How Ordinary Shares and Preference Shares are distinguished from one another in terms of characteristics, benefits and rights is important to understand for both business owners and investors.
Ordinary shares are the equity shares of a company, designating equity ownership proportionally based on the percentage of stocks purchased and owned. Holders of ordinary shares in a company have voting rights at the general meeting, which implies they have a say in matters such as appointing or removing directors and merger and acquisition terms and agreement. These shareholders also have rights to profits earned by the company and capital appreciation. However, dividends paid by the company is not fixed for ordinary shareholders, and it is common practice for newly operating companies not to pay out dividends, but instead re-inject profits back into the business. Very often dividends are only paid out to ordinary shareholders only after all of the company’s liabilities have been settled. Also, ordinary shares cannot be converted into preference shares.
Pros of Ordinary Shares
- Potential for Huge Yields: Since you have a partial ownership of the company, you will be awarded dividends and profits with the increase in market value of the company stock. If the company performs extremely well and it becomes more valuable, you will be able get capital gains, that are a measure of the worth of the company. Similarly, in case, company profits by its business, it may decide to benefit its common stockholders by giving individual dividends or payments in the form of cash or stocks.
- Ideal Investment Option: Using this type of investment, you will be allowed to invest having limited liability. So whatever amount that you have already invested partially will be the only investment that you are going to lose when they will be liquidated. Thus, you will not risk to lose money in excess of the total funds invested.
- Restricted Legal Liabilities: You will not be personally liable if there are problems arising from the outside of the financial investment of a shareholder. Only those who are running the company are at risk of facing the consequences.
- Easy Purchase and Sale: As the investment is liquid, selling a portion or all of the shares you own or making more purchase increase your shareholding at what you consider would be fair prices is typically not restrained.
- Two Ways to Gain Profit: When value of the company appreciates and revenue exceeds overheads, both Capital Gains and Dividends are available to you, as ordinary shareholders are partial owners of the business entitled to profit cuts.
Cons of Ordinary Shares
- High Risk Investment: Ordinary share prices are volatile, especially for start up companies, and their value can flucuate without any signs of warning, making it difficult to evaluate their performance even if the company is doing well. If the business should go bankrupt, the shares you hold in the company would likely become quite worthless.
- Lack of Control: Unless you buy up significant amount of shares to gain majority shareholding, which most cannot afford to do (and companies are also known to put a cap of the number of common stocks for public sale to keep the control of existing shareholders strong), you will not be able to join in the decision-making process or to demand a copy of the company’s books or business plans. Therefore, if those in control don’t do their jobs well, your investment would be jeopardised. Therefore, buying stocks from any company requires due diligence in researching whether a business has excellent potential, practices and performance.
- Last One to Get Paid: If the company you invested inshould liquidate, as an ordinary shareholder, you can only hope to get paid after everyone else ranking higher on the priority ladder does, including the creditors, employees, suppliers and taxes.
Companies issue Preference Shares to raise capital. Preference shares carry many of the benefits of both debt and equity capital and are considered to be a hybrid security. Benefits for preference shareholders also include dividend payments before ordinary shareholders. A drawback is that they have no voting rights as ordinary shareholders typically do.
Pros of Preference Shares
- Dividends Paid First: Preference shares come with fixed dividends that must be paid to their holders before they are paid out to ordinary shareholders. While dividends are only paid if the company turns a profit, some types of preference shares (called cumulative shares) allow for the accumulation of unpaid dividends. Once the business is out of the red, all unpaid dividends must be remitted to preference shareholders before any dividends can be paid to ordinary shareholders.
- Higher Claim on Company Assets: In the event of bankruptcy and liquidation, preference shareholders have a higher claim on company assets, which makes preference shareholding particularly attractive to investors with low risk tolerance. The company guarantees a dividend each year, but if it fails to turn a profit and must shut down, preference shareholders are higher in priority where compensation is concerned.
- Convertible to Ordinary Shares: Preference shareholders can trade in their shares for a fixed number of ordinary shares. This can be a lucrative option if the value and equity of the company begin to climb.
Preference shares also have a number of advantages for the issuing company.
- Ownership and Control not Diluted: The lack of shareholder voting rights for preference shareholders means ownership is not diluted by selling preference shares, as compared to issuing ordinary shares. The lower risk to investors also means the cost of raising capital for issuing preference shares is lower than that of issuing ordinary shares.
- Right to repurchase shares: A company can also issue callable preference shares, which can be repurchased at its discretion. This implies that if callable shares are issued with a 6% dividend but interest rates fall to 4%, the company can purchase any outstanding shares at the market price and then reissue shares with a lower dividend rate, thereby reducing the cost of capital.
Cons of Preference Shares
- Fixed Dividend Rate: Divident rate of preference shares are fixed at the time of sale and remains fixed until the shares matures, often 30 years. Compared to prevailing bond rates it may seem a better deal, but if market interest rates rise, the price of your preference shares will fall because other investments will become more attractive. For example, if you buy a preferred yielding 4 percent and market rates rise to 6 percent, investors will sell your preferred to buy the current, higher-yielding option.
- Limited Appreciation Potential: Share price of preference shares remains fairly stable, so any profit to be made from letting them go is usually quite limited. Also, value of preference shares is almost entirely dependent on current market interest rates, as they are a debt obligation issued by a company, and so, if interest rates increase, the value of your preference shares will decrease as investors are likely to steer toward higher yielding investments and won’t pay as much for shares with lower dividend rates.
- Risk of Corporate Insolvency: Preference shares are a mechanism for raising capital, and startup companies or firms endeavouring to expand are usually the ones to issue them. With such companies, the risk of insolvency is relatively greater than with established firms. When such a company go the route of liquidation, bondholders receive payments first, then preference shareholders (the remainder, if any, would then go to ordinary shareholders), though it is unlikely that any recompense would be enough to cover the entire amount of your initial investment.
- Risk of a Share Call: Your preference shares might get called in before you get the chance to sell them, as most of them come with a call date, which is typically 5 years after the date of issue. The issuer has the right to call in outstanding preference shares and buy them out, especially when interest rates are declining. If you want to reinvest your money, you will have to settle for a lower interest rate.