Companies need capital to run their operations and finance their growth. They can raise capital either through debt, equity, or both. The capital structure of the business is the combination of debt and equity used to finance its operations and growth. Debt is money borrowed from another party, which needs to be returned. Typically, debt involves interest payments, at a pre-decided rate, by the borrowers to the lenders.
Equity involves raising money by giving an ownership stake in the business. With equity, companies can raise money by issuing equity shares or preference shares. Equity shares do not involve any fixed payments to equity shareholders. Also, companies are not obligated to return the funds raised from equity shareholders. The return on their investment is linked to the performance of the company. If the company goes bankrupt, equity shareholders risk losing their entire investment.
Preference shares have characteristics of both equity shares and debt. Let us understand the key differences between equity and preference shares.
Important differences between Equity and Preference Shares
Every company must issue equity shares. However, the issuance of preference shares is voluntary.
Companies distribute their profits to their shareholders through dividends. While both equity and preference shares may receive dividends, there is a key difference. Equity shares are not entitled to any dividends. Even if a company is making profits, it can choose not to pay any dividends to equity shares owners. Also, the rate and amount of equity dividends can fluctuate. On the other hand, preference shares offer a fixed dividend. Companies have to pay the dividends on preferred shares first before paying any dividends on equity shares.
Order in Claiming the Company’s Assets
Both equity and preference shareholders are owners of a company. If the company goes bankrupt, both stand to lose their capital. However, in such an event, preferred shareholders have an advantage. Companies must settle the claims of preference shareholders first before paying any money to equity shareholders.
Equity shareholders have the right to vote on every resolution (key decisions of a company) related to the company. Examples of key decisions include mergers and acquisitions or the appointment of the board of directors. However, preference shareholders can vote only on matters relevant to preference shares.
An example includes a decision related to liquidating the company. However, there is an exception to this rule. If a company has not paid any dividend to preferred shareholders for two or more years, they get voting rights for every resolution, similar to equity shareholders.
Variety of Types
Equity shares can either be ordinary equity shares or differential voting rights (DVR) shares. DVR shares are similar to ordinary shares, except they have fewer voting rights. Preference shares can be of many types, including:
- Convertible (can be converted into equity shares) vs non-convertible
- Cumulative (dividends get accumulated if not paid in any year) vs non-cumulative
- Participatory (provide additional dividends subject to the company meeting certain targets) vs non-participatory
Trading in Exchanges and Liquidity
Equity shares in India trade on exchanges such as the Bombay Stock Exchange or the National Stock Exchange. Any retail investor with a Demat account can purchase equity shares. This makes equity shares highly liquid. On the other hand, preference shares do not trade on exchanges. These shares trade in the Over the Counter (OTC) market, where shares trade informally. As a result, preference shares are relatively less liquid.
Redemption versus Share Repurchases
There is a specific type of preferred shares known as ‘Redeemable Preference Shares’. These shares are redeemed or repaid after a certain time period. Shareholders must sell the stock upon redemption.
In share buybacks, the company buys back its shares at the current market price. This is a popular way of returning cash to equity stockholders. However, share buybacks are entirely voluntary, and shareholders can choose not to sell their shares.
Rights to Shareholders
Equity shareholders have voting rights, and they also become owners of the business. While preference shares do not have voting rights, they have several other rights. Examples include right of the first offer, right of first refusal, tag along, drag along, etc. Some of these rights may offer extra protection and benefits to preference shareholders.
Bonus Shares/Rights Issue
Companies may issue bonus shares to equity shareholders. Typically, companies issue bonus shares to reduce their share price and increase their investor base by improving their affordability. Equity shares can also participate in a rights issue when a company allows its existing shareholders to buy its shares at a lower price. Preference shares do not get bonus shares. Also, they do not get the rights to buy equity shares if the company is giving a rights issue.
Most equity shares in India have a face value of INR 10. On the other hand, preference shares have a higher face value of INR 100 or INR 1,000. Note that the face value is different from the market value of the company. Due to their higher face value (e.g., INR 1,000), preference shares can be unaffordable to small-scale investors.
Type of Investors
As we have seen, preference shares get preference in payments of dividends and claims on assets in case of bankruptcy. These features make preference shares attractive to risk-averse investors. On the other hand, equity shares are more attractive to investors willing to take risks.
Every public company listed on leading stock exchanges has issued equity shares. Preference shares are relatively rare. In the recent past, companies like Tata Capital and IL&FS have issued preference shares.
The differences between equity and preference shares are summarised below for your ready reference.
|Characteristic||Equity Shares||Preference Shares|
|Dividend payments||Not fixed||Fixed|
|Order in claim on assets||Lower||Higher|
|Voting rights||On all key decisions||Only on selective decisions|
|Trading on exchanges||
|Buyback options for the company||Possible under share buybacks||Possible for redeemable preference shares|
|Rights for shareholders||Voting rights||No voting rights, but several other rights|
|Face value||INR 10 per share in most cases||INR 100 or INR 1,000 per share|
|Types of investors||Attractive to investors willing to take risks||Attractive to risk-averse investors|
Both equity and preference shares have their own advantages and disadvantages. For first-time investors, equity shares are a good way to get started. These shares can be purchased with relative ease and have a liquid market. Risk-averse investors can invest in preference shares through the OTC market.