A joint stock company usually has two different ways to raise money, via shares and debt. Among shares, companies can issue two different kinds – preference shares and equity shares. Preference shares are also popularly known as preferred stocks.
Although holders of both types of shares are classified as ‘shareholders’, there are some minor distinctions between the two.
Let us understand what are the key differences between preferential and equity shareholders.
Preference shares have preferential rights when it comes to the payment of dividend and repayment of capital. In other words, these shareholders are given preference over equity shareholders at the time of disbursing of dividend and capital repayment.
This means, equity shareholders are entitled to receive dividends only after the company has cleared all its liabilities.
Recently, the Mumbai bench of NCLT (National Companies Law Tribunal) permitted a company to convert a part of its equity shares to 9 percent non-cumulative optionally convertible preference shares.
An objection was raised by the Registrar of Companies (RoC) but the NCLT approved the company’s submission that the change will not lead to any fundamental change in the paid up or subscribed capital as equity shares are converted into preference shares.
Dividend and repayment of capital
Unlike debt holders, a company's shareholders are entitled to receive dividends out of profits, and repayment of capital at the time of liquidation of the company. When there are less funds available, and the available money is not sufficient to clear all obligations, the preference shares are given a preference. This is the only key difference between two types of shares.
For instance, when a company announces its annual results and the profit after tax (PAT) is only ₹1 crore -- which is insufficient to be disbursed as dividend among all the shareholders.
On the top of it, the dividend due to be paid to preference shareholders stands at ₹80 lakh. In this case, at the outset, ₹80 lakh would be shared as dividend to preference shareholders, and the remainder of ₹20 lakh will be given to equity shareholders.
Likewise, if the company goes bankrupt, and the sale proceeds of all the assets are ₹10 crore. There are bank loans amounting to ₹6.5 crore. And after clearing all the dues, the balance ₹3.5 crore will be apportioned for shareholders.
Let us imagine that preference share capital is ₹3 crore and the equity capital is another ₹5 crore. In this instance, the remaining ₹3.5 crore will first be used to settle outstanding share capital of preference shareholders to the tune of ₹3 crore, and the remaining ₹50 lakh will be used to pay equity shareholders on a proportionate basis.
We can summarise that preference shareholders are the part owners of a company who are given a preferential treatment over equity shareholders at the time of giving out dividend, and also during winding up of the company.