Preference Shares vs Common Shares
Need to know the differences between preferred shares and common shares? Read on to find out.
What are classes of shares and how do they differ?
The term classes of shares refers to types of shares that are distinguished by the level of voting rights accruing to the individuals holding those shares, the likelihood of receiving a dividend, and who is prioritised in the event of insolvency, bankruptcy, or liquidation.
Common shares will generally carry more weight in terms of voting rights, whereas holders of preference shares are more likely to receive a fixed dividend and will be dealt with ahead of common shareholders should the company experience financial difficulties.
The bulk of shares issued by any company will be of the common type. As mentioned above, common shares confer voting rights – usually one vote per share. So, individuals holding these shares will have a say in electing board members and get to influence corporate policy and the general direction of the company.
Preferred shares come with no voting rights attached. However, one of their upsides is that they tend to come with the certainty of a fixed dividend.
Common shares, meanwhile, come with a variable dividend, so these shareholders will never know from one year to the next what dividend – if any – they are going to receive. That said, there is more potential long-term upside with common shares – if a company thrives then common shareholders will reap the benefits. However, the reverse also applies – if the company flounders, then the value of those shares will decline – so, there is risk attached.
In the event of the company experiencing a dire financial downturn and facing liquidation, preferred shareholders will be ahead of common shareholders in the queue, with the latter not receiving any money until all preferred shareholders have been paid out.
One final point to note is that while it is possible to convert preferred shares into common shares, the opposite does not hold true; as in, it is not possible to convert common shares into preferred shares.
When would you issue one over the other?
Generally speaking, companies that have been privately owned and then go public will be keenly aware of the distinction between these two types of shares. Companies that are conscious of not wanting to upset the internal balance of control and power might prefer to issue preferred shares, which come with the important trade-off mentioned above – guaranteed dividends, but no voting rights. Meanwhile, common shares, as already stated, come with voting rights, which means those shareholders will, in theory, be in a position to exert influence over the composition of the board and the day-to-day running of the business.
The financing lifecycle of a company usually follows the below timeline:
- Common Stock/Founders Shares
- Stock Options or other equity awards
- Convertible debt
- Preference Stock
It is common for companies seeking pre-seed and initial seed investment – when it is difficult to settle on a fixed valuation – to raise funds through convertible instruments, but as time goes by, equity investment will become unavoidable, and most often comes in the form of preference shares.
Investors are drawn to preference shares over common shares for several reasons, not least of which being that they offer more consistent dividends. If every start-up had a 100% chance of going public, then common stock would always be more attractive. However, liquidity events are usually the main focus of any investor’s interest in a private company, and because a positive outcome can never be guaranteed, they will look to protect themselves through use of the various terms that can be attached to preference shares.
Please see our information guide ‘Understanding Preference Shares’ for more information on Preference shares.