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Different types of shares; ordinary versus preference shares

The Companies Act 71 of 2008 (“the Act”) provides for the authorisation and issue of various classes of shares by a company. Although shares can hold many different descriptions, shares can be basically divided into two categories, namely ordinary shares and preference shares. Various different rights and obligations are attached to these catergories of shares, ranging from voting rights, preferential status in relation to the payment of dividends and the return of capital as well as an obligation to comply with the provisions of a company’s memorandum of incorporation or “MOI”. The class of shares to be employed and preferred by shareholders will depend on the particular circumstances at hand and may be tailored to fit the situation, as well as to address the specific concerns and needs of each shareholder. There is no ‘one size fits all’ approach when it comes to a company’s shares.

The Act makes provision for a company’s founding document, the MOI, to regulate the number and different classes of shares that may be authorised and issued by a company, with extensive leeway as to the manner and form in which rights and limitations may be attached to different classes of shares in an MOI, including determining that different classes of shares have distinct voting rights. Shares are distinguished from each other based on the benefits, rights and features that they offer to the holders of such shares

What is an ordinary share?

The most popular type of share is called a common or ordinary share. An ordinary share defines a single unit of equity ownership of a corporation, where the holders of the ordinary shares receive the right to cast a vote in decisions involving important corporate matters. Such votes are available to each ordinary shareholder in correspondence to the number of ordinary shares held within the company. Ordinary shareholders are the last to receive dividends, and are only entitled to funds which remain after dividends on preferred shares are paid. Ordinary share holders may not receive dividend payments every year, and payments to ordinary shareholders depend on reinvestment decisions made by the company directors. In an event of the company facing liquidation, the ordinary shareholders will be the last to receive their share of funds, after the creditors and preference shareholders are paid. As such ordinary shares are riskier than bonds or preference shares.

What is a preference share?

Preference shares are debt instruments. A preference share contains features of equity and debt as the dividend payments to preference shareholders are fixed. The types of preference shares include cumulative preference shares – in which dividends including those in arrears from past terms are also paid, non-cumulative preference shares – where the missed out dividend payments are not carried forward, participating preference shares are where the holder receives dividends and any additional funds in times of financial stability, and convertible preference shares is where an option is available to convert shares into ordinary shares.

Preference shares are offered preference in relation to ordinary shares, where the preference shareholder receives dividends before ordinary shareholders are paid out. Preference shareholders are paid a fixed dividend and have the first claim on the assets and earnings. As such, preference shareholders receive their share of the firm’s residual value before ordinary shareholders in the event of liquidation. Preference shareholders do not have voting rights.

Preference shares are listed on the JSE in the same way general equity shares are. They are issued by companies as an alternative way to raise capital. The shares are similar to debt instruments, as they pay investors a fixed return in the form of a dividend. Though preference shareholders are not guaranteed to receive dividends, they have a preferential right to be paid before ordinary shareholders — as long as the company has made a profit.

A brief comparison of Ordinary Shares vs Preference Shares

  • Ordinary shares are riskier than preference shares, in terms of uncertainty in dividends payments and lower claim in company assets as opposed to the fixed, and usually cumulative dividends and priority asset claims for preferred shares.
  • Preference shares offer benefits and disadvantages to the holder in terms of fixed dividends and preference during liquidation. However, the control that preference shareholders have in the company is minimal as they are not offered voting rights, and as such cannot influence company policies or decisions.
  • Ordinary shares may be preferable since they offer potential for growth in dividends in terms of higher earnings in times the company is financially thriving, and allow the shareholder a say in the company’s important decisions such as the selection of the board of directors.

Advantages of Preference Shares

  • Owners of preference shares receive fixed dividends well before common shareholders see any money.

In either case, dividends are only paid if the company turns a profit but a type of preference shares known as cumulative shares allow for the accumulation of unpaid dividends that must be paid out at a later date. Once a struggling business finally rebounds and is back in the black, those unpaid dividends are remitted to preferred shareholders before any dividends can be paid to common shareholders.

  • Higher Claim one Company Assets

In the event that a company experiences a bankruptcy and subsequent liquidation, preferred shareholders have a higher claim on company assets than common shareholders do. Not surprisingly, preference shares attract conservative investors, who enjoy the comfort of the downside risk protection baked into these investments.

Additional Investor Benefits

A subcategory of preference shares known as convertible shares lets investors trade in these types of preference shares for a fixed number of common shares, which can be lucrative if the value of common shares begins climbing. Such participating shares let investors reap additional dividends that are above the fixed rate if the company meets certain predetermined profit targets.

Disadvantages of Preference Shares

The main disadvantage of owning preference shares is that the investors in these vehicles don’t enjoy the same voting rights as common shareholders. This means that the company is not beholden to preferred shareholders the way it is to traditional equity shareholders. Although the guaranteed return on investment makes up for this shortcoming, if interest rates rise, the fixed dividend that once seemed so lucrative can dwindle. This could cause buyer’s remorse with preference shareholder investors, who may realize that they would have fared better with higher interest fixed-income securities.

Company Benefits

Preference shares benefit issuing companies in several ways. The lack of voter rights for preference shareholders places the company in a strength position, by letting it retain more control. Furthermore, companies can issue callable preference shares, which affords them the right to repurchase shares at their discretion. This means that if callable shares are issued with a 6% dividend but interest rates fall to 4%, then a company can purchase any outstanding shares at the market price, then reissue those shares with a lower dividend rate. This ultimately reduces the cost of capital. This same flexibility is a disadvantage to shareholders.

The five different types of preference shares

  • Cumulative preference shares. With these shares, if a company is “unable to pay preference share dividends in a particular financial year, the amount of these ‘unpaid’ dividends will be paid in subsequent years when results allow.
  • Non-cumulative preference shares. With non-cumulative shares, should the company you invest in be unable to pay preference share dividends in a particular year, as the holder of these shares, you’ll forfeit the right to this dividend.
  • Redeemable preference shares. A redeemable preference share is issued with the provision that the company you invest in will be able to redeem this share at some future date. This means the company will be able to ‘buy’ these shares back and remove them from circulation.
  • Convertible preference shares. At the request of the company, a convertible preference share may be converted into an ordinary share.
  • Participating preference shares. As the holder of a participating preference share, you’ll not only receive the fixed dividend entitlement, you’ll also receive the ordinary share dividend too.

Below is a summary table for the two basic types of shares

Author Craig Tonkin