What's the difference between equity and preference shares

Introduction

Equity capital is vital for companies . It allows them to fund operations, expand, and innovate without the immediate obligation of repayment, unlike loans. Companies can issue different types of shares to cater to various investor preferences and financial strategies. Equity shares and preference shares are two common types that serve distinct purposes.

Equity shares provide ownership, voting rights, and the potential for capital appreciation. On the other hand, preference shares offer a fixed dividend and priority in asset distribution. Understanding the difference between these shares helps you make more informed financial decisions.

Reading this blog is essential as it equips you with the knowledge to understand the core differences between equity and preference shares, enabling you to navigate the complexities of corporate finance and maximize your returns.

Understanding Equity Shares

Equity shares, also known as ordinary shares, represent a slice of ownership in a company. When you purchase equity shares, you gain voting rights and can influence major corporate decisions. These shares are traded on stock exchanges and their value fluctuates based on the company's performance and market conditions.

When you buy equity shares of any company, you become a part-owner of the company. This ownership comes with several important features and benefits:

Key Features Of Equity Shares:

1. Ownership rights: As an equity shareholder of the company, you have a residual claim on the company’s assets and earnings after meeting all debts and other obligations. If the company does well, the value of your shares can increase, providing you with capital appreciation.
2. Voting rights: Equity shareholders of the company can vote on significant company decisions. These decisions may include electing the board of directors, approving mergers and acquisitions, and other crucial matters. This gives shareholders a say in the company’s strategic direction.
3. Dividend: Dividends on equity shares are variable and depend on the company’s profitability. For instance, if the company announces a profitable year, it might declare a dividend per share to its equity shareholders. This dividend is not guaranteed and can vary based on the company’s financial performance.
4. Capital appreciation: Shareholders benefit from potential increases in the share price. For example, if you bought the company shares at ₹1,000 each and over time the share price increased to ₹2,000, you would have achieved capital gains of ₹1,000 per share.

Types Of Equity Shares

1. Common Shares (Ordinary Shares)

Common shares are the most prevalent type of equity shares. They represent ownership in a company and entitle shareholders to vote on corporate matters. Common shareholders have the potential for capital appreciation and receive dividends. However, these are not guaranteed and depend on the company’s profitability.

Example: The company issues common shares that trade on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Shareholders of the company's common shares can vote at the company’s annual general meetings and may receive dividends based on the company's financial performance.

2. Bonus Shares

Bonus shares are additional shares given to existing shareholders without any additional cost. Number of bonus shares allocated to each shareholder is based on the number of shares they already own. These are issued from the company’s reserves.

Example: A leading IT services company, might decide to issue bonus shares to its existing shareholders in a ratio of 1:1. This means if you own 100 shares of that company, you will receive an additional 100 shares as a bonus.

3. Rights Shares

Rights shares are offered to existing shareholders at a discounted price. This allows them to buy more shares before the company sells to the public. This helps companies raise additional capital while giving current shareholders a preferential option.

Example: A company could issue rights shares in a 1:4 ratio. It means that the existing shareholders have the right to buy one new share for every four shares they currently hold, at a price lower than the current market rate.

4. Sweat Equity Shares

Sweat equity shares are issued to employees or directors of the company as a reward for their hard work and valuable contributions. These shares are typically issued at a discount or for consideration other than cash.

Example: A company might issue sweat equity shares to its key employees who have significantly contributed to a major project’s success. This not only rewards the employees but also incentivises them to continue performing well.

5. Employee Stock Option Plan (ESOP) Shares

ESOP shares are part of an employee benefit plan designed to motivate employees by giving them an ownership stake in the company. Employees are granted the option to buy company shares at a predetermined price after a certain period.

Example: A company could implement an ESOP, allowing employees to purchase shares at ₹500 each after three years of service, regardless of the current market price. If the market price is higher at the time of purchase, employees benefit from the price difference.

Understanding Preference Shares

Preference shares are a type of stock that grants shareholders preferential rights over equity shareholders in certain aspects. While preference shareholders enjoy priority in dividend payments and during the liquidation of assets, they generally do not have voting rights in corporate decisions. Preference shares combine features of both equity and debt. It means that they offer a fixed dividend similar to interest payments on bonds but with some characteristics of equity ownership.

Key Features Of Preference Shares:

1. Fixed dividend: Preference shares provide a fixed dividend, offering predictable income to shareholders.
2. Priority over equity shares: In the event of liquidation, preference shareholders have a higher claim on the company's assets than equity shareholders.
3. Limited voting rights: Typically, preference shareholders do not have voting rights on corporate matters.
4. Less capital appreciation: Preference shares usually have limited potential for capital appreciation compared to equity shares.

Let's consider the example to understand preference shares better.

1. Fixed dividend: The company issues preference shares with a fixed dividend rate of 8% per annum. This means if you own 1,000 preference shares of the company with a face value of ₹100 each, you will receive an annual dividend of ₹8,000 (1,000 shares x ₹100 x 8%).

2. Priority over equity shares: In case the company faces financial difficulties and has to liquidate its assets, preference shareholders will be paid before equity shareholders. This reduces the risk for preference shareholders, making it a safer investment compared to equity shares.

3. Limited voting rights: The company's preferred shareholders typically do not have voting rights in the company's general meetings. However, if the company fails to pay dividends for a specified period, preference shareholders might gain voting rights as per regulatory norms.

4. Less capital appreciation: Preference shares of the company might not experience significant price fluctuations like equity shares. This means they offer stable income but limited growth potential. If the company’s equity shares rise from ₹500 to ₹800, the preference shares might remain relatively stable, reflecting their focus on income rather than growth.

Difference Between Preference Shares and Equity Shares