Difference Between Equity and Preference Shares

When a company decides to raise capital by issuing shares, two common types of shares are typically offered: equity and preference. These shares represent ownership in a company but differ in terms of their rights and benefits.

Understanding the differences between equity shares and preference shares is crucial for investors and businesses, as it can impact their decision-making and overall financial strategy. This post will explore the nuances of equity and preference shares, exploring their features, benefits, and potential drawbacks.

Topics Covered:

• What are Equity Shares?
• What are Preference Shares?
• Key Difference Between Equity and Preference Shares
• Conclusion

What are Equity Shares?

Equity shares, also known as common or ordinary shares, represent ownership in a company and entitle shareholders to a proportionate share of the company’s profits. These shares come with certain key characteristics that distinguish them from other share types.

Firstly, equity shareholders have voting rights, allowing them to participate in important company decisions such as electing board members and approving major corporate actions. Additionally, the dividends received by equity shareholders are based on the company’s performance, meaning that higher profits may result in higher dividends.

Note that equity shares also come with higher risk and reward potential than other shares. As the company’s performance fluctuates, the value of equity shares can rise or fall, offering the potential for significant returns and the risk of losses.

What are Preference Shares?

Preference shares, on the other hand, are a type of share that provides shareholders with certain preferential rights and privileges. These shares offer a fixed dividend payment, prioritised over any dividends issued to equity shareholders. This means preference shareholders receive dividends before profits are distributed to common shareholders.

Unlike equity shares, preference shares typically do not come with voting rights, meaning preference shareholders do not have a say in company decisions. Besides, in the event of liquidation or winding up of the company, preference shareholders have a preference in the repayment of their capital over equity shareholders.

This means preference shareholders have a higher chance of recovering their investment than equity shareholders.

Recommended Read: Cumulative Preference Shares

Key Difference Between Equity and Preference Shares

Equity and preference shares represent two fundamental categories of stock that companies issue as part of their capital structure. These share types exhibit distinct characteristics that cater to different investor profiles based on risk tolerance, dividend expectations, and involvement in corporate governance.

Starting with dividends, the nature of payouts varies significantly between equity shares and preference shares. Equity shareholders are subject to variable dividends contingent upon the company’s financial health and profitability. This variability introduces risk, as dividends can fluctuate widely or even be omitted during financial strain.

In contrast, preference shares offer a more stable investment with dividends issued at a fixed rate. This fixed dividend is typically disbursed before dividends are paid to equity shareholders, offering preference shareholders a layer of predictability and security.

Regarding corporate governance, equity shares often come with voting rights, allowing shareholders to influence company decisions, including the election of the board of directors.

This participatory role is not commonly afforded to preference shareholders, who usually do not have voting rights, thus limiting their direct influence on company operations.

Additional Read: Concept of Interim Dividends

The risk profile of these share types is also a key distinguishing factor. Equity shares are directly tied to the company’s performance, making them more susceptible to market fluctuations. This direct correlation means that equity shareholders bear a higher risk but also stand to gain from potential capital appreciation and increased dividend payouts.

Conversely, preference shares present a lower risk with their fixed dividends. However, this reduced risk comes at the cost of potentially lower returns than equity shares, given the absence of capital appreciation benefits.

In scenarios of company liquidation, the repayment order between these two types of shares becomes critical. Equity shareholders find themselves at the end of the queue, only receiving any remaining assets after all debts, including preference share payouts, have been settled.

Preference shares enjoy a higher priority over equity shares in this context, ensuring that preference shareholders have a claim on assets before any distribution to equity shareholders.

The return on investment (ROI) potential varies markedly between equity and preference shares. Equity shares offer higher returns through both dividends and capital appreciation.

However, this dual avenue for ROI is accompanied by a greater exposure to risk. Preference shares, by design, offer steadier, albeit typically lower, returns. The fixed dividend rate shields investors from the company’s performance volatilities but caps the upside potential associated with equity shares.

Lastly, the order of preference in receiving dividends and the capital repayment hierarchy during liquidation further delineate these share types. Equity shareholders are positioned to receive dividends only after preference shareholders have been paid.

Similarly, in the asset distribution pecking order upon liquidation, equity shareholders’ claims are addressed after all debts and preference share obligations have been satisfied, highlighting a fundamental risk-return trade-off between equity and preference shares.

Must Read: Types of Dividends

Recommended Read :EX Dividend Date

Conclusion

While equity and preference shares offer ownership in a company, their rights and privileges differ. Equity shares provide voting rights and the potential for higher returns, while preference shares offer fixed dividends and priority in the event of liquidation.

Investors should carefully consider their investment goals and risk tolerance before deciding between the two types of shares. Ultimately, both equity and preference shares play important roles in a company’s capital structure, and it is crucial to understand their distinctions before making any investment decisions.

Equity shares represent ownership in a company and offer voting rights, while preference shares typically offer fixed dividends and priority over equity shareholders in case of liquidation. Understand the nuances between equity and preference shares to make informed investment decisions and manage your portfolio efficiently through a demat account.