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.
Equity share capital refers to the funds raised by a company through the issuance of stock. It represents ownership in the company and provides a share in its profits and losses. In simple terms, equity share capital is the amount of money invested in a company in exchange for ownership.
Benefits of owning Equity shares
Some of the top benefits of owning equity shares are:
- Potential for capital appreciation: The value of equity shares can increase over time, providing the potential for capital appreciation.
- Dividend income: Companies may pay dividends to their shareholders, providing a source of income.
- Ownership in the company: Equity shareholders have a stake in the company and a say in its decisions through voting rights.
- Liquidity: Equity shares can be easily bought and sold on stock exchanges, providing liquidity to investors.
- Diversification: Investing in equity shares can help to diversify an investment portfolio, reducing overall risk.
Drawbacks of owning Equity shares
Some of the drawbacks of owning equity shares are:
- Market risk: The value of equity shares can fluctuate based on market conditions, leading to short-term losses.
- No guaranteed returns: Unlike fixed-income investments, there are no guaranteed returns with equity shares.
- Company-specific risk: The performance of equity shares is tied to the specific company, and problems with the company can negatively impact investment returns.
- Lack of liquidity: In some cases, it may be difficult to sell equity shares quickly, leading to a lack of liquidity.
- Dividend uncertainty: Companies may choose not to pay dividends, or may reduce the amount of dividends paid, leading to uncertainty for investors.
Types of equity shares
There are three main types of equity shares: common stock, preferred stock, and restricted stock.
Common Stock: This is the most commonly issued type of equity share. It provides a share in the profits and voting rights in the company.
Preferred Stock: Preferred shares typically offer a fixed dividend rate, but do not provide voting rights like common stock.
Restricted Stock: Restricted stock refers to shares that have restrictions on their sale or transfer. They may be granted as part of a compensation package and typically have fewer voting rights than common stock.
Preference share capital refers to the funds raised by a company through the issuance of preference shares. Preference shares are a type of equity capital that provides a predetermined rate of return to the investor in the form of dividends. Unlike common shares, preference shares do not typically provide voting rights to the shareholder, and the dividends are paid before any dividends are paid to common shareholders.
In terms of priority in case of liquidation, preference shareholders rank higher than common shareholders, but lower than creditors. This means that in the event of a company’s liquidation, preference shareholders are entitled to receive their invested capital back before common shareholders, but after all debts and obligations have been paid.
Overall, preference shares provide a trade-off between the stability of fixed-income investments and the potential for capital appreciation associated with equity investments. They can be an attractive investment option for individuals seeking a reliable source of income while taking on a limited amount of risk.
Benefits of owning preference share
Some of the benefits of owning preference shares are:
- Fixed rate of return in the form of dividends
- Prioritization in case of liquidation over common shares but lower than creditors
- Provides balance between stability of fixed-income investments and potential for capital appreciation
- Attractive investment option for those seeking reliable income with limited risk.
Drawbacks of owning preference share
The major drawbacks of owning preference shares are:
- No voting rights for shareholders
- Lower potential for capital appreciation compared to common shares
- Dividends are paid before common shareholders receive any dividends
- Lower priority in case of liquidation compared to creditors.
Types of preference shares
Preference shares can be classified into several types based on the characteristics of the dividends they offer and the rights they grant to shareholders. Some common types of preference shares include:
- Cumulative preference shares: Dividends accumulate if not paid in a particular year.
- Non-cumulative preference shares: Dividends are not cumulative and are only paid in the year they are declared.
- Redeemable preference shares: These shares can be redeemed by the company after a specified period.
- Irredeemable preference shares: These shares cannot be redeemed by the company and are perpetual in nature.
- Convertible preference shares: These shares can be converted into common shares after a specified period.
- Non-convertible preference shares: These shares cannot be converted into common shares.
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.
Preference shares and equity shares differ in terms of capital repayment in the event of liquidation. In the case of liquidation, preference shareholders have priority over equity shareholders in the repayment of capital, meaning they will be repaid before equity shareholders. However, equity shareholders have the potential for higher returns and are considered riskier investments.
The rate of dividend
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.
Role in management
Preference shares and equity shares also differ in terms of their role in management. Preference shares generally do not have voting rights and have limited involvement in the company’s decision-making process. On the other hand, equity shareholders have voting rights and play a larger role in the company’s management and decision-making process.
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.
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.
The cost of preference shares and equity shares also differ. Preference shares typically have a fixed dividend rate, making them a more predictable investment. Equity shares do not have a guaranteed dividend rate and their value is more dependent on the performance of the company. As a result, equity shares can be seen as a riskier but potentially more lucrative investment.
In terms of liquidation, preference shares have priority over common shares. In the event of a company’s liquidation, preference shareholders are entitled to receive their invested capital back before common shareholders, but after all debts and obligations have been paid. However, in normal business operations, equity shareholders have more control as they have voting rights while preference shareholders do not.
Preference shares do not dilute ownership like equity shares. The issuance of new preference shares does not change the ownership percentage of existing shareholders, while the issuance of new equity shares dilutes ownership for existing shareholders. Preference shares also provide a fixed return, while equity shares have potential for capital appreciation.
Preference shares have a fixed redemption date, while equity shares don’t. Preference shares can be redeemed by the company at a fixed price, while equity shares don’t have a fixed redemption price.
In simple terms, preference shares have a set rate of return, while equity shares do not. In the event of financial burden, preference shareholders have priority in repayment over equity shareholders, but both types may be impacted in case of liquidation.
In terms of arrears, preference shares have priority in receiving dividends and if there are arrears (unpaid dividends), they must be paid to preference shareholders before common shareholders. On the other hand, equity shareholders only receive dividends if there are no arrears for preference shares.
In financial terms, preference shares generally have a fixed rate of return, while equity shares do not have a predetermined rate of return. Preference shares may also have a fixed maturity date, whereas equity shares do not have a set redemption date.
Preference shares have lower risk exposure compared to equity shares. While preference shareholders receive a fixed rate of return, equity shareholders face fluctuations in dividend payouts and market price changes. Equity shareholders also have higher potential for capital appreciation, but with higher risk.
Preference shares generally have larger denominations compared to equity shares, meaning they can be more expensive to purchase. On the other hand, equity shares often come in smaller denominations, making them more accessible to a wider range of investors.
Some of the similarities between equity and preference shares are:
- Both equity shares and preference shares represent a portion of ownership in a company.
- Both types of shares have the potential to provide returns to investors in the form of dividends or capital appreciation.
- Both equity shares and preference shares are typically tradable on stock exchanges.
- Both types of shares are considered to be financial instruments and are subject to various regulations and laws.
- The value of both equity shares and preference shares is determined by supply and demand on the stock market.
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.