Equity & Preference shares

Equity Shares

Equity shares were earlier known as ordinary shares. The holders of these shares are the real owners of the company. They have a voting right in the meetings of holders of the company. They have a control over the working of the company. Equity shareholders are paid dividend after paying it to the preference shareholders.

The rate of dividend on these shares depends upon the profits of the company. They may be paid a higher rate of dividend or they may not get anything. These shareholders take more risk as compared to preference shareholders.

Equity capital is paid after meeting all other claims including that of preference shareholders. They take risk both regarding dividend and return of capital. Equity share capital cannot be redeemed during the life time of the company.

Features of Equity Shares:

Equity shares have the following features:

(i) Equity share capital remains permanently with the company. It is returned only when the company is wound up.

(ii) Equity shareholders have voting rights and elect the management of the company.

(iii) The rate of dividend on equity capital depends upon the availability of surplus funds. There is no fixed rate of dividend on equity capital.

Advantages of Equity Shares:

1. Equity shares do not create any obligation to pay a fixed rate of dividend.

2. Equity shares can be issued without creating any charge over the assets of the company.

3. It is a permanent source of capital and the company has to repay it except under liquidation.

4. Equity shareholders are the real owners of the company who have the voting rights.

5. In case of profits, equity shareholders are the real gainers by way of increased dividends and appreciation in the value of shares.

Disadvantages of Equity Shares:

Despite their many advantages, equity shares suffer from certain limitations. These are:

i. Disadvantages from the Shareholders’ Point of View:

(a) Equity shareholders get dividend only if there remains any profit after paying debenture interest, tax and preference dividend. Thus, getting dividend on equity shares is uncertain every year.

(b) Equity shareholders are scattered and unorganized, and hence they are unable to exercise any effective control over the affairs of the company.

(c) Equity shareholders bear the highest degree of risk of the company.

(d) Market price of equity shares fluctuate very widely which, in most occasions, erode the value of investment.

(e) Issue of fresh shares reduces the earnings of existing shareholders.

ii. Disadvantage from the Company’s Point of View:

(a) Cost of equity is the highest among all the sources of finance.

(b) Payment of dividend on equity shares is not tax deductible expenditure.

(c) As compared to other sources of finance, issue of equity shares involves higher floatation expenses of brokerage, underwriting commission, etc.

Deferred Shares:

These shares were earlier issued to Promoters or Founders for services rendered to the company. These shares were known as Founders Shares because they were normally issued to founders. These shares rank last so far as payment of dividend and return of capital is concerned. Preference shares and equity shares have priority as to payment of dividend.

These shares were generally of a small denomination and the management of the company remained in their hands by virtue of their voting rights. These shareholders tried to manage the company with efficiency and economy because they got dividend only at last. Now, of course, they cannot be issued and they are only of historical importance. According to Companies Act 1956, no public limited company or which is a subsidiary of a public company can issue deferred shares.

Different Types of Equity Issues:

Equity shares are the main source of long-term finance of a joint stock company. It is issued by the company to the general public. Equity shares may be issued by a company in different ways but in all cases the actual cash inflow may not arise (like bonus issue).

The different types of equity issues have been discussed below:

1. New Issue:

A company issues a prospectus inviting the general public to subscribe its shares. Generally, in case of new issues, money is collected by the company in more than one installment— known as allotment and calls. The prospectus contains details regarding the date of payment and amount of money payable on such allotment and calls. A company can offer to the public up to its authorized capital. Right issue requires the filing of prospectus with the Registrar of Companies and with the Securities and Exchange Board of India (SEBI) through eligible registered merchant bankers.

2. Bonus Issue:

Bonus in the general sense means getting something extra in addition to normal. In business, bonus shares are the shares issued free of cost, by a company to its existing shareholders. As per SEBI guidelines, if a company has sufficient profits/reserves it can issue bonus shares to its existing shareholders in proportion to the number of equity shares held out of accumulated profits/ reserves in order to capitalize the profit/reserves. Bonus shares can be issued only if the Articles of Association of the company permits it to do so.

i. Advantage of Bonus Issues:

From the company’s point of view, as bonus issues do not involve any outflow of cash, it will not affect the liquidity position of the company. Shareholders, on the other hand, get bonus shares free of cost; their stake in the company increases.

ii. Disadvantages of Bonus Issues:

Issue of bonus shares decreases the existing rate of return and thereby reduces the market price of shares of the company. The issue of bonus shares decreases the earnings per share.

iii. Rights Issue:

According to Section 81 of The Company’s Act, 1956, rights issue is the subsequent issue of shares by an existing company to its existing shareholders in proportion to their holding. Right shares can be issued by a company only if the Articles of Association of the company permits. Rights shares are generally offered to the existing shareholders at a price below the current market price, i.e. at a concessional rate, and they have the options either to exercise the right or to sell the right to another person. Issue of rights shares is governed by the guidelines of SEBI and the central government.

Rights shares provide some monetary benefits to the existing shareholders as they get shares at a concessional rate—this is known as value of right which can be computed as:

Value of right = Cum right market price of a share – Issue price of a new share / Number of old shares + 1

a. Advantages of Rights Issue:

Rights issues do not affect the controlling power of existing share­holders. Floatation costs, brokerage and commission expenses are not incurred by the company unlike in the public issue. Shareholders get some monetary benefits as shares are issued to them at concessional rates.

b. Disadvantages of Rights Issue:

If a shareholder fails to exercise his rights within the stipulated time, his wealth will decline. The company loses cash as shares are issued at concessional rate.

iv. Sweat Issue:

According to Section 79A of The Company’s Act, 1956, shares issued by a company to its employees or directors at a discount or for consideration other than cash are known as sweat issue. The purpose of sweat issue is to retain the intellectual property and knowhow of the company. Sweat issue can be made if it is authorized in a general meeting by special resolution. It is also governed by Issue of Sweet Equity Regulations, 2002, of the SEBI.

a. Advantages of Sweat Issue:

Sweat equity shares cannot be transferred within 3 years from the date of their allotment. It does not involve floatation costs and brokerage.

b. Disadvantage of Sweat Issue:

As sweat equity shares are issued at concessional rates, the com­pany loses financially.

Preference Shares

As the name suggests, these have certain preferences as compared to other types of shares. These shares are given two preferences. There is a preference for payment of dividend. Whenever the company has distributable profits, the dividend is first paid on preference share capital.

Other shareholders are paid dividend only out of the remaining profits, if any. The second preference for shares is repayment of capital at the time of liquidation of the company. After payment of outside creditors, preference share capital is returned. Equity shareholders will be paid only when preference share capital is paid in full.

Features of Preference Shares:

(i) Preference shares have priority over payment of dividend and repayment of capital.

 (ii) The rate of dividend on preference shares is fixed. Only in case of participating preference shares additional dividend may be paid if profits remain after paying equity dividend.

(iii) Except in case of redeemable preference shares, the preference share capital remains with the company on a permanent basis.

(iv) Preference shares do not create any charge over the assets of the company.

(v) Preference shareholders do not hold voting rights.

 (vi) Redeemable preference shares can be paid off, if the company has surplus funds.

(vii) Dividend on cumulative preference shares is carried forward to the next year if company does not have sufficient profits in the current year.

Types:

Preference shares are of the following types:

(a) Cumulative Preference Shares:

These shares have a right to claim dividend for those years also for which there were no profits. Whenever there are divisible profits, cumulative preference shares are paid dividend for all the previous years in which dividend could not be declared.

Take for example, a company which is unable to pay dividend on preference shares for the year 1981 and 1982. If in the year 1983 the company has sufficient profits, cumulative dividend will be paid first for the year 1981 and 1982 and only then the dividend for the year 1983 will be declared. The dividend goes on cumulating unless otherwise it is paid.

(b) Non-Cumulating Preference Shares:

The holders of these shares have no claim for the arrears of dividend. They are paid a dividend if there are sufficient profits. They cannot claim arrears of dividend in subsequent years.

(c) Redeemable Preference Shares:

Formally, the capital of a company is repaid only at the time of liquidation. Neither the company can return the share capital nor the shareholders can demand its repayment. The company, however, can issue redeemable preferences shares if articles of association allow such an issue. The company has a right to return redeemable preferences share capital after a certain period.

The Companies Act has provided certain restrictions on the return of this capital. The shares to be redeemed should be fully paid up. The company should redeem these shares either out of profits or out of fresh issue of capital. The object of these restrictions is that the resources of the company are not depleted.

(d) Irredeemable Preference Shares:

The shares which cannot be redeemed, unless the company is liquidated, are known as irredeemable preference shares.

(e) Participating Preference Shares:

The holders of these shares participate in the surplus profits of the company. They are firstly paid a fixed rate of dividend and then a reasonable rate of dividend is paid on equity shares. If some profits remain after paying both these dividends, then preference shareholders participate in the surplus profits. The mode for dividing surplus profits between preference and equity shareholders is given in the articles of association.

(f) Non-Participating Preference Shares:

The shares on which only a fixed rate of dividend is paid are known as non- participating preference shares. The shares do not carry the additional right of sharing of profits of the company.

(g) Convertible Preference Shares:

The holders of these shares may be given a right to convert their holdings into equity shares after a specified period. These are called convertible preference shares. The right of conversion must be authorised by the articles of association.

(h) Non-Convertible Preference Shares:

The shares which cannot be converted into equity shares are known as non- convertible preference shares.

Advantages:

1. Appeal to Cautious Investors: Preference shares can be easily sold to investors who prefer reasonable safety of their capital and want a regular and fixed return on it.

2. No Obligation for Dividends: A company is not bound to pay dividend on preference shares if its profits in a particular year are insufficient. It can postpone the dividend in case of cumulative preference shares also. No fixed burden is created on its finances.

3. No Interference: Generally, preference shares do not carry voting rights. Therefore, a company can raise capital without dilution of control. Equity shareholders retain exclusive control over the company.

4. Trading on Equity: The rate of dividend on preference shares is fixed. Therefore, with the rise in its earnings, the company can provide the benefits of trading on equity to the equity shareholders.

5. No Charge on Assets: Preference shares do not create any mortgage or charge on the assets of the company. The company can keep its fixed assets free for raising loans in future.

6. Flexibility: A company can issue redeemable preference shares for a fixed period. The capital can be repaid when it is no longer required in business. There is no danger of over-capitalisation and the capital structure remains elastic.

7. Variety: Different types of preference shares can be issued depending on the needs of investors. Participating preference shares or convertible preference shares may be issued to attract bold and enterprising investors.

Disadvantages:

1. Fixed Obligation: Dividend on preference shares has to be paid at a fixed rate and before any dividend is paid on equity shares. The burden is greater in case of cumulative preference shares on which accumulated arrears of dividend have to be paid.

2. Limited Appeal: Bold investors do not like preference shares. Cautious and conservative investors prefer debentures and government securities. In order to attract sufficient investors, a company may have to offer a higher rate of dividend on preference shares.

3. Low Return: When the earnings of the company are high, fixed dividend on preference shares becomes unattractive. Preference shareholders generally do not have the right to participate in the prosperity of the company.

4. No Voting Rights: Preference shares generally do not carry voting rights. As a result, preference shareholders are helpless and have no say in the management and control of the company.

5. Fear of Redemption: The holders of redeemable preference shares might have contributed finance when the company was badly in need of funds. But the company may refund their money whenever the money market is favourable. Despite the fact that they stood by the company in its hour of need, they are shown the door unceremoniously.

Comparison Chart

BASIS FOR COMPARISON	EQUITY SHARES	PREFERENCE SHARES
Meaning	Equity shares are the ordinary shares of the company representing the part ownership of the shareholder in the company.	Preference shares are the shares that carry preferential rights on the matters of payment of dividend and repayment of capital.
Payment of dividend	The dividend is paid after the payment of all liabilities.	Priority in payment of dividend over equity shareholders.
Repayment of capital	In the event of winding up of the company, equity shares are repaid at the end.	In the event of winding up of the company, preference shares are repaid before equity shares.
Rate of dividend	Fluctuating	Fixed
Redemption	No	Yes
Voting rights	Equity shares carry voting rights.	Normally, preference shares do not carry voting rights. However, in special circumstances, they get voting rights.
Convertibility	Equity shares can never be converted.	Preference shares can be converted into equity shares.
Arrears of Dividend	Equity shareholders have no rights to get arrears of the dividend for the previous years.	Preference shareholders generally get the arrears of dividend along with the present year's dividend, if not paid in the last previous year, except in the case of non-cumulative preference shares.

Key Differences Between Equity Shares and Preference Shares

·         Equity shares cannot be converted into preference shares. However, Preference shares could be converted into equity shares.

·         Equity shares are irredeemable, but preference shares are redeemable.

·         The next major difference is the ‘right to vote’. In general, equity shares carry the right to vote, although preference shares do not carry voting rights.

·         If in a financial year, dividend on equity shares is not declared and paid, then the dividend for that year lapses. On the other hand, in the same situation, the preference shares dividend gets accumulated which is paid in the next financial year except in the case of non-cumulative preference shares.

·         The rate of dividend is consistent for preference shares, while the rate of equity dividend depends on the amount of profit earned by the company in the financial year. Thus it goes on changing.