The capital structure of a company describes how it pays for its assets. It consists of the company’s liabilities and its equity. The equity portion measures how much has been invested into the company by shareholders – known as shareholders’ equity – as well as the firm’s retained earnings, which are the accumulated profits that have not yet been used. Shareholders’ equity can come in several forms, but always includes equity shares, also known as common stock. Preference shares, commonly called preferred shares, may also be issued. They have some characteristics that set them apart from common stock.
Exploring Liquidation and Seniority
If a company is forced into liquidation, its assets are sold and the proceeds are distributed to lenders and shareholders in order of seniority. Lenders are the most senior, and must be paid off in full before shareholders can partake of the liquidation proceeds.
Preferred shares are called preferred because they are senior to equity shares for purposes of liquidation. If there are several different issues of preferred shares, distributions will be made according to their relative seniorities. The highest seniority preferred shares are called "prior preferred."
Evaluating Dividend Payments
Most preferred shares pay dividends; equity shares may or may not. Equity shares cannot pay dividends if the preferred shares fail to pay theirs. Cumulative preferred shares are ones in which missed dividends accumulate and must eventually be paid. Preferred shares tend to have higher dividend yields -- annual dividend divided by share price -- than do equity shares.
In this sense, preferred shares are looked upon as hybrids of debt and equity, in that the dividend yield on preferred shares is similar to the interest rate paid on the company's debt. Preferred dividends are fixed; equity dividends can change with the fortunes of the company.
Assessing Options Included With Preferred Shares
Preferred shares are often issued with certain embedded options that are not found in equity shares. Convertible preferred shares can be converted by shareholders into a specified number of equity shares. As equity share prices rise, conversion becomes more likely, as the resulting equity shares will be worth more than the original preferred shares.
Callable preferred shares can be forcibly redeemed by the issuing corporation for a preset cash payment. Corporations tend to call preferred shares if interest rates fall and the preference shares can be replaced by ones with a lower dividend yield.
Identifying Other Key Differences
There are a few other differences between preference and equity shares. Equity shareholders have the right to vote at annual corporate meetings, whereas preference shares are almost always non-voting. Preference shares are often issued with a warrant “sweetener.”
Warrants are securities that can be converted into equity shares at a predetermined price, which makes them increase in value as equity share prices rise. Finally, preferred dividends reduce the earnings per share of corporations, but equity share dividends do not.
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