Ordinary shares and preference shares represent two distinct types of equity ownership in a company, each offering different rights, privileges, and risks to shareholders. Understanding the differences between these shares is crucial for investors, company management, and stakeholders, as they impact voting rights, dividend payments, and the distribution of assets during liquidation.
1. Ordinary Shares
Ordinary shares (also known as common shares) are the most prevalent type of equity issued by companies. They represent ownership in the company and come with certain rights and responsibilities.
A. Features of Ordinary Shares
- Voting Rights: Ordinary shareholders typically have voting rights in company decisions, such as electing directors and approving major corporate policies.
- Dividends: Dividends are paid to ordinary shareholders after preference shareholders. The amount is variable and depends on the company’s profitability and dividend policy.
- Residual Claim on Assets: In the event of liquidation, ordinary shareholders are the last to receive any remaining assets after all debts and preference shares are paid.
- Capital Appreciation: Ordinary shareholders benefit from increases in the company’s share price, providing potential for significant capital gains.
- Risk Exposure: Ordinary shares carry higher risk as dividends are not guaranteed, and there’s a greater chance of losing the investment if the company fails.
B. Advantages of Ordinary Shares
- Voting Power: Shareholders can influence key decisions and the company’s strategic direction.
- Unlimited Profit Potential: Shareholders benefit from rising share prices and increasing dividends during profitable periods.
- Ownership Rights: Ordinary shareholders are considered partial owners of the company, entitling them to participate in general meetings.
C. Disadvantages of Ordinary Shares
- Dividend Uncertainty: Dividends are not fixed and may fluctuate based on company performance or may not be paid at all.
- Subordinate Claim on Assets: In the event of liquidation, ordinary shareholders receive payments only after creditors and preference shareholders.
- Higher Risk: Ordinary shareholders bear more financial risk, especially in volatile markets.
2. Preference Shares
Preference shares are a type of equity that provides shareholders with preferential rights over ordinary shareholders, particularly regarding dividend payments and claims on assets during liquidation.
A. Features of Preference Shares
- Fixed Dividends: Preference shareholders typically receive a fixed dividend, paid before any dividends are distributed to ordinary shareholders.
- No Voting Rights: Preference shareholders usually do not have voting rights, although some classes of preference shares may have limited voting power.
- Priority in Liquidation: In the event of liquidation, preference shareholders have a higher claim on the company’s assets compared to ordinary shareholders.
- Convertible and Redeemable Options: Some preference shares can be converted into ordinary shares or redeemed (bought back) by the company at a predetermined price.
B. Types of Preference Shares
- Cumulative Preference Shares: If the company skips a dividend payment, the unpaid dividends accumulate and must be paid before any dividends can be paid to ordinary shareholders.
- Non-Cumulative Preference Shares: Dividends do not accumulate if not paid in a given period; shareholders have no claim on missed dividends.
- Participating Preference Shares: In addition to the fixed dividend, shareholders may receive additional dividends based on the company’s performance.
- Convertible Preference Shares: Can be converted into ordinary shares at a specified time or under certain conditions.
- Redeemable Preference Shares: Can be repurchased by the company at a predetermined price and date.
C. Advantages of Preference Shares
- Fixed Income: Shareholders receive consistent, fixed dividends, providing a steady income stream.
- Lower Risk: Preference shareholders have a priority claim on assets and earnings over ordinary shareholders.
- Convertible Options: Convertible preference shares offer flexibility to switch to ordinary shares if the company performs well.
D. Disadvantages of Preference Shares
- Limited Growth Potential: Fixed dividends mean shareholders may not benefit from increased company profits as much as ordinary shareholders.
- Lack of Voting Rights: Preference shareholders typically do not have a say in company decisions.
- Interest Rate Sensitivity: Preference shares may lose value when interest rates rise, as their fixed dividends become less attractive compared to other investments.
3. Key Differences Between Ordinary Shares and Preference Shares
| Feature | Ordinary Shares | Preference Shares |
|---|---|---|
| Dividends | Variable, paid after preference shareholders, and may not be paid if profits are insufficient. | Fixed, paid before ordinary shareholders, and often cumulative. |
| Voting Rights | Typically have voting rights on company matters. | Usually do not have voting rights, though some exceptions exist. |
| Claim on Assets (in Liquidation) | Last to receive any remaining assets after creditors and preference shareholders. | Priority over ordinary shareholders in asset distribution during liquidation. |
| Risk | Higher risk with potential for higher returns through capital appreciation. | Lower risk due to fixed dividends and priority claims. |
| Capital Growth | Potential for significant capital appreciation if the company performs well. | Limited capital growth due to fixed dividend structure. |
| Convertibility | Non-convertible. | Some preference shares can be converted into ordinary shares. |
4. Example of Ordinary and Preference Shares
Consider a company, XYZ Ltd, with both ordinary and preference shares issued:
- Ordinary Shares Issued: 1,000,000 shares at $1 each.
- Preference Shares Issued: 500,000 shares at $2 each, with a fixed dividend of 5% annually.
A. Dividend Distribution Example
Annual Profit: $150,000
- Preference Dividend: 5% of $1,000,000 (500,000 shares × $2) = $50,000
- Remaining Profit for Ordinary Shareholders: $150,000 – $50,000 = $100,000
- Dividend per Ordinary Share: $100,000 ÷ 1,000,000 shares = $0.10 per share
B. Liquidation Scenario
If XYZ Ltd is liquidated and has $300,000 in remaining assets after paying creditors:
- Preference Shareholders: Receive $2 per share ($1,000,000 total) before ordinary shareholders are paid.
- Ordinary Shareholders: Receive any remaining assets after preference shareholders are paid, but in this case, they may receive nothing if assets are insufficient.
5. Choosing Between Ordinary Shares and Preference Shares
The choice between ordinary and preference shares depends on an investor’s risk tolerance, income needs, and desire for involvement in company decisions:
A. When to Choose Ordinary Shares
- Higher Risk Appetite: Investors seeking higher returns and capital appreciation may prefer ordinary shares.
- Desire for Voting Rights: Investors who want a say in company decisions should opt for ordinary shares.
- Long-Term Growth Focus: Suitable for those focused on long-term value and growth potential.
B. When to Choose Preference Shares
- Fixed Income Preference: Investors seeking stable, predictable income may prefer preference shares.
- Lower Risk Tolerance: Suitable for conservative investors who prioritize capital preservation and reduced risk.
- Priority in Liquidation: Ideal for investors concerned about securing their investments in case of company liquidation.
Understanding Ordinary and Preference Shares
Ordinary shares and preference shares offer distinct benefits and risks to investors, reflecting different priorities in terms of income, control, and security. Ordinary shares provide voting rights and the potential for higher returns through capital appreciation, while preference shares offer fixed dividends and greater security during liquidation. By understanding the features and implications of each type of share, investors can make informed decisions aligned with their financial goals and risk tolerance.