debt interest rates.
- Redemption Pressure: Callable shares may require buy-back after a certain period, affecting cash flows.
Preference Shares in India тАУ Legal & Tax View
Preference shares in India, particularly hybrid instruments like Compulsorily Convertible Preference Shares (CCPS), are widely used by startups and private companies to raise capital without immediately diluting ownership. While they offer distinct investor advantages, their legal and tax treatment involves nuanced considerations.
Regulatory Framework
In India, preference shares are regulated under the Companies Act, 2013, and the Income Tax Act, 1961. The issuance terms, such as dividend rate, convertibility, and redemption, are usually defined in shareholder agreements and company resolutions.
Key regulatory points include:
- Tenure Limit: As per Rule 9 of Companies (Share Capital and Debentures) Rules, 2014, companies (other than infrastructure firms) must redeem preference shares within 20 years.
- Conversion Terms: For instruments like CCPS, conversion into equity is not treated as a тАЬtransferтАЭ under Section 47 of the Income Tax Act, meaning no capital gains tax is levied at the time of conversion.
- Liquidation Priority: Until conversion, preference shareholders enjoy priority over equity holders during liquidation.
- Valuation: Valuation of unlisted preference shares, especially CCPS or CCDs (Compulsorily Convertible Debentures), is governed under Rule 11UA using open market value (OMV), which is often interpreted as fair market value (FMV).
Tax Treatment for Investors
- Dividend Income: Dividends received on preference shares are taxed as тАШIncome from Other SourcesтАЩ and taxed at the applicable slab rate of the investor.
- Conversion to Equity: When CCPS are converted into equity, no immediate capital gains tax is applicable. Tax is levied only when the resulting equity shares are sold.
- Holding Period: To qualify as a long-term capital asset, CCPS must be held for at least 2 years (vs 3 years for CCDs).
- Valuation Disputes: If CCPS are valued using methods like DCF (Discounted Cash Flow), tax authorities may challenge the valuation, insisting on redemption value instead. This could result in the difference being taxed as income.
Who Should Invest in Preference Shares?
Preference shares are best suited for conservative, income-focused investors who prioritise regular returns over high-risk, high-growth opportunities. Since these shares offer fixed dividends and payout priority over equity holders, they are ideal for those looking to stabilise their portfolio with predictable income.
Ideal Investor Profiles
Investors who should invest in preference shares are:
- Retirees or near-retirement individuals seeking fixed income without high volatility.
- Risk-averse investors looking for alternatives to debt instruments like bonds or fixed deposits.
- Investors with medium-term horizons who prefer defined dividend streams without the ups and downs of stock markets.
- Hybrid portfolio builders who want a mix of fixed income and equity-linked exposure (in the case of convertible preference shares).
Institutional Use Cases
- Insurance companies and pension funds invest in preference shares to match long-term liabilities with predictable cash flows.
- Banks and NBFCs may use them to diversify their fixed-income portfolios.
- Private equity and VC-backed firms sometimes use preference shares (with special terms) to structure funding rounds with downside protection.
- Family offices and HNIs (High Net-Worth Individuals) use them to gain fixed returns while preserving some capital protection.
Conclusion
Preference shares offer a balanced investment option for those seeking fixed income with relatively lower risk. With features like fixed dividends, priority in payouts, and limited downside compared to equity shares, they appeal especially to conservative investors and institutions managing long-term liabilities.
If youтАЩre looking for a stable income stream without the volatility of equity markets, preference shares can be a strategic addition to your portfolio, especially when chosen carefully based on type, issuer credibility, and terms of issue.
FAQs
What is a preference share, and how does it work?
A preference share is a type of share that gives holders priority over equity shareholders when it comes to receiving dividends and capital repayment during liquidation. Preference shares typically offer fixed dividends and do not carry voting rights, making them a hybrid between debt and equity instruments.
What are the different types of preference shares?
The different types of preference shares include:
- Cumulative Preference Shares: Accumulate unpaid dividends and pay them out before equity shareholders.
- Non-Cumulative Preference Shares: Do not accumulate unpaid dividends.
- Convertible Preference Shares: Can be converted into equity shares after a specific period.
- Non-Convertible Preference Shares: Cannot be converted into equity shares.
- Participating Preference Shares: Allow shareholders to receive extra dividends if the company performs well.
Are preference shares better than equity shares?
Preference shares are better than equity shares if you seek fixed returns and priority in payouts, but they lack voting rights and growth potential. Equity shares may offer higher long-term returns and ownership benefits, but come with more risk. So, the choice depends on your investment goalsтАФstability or growth.
Do preference shares give fixed returns?
Yes, preference shares give fixed returns in the form of dividends, usually set as a percentage of the face value. This makes them more predictable than equity shares, especially in companies that consistently pay out dividends.
Can retail investors buy preference shares in India?
Yes, retail investors can buy preference shares in India, either through public issues (when offered by companies) or via stock exchanges if they are listed. However, availability is limited compared to equity shares, and liquidity can be a concern in secondary markets.
Disclaimer
The information provided in this article is for educational and informational purposes only. It should not be considered as financial or investment advice. Investing in stocks involves risk, and it is important to conduct your own research and consult with a qualified financial advisor before making any investment decisions. The author and publisher are not responsible for any financial losses or gains that may result from the use of this information.
