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Ordinary Shares vs Preference Share

This article explores the differences of Ordinary Shares and Preference Shares in terms of characteristics, benefits and rights, for both business owners and investors.

Ordinary Shares

These type of shares are the equity shares issued by a company, designating equity ownership proportionally based on the percentage of stocks purchased and owned.  Holders of ordinary shares in a company have voting rights at the general meeting, which means they have a right to decide in matters such as appointing or removing directors etc. These shareholders also have rights to profits earned by the company and capital appreciation.

However, dividends paid by the company are not fixed for ordinary shareholders, and it is common for newly incorporated companies (start-ups) not to pay out dividends, but instead to re-invest profits back into the business. Dividends are only paid out to ordinary shareholders only after all of the company’s liabilities have been settled. Ordinary shares cannot be converted into preference shares.

The Benefits of holding Ordinary Shares 

Potential for Profits:  As a partial owner of the company, you will be rewarded with dividends and profits when there is an increase in the market value of the company. If the company performs extremely well and it becomes more valuable, you will be able to get capital gains, which is a measure of the worth of the company over time. Similarly, when the company is profitable, it may decide to benefit its common shareholders by giving individual dividends or payments in the form of cash or issuing more shares also known as a bonus issue.

Ideal Investment Option: Using this type of investment, you have limited liability. Whatever amount you have already invested partially in, will be the only investment that you are going to lose if the Company is liquidated. Thus, you will not be at risk to lose money above the total funds already invested.

Restricted Liabilities: You will not be personally liable if problems are arising from the outside of the financial investment of a shareholder. Only those who are running the company are at risk of facing the consequences.

Easily Transferable/Purchase:  You may sell a portion or all of the shares you own or make more purchases of shares to increase your shareholding at an agreed price. There is no restriction to sell as this is a liquid investment.

Profit from Capital Gains and Dividends: When the value of the company appreciates and revenue exceeds expenses, you stand to profit from both the capital gains and dividends as ordinary shareholders are owners of the business who are entitled to the profits of the Company.

Disadvantages of holding Ordinary Shares 

High Risk, High Reward Investment: Ordinary share prices are volatile, especially for newly incorporated companies, and their value can fluctuate without any signs of warning. It is quite difficult to evaluate the Company’s performance even if the company is doing well. If the Company goes bankrupt, the shares you hold in the company would likely become quite worthless.

Lack of Control: Unless you own a huge amount of shares to gain majority control, (and companies are also known to put a cap on the number of shares for outside investors, to stay in the control) you will not be able to be involved in the decision-making process or have much say in the management or control of the Company. Therefore, if management is bad, your investment would be at risk. Therefore, buying shares from any company requires a good due diligence process to gauge whether a business has the propensity to grow.

Ranks last:  In times when the Company fails and decides to wind up or liquidate, as an ordinary shareholder, you will get paid after everyone else, e creditors, employees, suppliers, taxes and preference shareholders (if any)

Preference Shares

Some companies may issue preference shares to raise capital. Preference shares are considered to be a type of hybrid security and carry the benefits of both debt and equity capital. Preference shareholders get dividend payments before ordinary shareholders. However, preference shareholders typically have no voting rights as ordinary shareholders typically do (unless in some circumstances which may affect their rights)

The benefits of holding Preference Shares 

Dividends Paid First: Preference shares typically are issued with fixed dividends that must be paid to their holders before they are paid out to ordinary shareholders. While dividends are only paid if the company registers a profit, some types of preference shares (called cumulative shares) allow for the accumulation of unpaid dividends. When the company is showing a profit again, then all unpaid dividends must be paid to preference shareholders before any dividends can be paid to ordinary shareholders.

Higher Claim on Company Assets: If the company fails and ends up in liquidation, preference shareholders have a higher claim on company assets. This makes it attractive to investors with low-risk tolerance. As dividends are guaranteed each year, in the event of a loss and the company has to wind up, the preference shareholders rank higher in priority when compensation is paid out.

Convertible to Ordinary Shares:  If the company issues convertible preference shares, the holders can trade in their shares for a fixed number of ordinary shares. This may seem attractive and lucrative if the value and equity of the company go up.

Certain companies prefer to issue Preference shares to raise capital as it also advantageous to the issuing company, whereby,

Ownership and Control are not Diluted: As the preference shareholders have no (or rather restricted) voting rights this means that ownership is not diluted by the issue of preference shares, as compared to issuing ordinary shares. The lower risk to investors also means the cost of raising capital for issuing preference shares is lower than that of issuing ordinary shares.

Company right to repurchase shares: A company can also issue redeemable preference shares, which can be repurchased at its discretion. Hence if the shares were issued with a 6% dividend but interest rates fall to 4%, the company can purchase any outstanding shares at the market price and then reissue shares with a lower dividend rate, thereby reducing the cost of capital.

The Disadvantages of holding Preference Shares 

Fixed Dividend Rate: The rate of dividends of preference shares are fixed at the time of sale and remains fixed until the shares mature, often 30 years. 

Limited Appreciation Potential: The share price of preference shares remains fairly stable, so any profit to be made from letting them go is usually quite limited. The lower the risk, the lower the reward.

Risk of Insolvency: Preference shares are a mechanism for raising capital, usually by startup companies or small SMEs hoping to grow. With such companies, the risk of insolvency is relatively greater than with established firms. In the event of a liquidation, you will likely be unable to recover the entire amount of your initial investment.

Risk of a Share Call/Redemption: Your preference shares might get called in before you get the chance to sell them. Most preference shares are issued with a call date, typically 5 years after the issue. Redemptions are when a company requires shareholders to sell a portion of their shares back to the company. For a company to redeem shares, it must have stipulated upfront that those shares are redeemable, or callable. Redeemable shares have a set call price which is the price per share that the company agrees to pay the shareholder upon redemption. The call price is set at the onset of the share issuance. Shareholders are obligated to sell the stock in redemption. The issuer has the right to call in outstanding preference shares and buy them out, especially when interest rates are declining. If you want to reinvest your money, you will have to settle for a lower interest rate.



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