Common shares and preference shares

What does an equity investor own?

An investor in equity instruments owns a fractional stake in a company. The stake comes with economic, voting and legal rights : a proportional share of any distributions the company makes, a say in electing the board and in big decisions, and a legal claim on what is left in a liquidation once creditors are paid.

The claim has no end date. Equity has an indefinite life : there is no maturity, and the shares stay outstanding until a restructuring (an acquisition or divestiture, in which holders receive shares or cash) or a liquidation. The issuer owes no repayment and no periodic payment.

Common shareholders hold the residual claim . Customers and suppliers are paid through costs, employees through pay, lenders through interest and principal, and the government through tax. What is left is net income, which the company either keeps and reinvests or pays out as dividends . Dividends are discretionary: a company may pay them regularly, occasionally or never.

An investor is paid in three ways:

• the price paid to the issuer at the start, which is the investor’s outlay;
• any discretionary dividends along the way;
• an exit, by a sale in the secondary market, by an acquisition or divestiture, or in a liquidation.

With no dividends, the whole return is the change in the share price. Limited liability means the most a holder can lose is what the shares cost.

Companies can also issue several classes of common shares with different votes or dividends; Learning Module 2 covers share classes and how votes are cast.

Equity instrumenta fractional ownership claim with no maturity

• Common shares Memorize residual claim, votes, highest payoff uncertainty
  • Economic rights a proportional share of dividends and of net assets in liquidation
  • Voting rights board elections, mergers, auditors; in person or by proxy
• Preference shares Memorize senior to common, junior to debt; fixed dividend; rarely vote
  • Standard features fixed percentage of par, often cumulative, no maturity
  • Contingency features upside, downside protection or an issuer right

Why do some companies pay dividends and others none?

The company life cycle drives dividend policy. Start-ups and growth companies make losses or small, growing profits and reinvest everything, so their investors look for capital appreciation. Mature companies with stable cash flows and fewer new projects tend to pay a regular dividend, so investors who want income favor them.

Halden Robotics, a five-year-old warehouse-automation company, reinvests every dollar and says it has no plans to pay a dividend. Fernway Utilities, a 60-year-old water company, pays a steady quarterly dividend. Both are common shares; the life cycle explains the difference.

What rights come with a common share?

Common shares (also called ordinary shares or common stock) are the main type of equity. Unlike bonds and preference shares, they have no par value that sets the claim. Each share is a fraction of the company’s assets less its liabilities, and that fraction changes when the number of shares outstanding changes.

The rights of common shareholders are six:

• voting;
• dividend;
• conversion;
• liquidation;
• split, subdivision or combination;
• preemptive.

Common shareholdereach right is proportional to the shares held, unless the terms say otherwise

• Voting Memorize a proportional say in governance decisions
• Dividend Memorize a proportional share of any regular or extraordinary distribution
• Conversion Memorize any right to swap one class or type of equity for another
• Liquidation Memorize a proportional claim on net assets left after higher claims
• Split, subdivision or combination Memorize how the claim adjusts when shares are split or combined
• Preemptive Memorize first call on new shares or securities convertible into shares

Preemptive rights are existing holders’ first call on new shares, or on securities convertible into shares. They let a holder buy enough of the new issue to avoid dilution of her percentage stake. A company’s terms can leave a right out. Many listed companies, for example, give no preemptive rights.

Votes are normally proportional to the shares owned. Typical topics are board elections, mergers and takeovers, and ratifying the auditor. Voting usually happens at the annual meeting, in person or by proxy vote , where another shareholder, a shareholder representative or management votes on the holder’s behalf. The shareholder voting process shows the full chain.

Common shares work for both sides:

• The issuer raises capital while keeping operational control of the business.
• The investor gets economic and voting rights for a small outlay, whatever the company’s size, plus dividends or growth in net asset value, and can sell freely in the secondary market.

Why do companies issue common shares?

There are three standard reasons:

• to raise public equity capital for expansion;
• to sell a company that was restructured under private ownership;
• to let a founding family diversify out of a concentrated stake.

New shares change the capital structure and the weighted average cost of capital (WACC). Selling because managers think the price is too high is not one of the standard reasons: it assumes buyers will not notice why the company is selling.

New shares are usually listed on an equity exchange (a stock exchange): a regulated, organized marketplace with set rules, where approved participants trade shares.

When shares are issued, prospective investors receive an equity prospectus , or an offering memorandum in the case of a private placement. It sets out:

• the key features of the security;
• the use of proceeds;
• the business;
• risk factors;
• management discussion and analysis (MD&A);
• management and key shareholders;
• financial information.

What are preference shares?

Preference shares (also called preferred stock) rank above common shares for dividends and for assets in a liquidation, but behind all debt. The dividend is set as a fixed percentage of par (or of the original issue price), and holders give up the vote and most of the upside in exchange for priority. The dividend is usually higher than a common dividend, though preference shares offer less chance of capital appreciation. Like common shares, they have an indefinite life and can be perpetual.

They mix features of bonds and common shares. Like a bond, the dividend is fixed. Unlike a bond, the dividend is not a contractual obligation, so missing it is not a default. The curriculum also calls preference dividends non-discretionary: they are expected and fixed, but skipping one is still not a default.

Which features change a preference share?

Preference shares are customized through a handful of features. The first is what happens to a skipped dividend.

On cumulative preference shares , a missed dividend accrues and must be paid in full before any common dividend. The unpaid amount is called dividends in arrears . On non-cumulative preference shares , a missed dividend is gone for good. The company still may not pay common holders until the current preference dividend is paid, but it owes nothing for the past.

$$D = (n + 1) \times r \times \text{par}$$

The exam tests the cumulative feature in words; the calculation is our own illustration of it.

To attract investors, issuers add contingency provisions : terms that give the investor a share of improved performance, protect the investor if results are weak, or give the issuer flexibility.

Participating. Participating preference shares pay the standard dividend plus an extra amount when profits pass a set level. This is upside for the investor. Shares without the feature are non-participating: the fixed dividend is all they ever get.

Convertible. Convertible preference shares can be exchanged for a set number of common shares (sometimes at a set price) agreed at issue. They suit a young, closely held company. With little revenue, no collateral and little operating cash flow, such a company can rarely borrow. Issuing convertible preference shares instead of common shares keeps control with the founders for now, and costs less in cash, because the dividend is lower than on a plain preference share. Investors accept the lower dividend for the option to share in the upside, often ahead of an initial public offering (IPO).

Exam tip Contingency features are easiest to sort by asking who holds the right and what it does: upside for the investor, protection for the investor, or flexibility for the issuer.

Which features protect the investor, and which help the issuer?

Callable preference shares give the issuer the right, not the obligation, to buy the shares back at a set price. That is flexibility for the issuer.

Putable preference shares give the holder the right, not the obligation, to sell them back at a set price, the put contingency price . That is downside protection.

A liquidation preference payout is a set cash amount paid to preference holders before anything goes to common holders if the company is liquidated. That is downside protection too.

Preference share featuresmix and match, for example cumulative and putable

• Missed dividends Memorize what happens to a skipped dividend
  • Cumulative Memorize accrue; paid before any common dividend
  • Non-cumulative Memorize lost for good
• Upside for the investor Memorize a share of better results
  • Participating Memorize extra dividend when profits pass a set level
  • Convertible Memorize switch into a set number of common shares
• Downside protection for the investor Memorize a safety net if results are weak
  • Putable Memorize sell back to the issuer at the put contingency price
  • Liquidation preference payout Memorize a set cash amount before any common holder in liquidation
• Right for the issuer Memorize flexibility for the company
  • Callable Memorize issuer may buy back at a set price

How these features change what a preference share is worth comes in Learning Module 6.

How do common shares, preference shares and debt compare?

	Common	Preference	Debt
Contractual obligation	no	no	yes
Claim	residual, paid last	ahead of common	ahead of preference
Payoff uncertainty	highest	lower; dividends more debt-like	lowest
Votes	yes	rarely	no
Maturity	none	none	finite

Seniority runs debt, then preference, then common; payoff uncertainty runs the other way.

Go deeper Why preference shares feel like bonds but count as equity

A preference share has a fixed payment and seniority over common shares, like a bond. It has no contract to pay, no maturity and rarely a vote, unlike a bond. That is why an issuer can skip the dividend without defaulting, and why preference holders still rank behind every lender.