What it means
A preference share is best understood as equity with a bond-like personality. The dividend is usually a fixed percentage of the par value, the nominal face amount printed on the share, so the holder expects a steady payment rather than growth.
The word preference refers to queue position, not to popularity. Preference holders must be paid their dividend before ordinary shareholders receive anything, and in a liquidation they are repaid after all creditors but before ordinary shareholders.
The most important variant is whether the shares are cumulative. If a cumulative preference dividend is missed, it accumulates as arrears that must be cleared in full before any ordinary dividend can be paid, while a non-cumulative missed dividend is simply lost.
Companies issue them to raise money without diluting control or adding formal debt covenants. Investors buy them for predictable income, and the trade-off is that a preference holder rarely benefits if the company triples in value.
Two further features often appear in the terms. Participating preference shares receive the fixed dividend and then share in surplus profits as well, and convertible preference shares can be exchanged for a set number of ordinary shares, which is common in venture capital funding rounds.
Redemption is the other clause to read carefully. Shares that the company must buy back on a fixed date behave so much like a loan that accounting standards often require them to be shown as a liability, with the dividend appearing as a finance cost rather than a distribution.
In practice
Real-world examples
Example 1
A family-owned brewery raises $5,000,000 from an outside investor by issuing preference shares rather than ordinary shares, so the founding family keeps all the votes at the annual meeting. The investor accepts a fixed 7% dividend instead of a share of future growth.
Example 2
A property group facing a weak letting year suspends its preference dividend to preserve cash. Because the shares are cumulative, the missed amount is disclosed as arrears in the accounts and blocks ordinary dividends until it is cleared.
Example 3
A venture fund invests in a software start-up using convertible preference shares that also carry a liquidation preference. If the company sells cheaply the fund gets its money back first, and if the company does well the fund converts to ordinary shares and shares the upside. The founders accept the structure because it lets them agree a higher headline valuation than a plain equity deal would support.
Think of it
Preference shares are like holding a VIP pass at a concert. You get better seating and snacks before everyone else, but you do not get to choose the band's setlist like the main organisers do.
Formula
Calculation
Annual preference dividend = Number of preference shares x Par value x Dividend rate
Arrears owed on cumulative shares = Annual preference dividend x Number of years missed
A manufacturer has 50,000 preference shares in issue with a par value of $100 each and a fixed rate of 6%. The dividend per share is $100 x 6% = $6, so the annual cost to the company is 50,000 x $6 = $300,000.
Trading is poor for two years and the board skips the payment. Because the shares are cumulative, arrears build up to $300,000 x 2 = $600,000. In the third year the company recovers and wants to pay ordinary shareholders, so it must first pay the $600,000 of arrears plus the current year charge of $300,000, a total of $900,000, before a single cent reaches ordinary holders.Case study
Seen in the real world
The following is an illustrative and fictional example. Corran Foods, a mid-sized chilled-meals producer, needed $8,000,000 to fit out a second factory but did not want to add bank debt with strict covenants on top of an existing facility.
The board issued 80,000 cumulative preference shares at a par value of $100 with a 6.5% rate, creating an annual dividend cost of 80,000 x $100 x 6.5% = $520,000. The investors got priority income and no vote; the founders kept control of the board.
In the fictional third year a supply problem cut profits and the dividend was skipped once. Arrears of $520,000 appeared in the accounts, and the family shareholders learned an uncomfortable lesson: preference shares are not debt, but the queue they create still has to be honoured before any money reaches them.
Watch out
Common mistakes
- Calling preference dividends a guaranteed payment. They are only paid if the board declares them and the company has distributable profits.
- Treating all preference shares as equity in the accounts. Some, particularly redeemable ones with mandatory payments, are classified as liabilities under accounting standards.
- Ignoring arrears when valuing ordinary shares. Unpaid cumulative dividends sit ahead of ordinary holders and reduce what is left for them.
Questions
People also ask
Do preference shareholders get to vote?
Usually not on ordinary business, though voting rights often revive if dividends go unpaid for a set period.
Are preference dividends tax deductible for the company?
Generally no, because they are distributions of profit rather than interest, which is one reason some companies prefer debt.
What happens in a liquidation?
Preference holders rank behind all creditors but ahead of ordinary shareholders for the return of their capital.