Preference Shares vs Other Types of Shares – A Brief Comparison

Shares

A share is one of the equal parts of ownership of a company which can be bought by members of the public. As a return for investing in a company, a shareholder is awarded certain rights in the company. A share is often measured by a sum of money, the amount of liability and other mutual agreements decided upon by the shareholders of the company. Shareholding is a complex system of shared ownership. There is no one definition of what shares constitute, the rights enjoyed and the liabilities borne by the shareholders which vary from company to company.

It is now commonplace, even with small companies , to issue different classes of shares, each with its own rights. Sometimes owners might split company shares with their spouses to enjoy certain tax benefits. It is important to remember that there is no standard for what a class of shares should constitute. The share class system is flexible and varies from company to company. It allows for flexibility in the pay out of the dividends , rights to capital, the division of liabilities and deciding the rights assigned to each class, for example, voting rights. A company can decide what to call a class and the rights it gives to it. The Articles of Association of a company will clearly underline the rights that are enjoyed by a share class and this is the best way to understand what their class of shares constitutes.

Class of shares

The rights of each class of shares is decided by the existing shareholders of the company. There are a variety of reasons that a company adopts different classes of shares which also depends on the value of the company

Pay out of dividends

A class of shares can be created for the purpose of preferential dividend rights or rights to dividends in certain circumstances, such as the winding up of the company. If the company has declared it, different dividends may be paid to different classes, if it has been declared in the Articles of Association of the company. There can also be shares which have no dividends.

Voting rights

Not all shares come with voting rights. One reason for creating different share classes is to retain the control of the company with a few key individuals, such as founders, certain stakeholders and executives. In this way, the voting rights of certain individuals may be removed or increased. With super voting rights, the key controllers of the company can drive the corporate actions of the company, even in the face of a hostile takeover. Non-voting rights are often given to family members since it may be more tax-beneficial than simply sharing the profits with them.

Asset distribution in the event of a close down or disposal

In the event of a company closing down or being disposed of, all the creditors will be paid first. Then the capital and surplus funds will be divided amongst the shareholders. In the event of a winding up of the company, there may be shares which have priority over this distribution of assets.

Employee loyalty

Some companies may create a share class specifically for employees. Employees who own shares in the company will be more loyal as it creates a sense of ownership.

Different share classes

Ordinary shares

One of the most common type of shares in a company is called ordinary shares. Ordinary shares represent the company’s basic voting rights and reflect the equity ownership of a company. They also dictate the distribution of the company’s assets in the event of closure, merger or sale. Ordinary shares typically carry one vote per share and equal rights to the company’s profits (dividends). Sometimes there can be ordinary shares can have different nominal values. For example, shares that are £1 another share which is £0.10. If each share has one vote, then the £1 shareholder has 1 vote per £1 while the £0.10 shareholder has 10 votes per £1.

Non-voting ordinary shares

Ordinary shares that do not carry voting rights will still be eligible for dividends. However, because they are non-voting shares, its shareholders may not be eligible to attend general meetings. Non-voting shares are often issued to family members of the main shareholders and to employees. Non-voting ordinary shares increases the number of shareholders in the company at the same time allowing the main shareholders to retain control.

Deferred ordinary shares

Dividends are paid out to the shareholders only after all other accounts have been settled. Even in the event of a company winding up, they will be the last class to receive dividends. It usually comes with no voting rights.

Redeemable shares

A company may issue shares on the understanding that these shares will be bought back by the company after a specified period, for example, after 3 or 5 years. Redeemable shares are often issued to outside investors. For the investor, it is the privilege of enjoying dividends and then receiving the capital invested after the said period. For the company, it means the control of control will revert to key persons. Redeemable shares may also be issued to employees as non-voting redeemable shares. This benefits the company in that, if the employee leaves, the shares revert to the company. Often the redemption price may be the same as the issue price. However, if terms have been set that the company can redeem these shares only from its profits or from the sale of a new share class, the company may not be able to buy back these redeemable shares. Remember that shares are always taxed , usually 0.5% on the transaction.

Preference or preferred shares

As the name suggests, shareholders have the preference of receiving a fixed amount of dividends. This pay-out is made ahead of other shareholders and is calculated as a fixed percentage of the nominal value of the share. For example, a 5% preference on a £1 share will earn a dividend of 5p annually. This is still a dividend of the profits and if the profits are insufficient, they may accumulate and will be paid in arrears. These shareholders may receive priority on their arrears of dividends and their capital. However, they may not receive any of the surplus capital resulting from the closure unless they are participating shares. Participating shares can participate in the profits beyond their fixed dividend. Preference shares may also be redeemable shares. They usually do not carry voting rights.

Management shares

This share class is issued to give the founders, original owners and key management extra voting rights so that they can retain control of the company. It can be created by allotting multiple votes per share or by issuing shares at a smaller nominal value, creating more shares and thereby, more votes per amount put in.

Alphabet shares

Most companies simply label share classes with alphabet letters, that is, class A, class B and so on (as many share classes as are created by the company). As discussed, the difference in the classes is the voting rights, rights to dividends and rights to capital. It is important to remember that the difference in class does not affect the share of profits, company ownership or other benefits derived from the success of the company.

Since each company determines the rights given to each class, there is no fixed definition of the rights enjoyed by a class. Class A could be an ordinary share in one company while it is redeemable preference share in another.

Class A and B Shares

Class A and B shares are issued with separate purposes usually to separate ownership and control. Class B shares, for example, might be held by the original owners and have superior voting rights that allow them to maintain control and decide who gets elected to the board of directors.

For family members, for example, continue to control Ford Motor Co. via a special class of shares. May media companies today are controlled by founding members who hold special classes of stock. In the past, the creation of such special classes was controversial since it appeared to disenfranchise other shareholder or deprive them of their rights as owners . Gradually, however, such concerns have disappeared.

Companies may also issue a class of stock for a specific purpose in mind, such as an acquisition or merger. General Motors, for example, issued its Class E shares to finance the acquisition of Electronic Data Systems and Class H Stock to finance the buyout of Hughes Electronics. Those who invested in these shares were entitled to a portion of the profits the two companies generated.

Advantages and Disadvantages of Class of Shares

Dual class of shares are generally looked at very a lot of negativity, however there are many who will look at it in a positive light. We have listed some advantages and disadvantages, so you can make up your own mind.

Advantages

• Class of Shares generally insulate managers from the short-term mindset found in Wall Street.
• It is observed that shareholder have long-term vision that exceeds their most recent quarterly figures which keeps them invested in the company for the long term.
• Companies generally tend to have a more loyal set of investors because it gives rise to extra voting rights often cannot be traded.
• In all the above cases, the company performance is affected enormously from the existence of dual-class shares.

Disadvantages

• There is a distinction of shareholders and gives rise to an inferior class of shareholders. This gives power to a select few, who as a result to transfer the financial risk onto others.
• Managers holding super-class have absolute authority and power and worst still fewer constraints. This makes their stock very unreliable and prone to spin out of control at any time. Families and senior managers are given authority not based on their ability and performance and can lead to permanent interferences in the day-to-day operations of the company.
• Companies generally tend to have a more loyal set of investors because it gives rise to extra voting rights often cannot be traded.

Final Words

History shows us that not all dual-class companies are destined to fail. One good example for this exception is Berkshire Hathaway. The company has showed time and time again that delivering great fundamentals and shareholder value is not just possible but can be great for the long run interest of the company.

Controlling shareholders have to maintain a good relationship with investors, this is not just for the company’s benefit, but for their own interests. Family members, due to their close association with the founders have an additional motivation to vote in favour of the company while also improving the standing of the company. Although, there are numerous benefits, investors should also keep in mind the possibilities of a dual-class ownerships on the company essential functionaries.

About the author

Sumit Agarwal
Sumit Agarwal (ACMA ACA India), the Managing partner of dns accountants is a highly respected accountant with expertise in helping owner-managed businesses.