Preferred shares – also known as preference shares or collectively as preferred stock – are title deeds which give their bearers a share of ownership in a company’s stock. There are significant differences between preferred shares and ordinary shares.
While ordinary shares generally entitle their holders to voting rights, preferred shares do not normally include voting rights (although these rights can be included).
Preferred shares have a face value, much like bonds. The face value of each preferred share is determined by the number of preferred shares issued in relation to the portion of the business which is divided between preferred shares. The holder of a preferred share receives a guaranteed dividend for that share based on its face value, much like a bond holder receives a guaranteed coupon for a bond.
These features set preferred shares apart from common shares, which do not have a face value. Holders of common shares may receive dividends if the company performs well, but dividends are not guaranteed and can fluctuate from year to year. The dividends of preferred shares are guaranteed.
Another important difference between preferred shares and common shares affects shareholders if the company which issues the shares goes bankrupt. Holders of preferred shares have a greater claim to the company’s liquidated assets than holders of common shares. However, they have a lower claim to liquidated assets than bond holders. So the risk of loss in the event of bankruptcy is lower than that of common shares, but higher than that of bonds.
Because the risk of loss is higher than that of a bond, the dividends of preferred shares are typically higher than the coupons of bonds.
Like common shares, preferred shares do not normally have a validity term. They are perpetual and continue to pay out dividends until the issuing company is liquidated. Bonds, on the other hand, typically have predetermined terms at the end of which they mature and the loan principal is paid out (Exception: Perpetual bonds). However, the terms and condition of preferred shares can vary, and some preferred shares specify limited terms after which the issuing company is entitled to buy back the share at its face value.
Other than in the event of a stock buyback, preferred shares cannot be redeemed at their face value. As with common shares, there is a secondary market for preferred shares and they can be traded on stock exchanges. It is possible for preferred shares to be sold at prices above their face value on the secondary market. The secondary market for preferred shares is smaller and less liquid than those for common shares and bonds.
The terms and conditions of preferred shares are stated in their certificates of designation. This certificate states the dividend entitlements and how and when dividends will be paid (annually, after a predetermined number of years, or when the company buys back the share, for example). It also states whether the share includes voting rights, and whether the company is entitled to buy back the share after a stated term. Companies have a great deal of flexibility in setting the terms and conditions of preferred shares, so investors who are considering investing in preferred shares should carefully study the certificates of designation attached to those shares.
Preferred shares differ from Swiss participation certificates in that they represent a share of ownership in a company and provide greater company bankruptcy protection than common shares. They are similar to participation certificates in that they have face values, deliver dividends proportionate to their face value and do not (normally) include voting rights.