Equity: What are common and Preference shares

Posted by Susan Woods on March 31st, 2019

There are numerous similarities and differences between common stocks and preferred stocks. Both offer ownership and voting rights. However, preferred shareholders get a fixed dividend from the company, whereas common shareholders may or may not receive one. Also, preferred shareholders have a greater claim to a company's assets and earnings. Lets take a in depth look at both types of shares.

What are common shares?

Common shares are the most common form of equity and represent an ownership interest in the Company. Common shareholders have a residual claim (i.e, they can claim only after the claims of debt-holders and preferred stockholders) on firm assets if the firm is liquidated and govern the corporation through voting rights. Firms are under no compulsion to pay dividends on common equity; the firm on the basis of profit determines what dividend will be paid periodically. Common stockholders are able to vote for the resolution that affects the shareholders interest in the Company like important merger decisions, the selection of auditors, appointment of directors etc.. If they are unable to attend the annual meeting, shareholders can vote by proxy authorizing someone else to vote on his or her behalf.

The Common shares can be divided into two types:-

Callable common shares give the firm the right to repurchase the stock at a pre-specified call price. Investors receive a fixed amount when the firm calls the stock. The call feature benefits the firm because when the stock's market price is greater than the call price, the firm can call the shares and reissue them later at a higher price. Calling the shares, similarly to the repurchase of shares, allows the firm to reduce its dividend payments without changing its per-share dividend.

Putable common shares give the shareholder the right to sell the shares back to the firm at a specific price. A put option on the shares benefits the shareholder because it effectively places a floor under the share value. Shareholders pay for the put option because other things equal, putable shares are sold for higher prices than non-putable shares and raise more capital for the firm when they are issued.

Preference shares (or preferred stock) have features of both common stock and debt. As with common stock, preferred stock dividends are not a contractual compulsion, the shares usually do not mature, and the shares can have put or call features. Like debt, preferred shares typically make fixed periodic payments to investors in the form of dividend and do not usually have voting rights.

Cumulative preference shares are usually promised fixed dividends, and any dividends that are not paid must be made up before common shareholders can receive dividends. The dividends of non-cumulative preference shares do not accumulate over time when they are not paid, but dividends for any period must be paid before common shareholders can receive dividends.

Preferred shares have a stated par value and pay a percentage dividend based on the par value of the shares. Investors in participating preference shares receive extra dividends if firm profits exceed a predetermined level and may receive a value greater than the par value of the preferred stock if the firm is liquidated. Non-participating preference shares have a claim equal to par value in the event of liquidation and do not share in firm profits. Smaller and riskier firms whose investors may be concerned about the firm's future often issue participating preferred stock so investors can share in the upside potential of the firm

Convertible preference shares are those which can be exchanged for common stock at a pre-determined conversion ratio.. It has the following advantages:

1. The preferred dividend is higher than a common dividend.
2. If the firm is profitable, the investor can share in the profits by converting his sharesinto common stock.
3. The conversion option becomes more valuable when the common stock priceincreases.
4. Preferred shares have less risk than common shares because the dividend is stable and they have priority over common stock in receiving dividends and in the event of liquidation of the firm.

Because of their upside potential, convertible preferred shares are often used to finance risky venture capital and private equity firms. The conversion feature compensates investors for the additional risk they take when investing in such firms.

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