This article has been written by Shailaja Mishra pursuing Diploma in Corporate Law & Practice: Transactions, Governance and Disputes and has been edited by Oishika Banerji (Team Lawsikho).
This article has been published by Sneha Mahawar.
Table of Contents
Like every human being requires food and water to survive, the same way every company requires certain funds for its growth and day to day requirements. These funds basically come from long term and short term borrowings and hence long term financial sources are decided by a proper capital structure. In the current scenario the middle class investors have shown a huge interest in shares and stock market, which was earlier restricted to the rich and powerful investors. The concept of investing in shares has made investors realize how to gain more wealth through investment. Shares and stocks are the gateway to it. Economy and technology also play a vital role for making it way to invest in shares. Although investment in the stock market can lead you to high profit it can equally be financially risky. As it is rightly said “NO PAIN NO GAIN” because investment does not happen without taking some amount of risk but these risks vary in all kinds of investment. This article aims to discuss the concept of preference shares vis a vis equity shares.
Basic concept on capital structure
Capital structure of a company is basically debts and financial instruments which consists of the company’s financing of assets. It is a permanent source of financing which consists of long term debts , preferred stock, & net worth. It is thus the elimination of short term borrowings. Although there are certain factors which affect the capital structure of the company:cash flow position,high rate of interest,low rate of interest,cost of equity,floatation cost,risk consideration and stock market condition.
Shares : smallest unit of share capital
As mentioned in Section 2(84) of the Companies Act 2013, company’s share capital is divided into small fragments which are known as shares. Each share forms a unit of ownership of the company and shareholders are entitled to profits that company may earn in the form of dividend in the future. Shareholders are both the loss bearer as well as the maximum portion of profit of the company. In simple words the shareholder is entitled for certain percentage ownership in the company equivalent to the share acquired by him.
Salient features of shares
- A share is basically a right which specifies the amount of the share capital of the company, which holds rights and liabilities.
- As mentioned in Section 44 of the Companies Act, 2013 share shall be movable and transferable property as provided in the Article of Association.
- Share is the right to participate in the profit making of the company.
- Share in India is known as goods and goods according to the Sales and Goods Act,1930 refers to any movable property.
- As mentioned in Section 45 of the Companies Act, 2013 each share in the company has a share capital which is further differentiated by the different numbers but this provision does not apply to the shareholders.
Types of shares
Equity shares are those small portions of the company that are bought by the investors in anticipation of future profits. When someone owns a stock as equity shares are also known as stock they eventually become the shareholder of the company which as a result makes them liable of all the profits and losses of the company.
Shareholders also have the right to vote in all the major and important decisions of the company besides the profit which they receive out of appreciation in value. Equity shareholders also may receive the dividend in the form of bonus from the company. Typically these bonuses are given by the company which is financially strong and which earns regular profits in the accounting year.
Classification of equity shares
On the basis of definition
1. Bonus equity share – It refers to additional stocks issued free of cost to the existing shareholders as bonus.
2. Rights equity share – It is a new share provided to the existing shareholders at a particular price and time before trading it in the stock market.
3. Sweat equity shares – it refers to the reward granted to the employees for their exceptional service towards the company.
On the basis of share capital
- Authorized share capital – Every company needs to prescribe the maximum amount of capital which can be raised by issuing equity shares in its Memorandum of Association. It can further be changed from time to time.
- Issued share capital – It refers to a company’s specific portion of share capital which is offered to investors through issuance of equity share.eg, suppose value of one share is priced 100 and the company issues 10000 equity shares, then the issued share capital will be 1 lakhs.
- Subscribed share capital – It is a part of the issued capital upon which investors apply and agree to accept.
- Paid up capital – It refers to the portion of subscribed share capital which the investors have made the payment of. These may be paid in different calls i.e.,application allotment , 1st call, 2nd call, final call.
Preference shares are also known as preferred stocks. These shares are thus those which give the preferential right of receiving the dividend over the equity shareholders. At the time of deciding to payout the investors preference is always given to preference shareholders first. These shares are released to procure the capital for the company which is called as preference share capital. During the time of winding up of a company due to loss the preference shareholders receive the payment first over the equity shareholders.
Types of preference shares
- Cumulative preference share – These shares have the right of receiving arrears of dividend before payment made to equity shareholders.
- Non-Cumulative preference shares – These shares do not have the right to receive arrears out of the dividend.
- Participating preference shares – As per mentioned in Article of Association after the payment made out of dividend to the equity shareholders, preference shareholders can participate in remaining profit.
- Non participating preference shares – These are those preference shares which do not participate in the remaining profit.
- Convertible preference share – These preference shares can be converted into equity shares.
- Non-Convertible preference shares – These preference shares cannot be converted into equity shares.
- Redeemable preference shares – These preference shares can be redeemed by the company at a particular time which cannot exceed 20 years from the date of issue of repayment.
- Irredeemable preference shares – During the time of winding up a company the amounts received by the respective holders is known as irredeemable preference share.
Differences between preference shares and equity shares
As per Companies Act, 2013 in India companies have no rights of issuing Irredeemable preference shares. On the basis of above mentioned types shares we arrive at the following differences :
- Equity shareholders are the co-owners as of which they enjoy the right of participation in the management of the company whereas there is no such right given to preference shareholders. In other words equity shareholders represent the ownership whereas preference shares represent the payment of dividend.
- Equity shareholders receive dividend payout after the payment is made to preference shareholders. The preference shareholders have the fixed rate of dividend whereas in case of equity shareholders it fluctuates on the basis of profit.
- At the time of liquidation equity shareholders are the last to receive the capital repayment whereas preference shareholders receive it before equity shareholders.
- Equity shares cannot be converted into preference shares whereas preference shares can be converted into equity shares.
- Equity shareholders have the right to vote and be part of the decision making process of the company whereas preference shareholders do not have such right as they are the outsiders to the company and do not have any claim over the company’s assets.
- Payment of equity dividend is optional whereas payment of preference dividend is must.
- Equity shares are best preferred for long-term investment financing whereas preference shares are the best way of investment in short and medium term of financing.
- Investors who have the desire of great risk should go for investment in equity shares whereas investors with desire for low risk can invest in preference shares.
- For companies it is a must thing to issue equity shares whereas in case of preference shares it is not mandatory to issue preference shares for all the companies.
- Equity shareholders receive bonus stocks whereas preference shareholders do not receive bonus stocks.
- Equity stocks are irredeemable whereas preference shares can be redeemed at a certain point of time or when the company achieves its goal.
- Chances of over capitalisation is higher in case of equity shares whereas there is less chance of over capitalisation in case of preference shares.
- The cost of equity shares is low because of which any small investor can easily have access to it whereas prices of preference shares is high because of which only medium to big investors can have access to it.
Key points to be kept in mind while investing in shares:
If the purpose is gaining the ownership one should always be an equity shareholder as they have the right to vote in the company’s major decision. Preference shareholders receive the fixed amount of dividend over the equity shareholders because of their preferential rights. It is also much safer than equity shares.
These 2 are general investments in the market with just one point of difference i.e., both of these shares have their own distinctive financial goals which further makes them recommendable by different investors. One needs to decide the time horizon before investing in shares as it plays an important role in deciding which stocks to buy.
Various ratios help us understand the fundamentals of investment in stocks i.e, price to earning ratios, debt to equity ratio etc. A new investor should also check how the shares have performed in comparison to the shares of the other companies. The dividend history is also a key factor for deciding which shares to choose. The investors who are looking to generate a high level of income should look at the company’s dividend declaration which is expressed as a percentage. The stocks with high levels of volatility will rise quickly when the share market is on a boom while they fall like a sand castle when the market is performing not so well,so investment should be made considering the market situation as well as the volatility of the stocks.
Before trading in any stock market one should first acquire complete knowledge of the same. Although there are noteworthy points of distinction between preference shares and equity shares. Regardless of the fact that these shares are the key essentials for any company inclined to raise funds through the general public or the investors. Such investments are of much higher risk but at the same time they also have high profitability rates,perks and bonuses are also high particularly when investment is made in equity shares. One of the most important points to always remember before purchasing the stocks or shares is that they should be bought when the market value is down and be sold off when the prices of shares hike. Any investor should always go for long term investment because the share market is subject to fluctuations. Therefore in the long run better returns can be gained. Economy is the important barometer in investing in the stock market as stocks are volatile ,prices fluctuate as per the need of supply and demand. Further, the important factor that dominates the prices is the networth of the company.
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