Definition
Equity shares, also known as common shares, represent ownership in a company where shareholders have voting rights and can benefit from the company’s success through dividends and capital appreciation. Preference shares, on the other hand, give holders a higher claim to dividends and assets in the event of liquidation, but usually without voting rights. Therefore, while equity shareholders take higher risk but potentially reap more reward, preference shareholders have more financial security but less control over the company.
Key Takeaways
- Equity Shares are shares issued by a company that represent ownership in the company. With ownership, equity shareholders have a right to share the company’s profits and losses, and they also have voting rights in the company’s decisions. On the contrary, Preference Shares are shares that give shareholders a fixed dividend, whose payment takes priority over that of equity share dividends.
- In the event of liquidation, preference shareholders have a higher claim on assets and earnings. This means, the earnings are distributed to preference shareholders before equity shareholders. However, equity shareholders have the potential for higher returns if the company performs well as there is no cap on their dividend payments like there is for preference shareholders.
- Preference shares are considered less risky than equity shares since preference shareholders are prioritized during the payment of dividends and at the time of liquidation. However, equity shares can offer higher returns and also carry voting rights, providing shareholders with a say in the company’s decisions.
Importance
The distinction between equity shares and preference shares is crucial in corporate finance because it defines the rights and claims of shareholders.
Equity shareholders are the real owners of the company who bear the highest risk; they have voting rights and receive dividends when the company turns a profit, but are last in line to claim any remaining assets in the case of liquidation.
Preference shareholders, on the other hand, have preferential rights over the payment of dividends and the repayment of capital during the liquidation process, but they typically do not have voting rights.
This distinction helps investors understand the level of risk they are assuming and the potential returns they may receive, and therefore plays a vital role in investment decisions.
Understanding this distinction is also essential for companies in structuring their capital and raising funds.
Explanation
Equity shares, often referred to as common shares, primarily serve as a means for companies to raise capital. They offer shareholders a claim on a portion of the company’s profits, and in some cases, voting rights. Equity shareholders are effectively owners of the company and share the risk associated with the business.
The funds raised through the issuing of equity shares generally go toward funding business operations, expansion, or any other initiatives that could promote the company’s growth in the future. Higher investment in equity shares offers a higher reward possibility as the growth of a company often leads to an increase in the value of its shares. On the other hand, preference shares, or preferred shares, serve a different purpose.
They offer a more stable, albeit generally lower, return for investors. Holders of preference shares are entitled to receive dividends before equity shareholders and have a higher claim on company assets if the company were to go bankrupt. The purpose of issuing preference shares is to raise capital while avoiding diluting control of the company.
This is because preferred shareholders usually don’t have voting rights. By providing a priority claim on dividends and liquidation proceeds, companies can make preferred shares attractive to risk-averse investors, even if they don’t have as large of a potential upside as equity shares.
Examples of Equity Shares vs Preference Shares
Company A and Company B: Company A issues Equity Shares, whereas Company B issues Preference Shares. This means that investors in Company A have voting rights and potential for higher returns if the company performs well, but they also risk higher losses. On the other hand, investors in Company B receive a fixed dividend and have a higher claim on assets if the company goes bankrupt, but they don’t participate in the extra profits when the company performs exceptionally well.
Google and Tesla: Google has only issued Equity Shares to the public, giving their investors the right to vote on company matters and a share in the profits. Contrast this with Tesla, who issued both Preference and Equity Shares. Preference shareholders receive dividends before Equity shareholders and have a prior claim on the assets if the company were to be liquidated, but they don’t have any voting rights.
Startup X and Established Company Y: Startup X issues Equity shares to attract investors who are willing to take on more risk with the potential for high returns when the company takes off. This type of share enables the investors to have a voice in key business decisions. In contrast, more established Company Y issues Preference Shares with a fixed dividend to attract investors looking for lower risk and steady income. These investors do not have a vote in the company matters.
FAQ: Equity Shares vs Preference Shares
What is the primary difference between Equity Shares and Preference Shares?
Equity Shares are the main form of share where shareholders enjoy the rights of control in the company and receive profits after the Preference Shareholders. Preference Shares, on the other hand, have lesser control in the company but get priority in terms of profit distribution and during bankruptcy.
Who gets the precedence for dividend payments?
Preference shareholders have the precedence for dividend payments over Equity shareholders. This means that Preference shareholders receive dividends before Equity shareholders.
Do Preference shareholders have voting rights?
Generally, Preference shareholders do not have voting rights in the company or they have limited voting rights. However, the voting rights may vary based on the nature and structure of the Preference shares.
Which is riskier, Equity shares or Preference shares?
In terms of risk, Equity shares are considered riskier. This is because Preference shareholders have a higher claim on assets and earnings. For instance, if a company goes bankrupt, Preference shareholders are paid off before Equity shareholders.
Can Preference shares be converted to Equity shares?
Yes, there are certain types of Preference shares, known as Convertible Preference shares, which can be converted into Equity shares under specific conditions.
Related Entrepreneurship Terms
- Dividend Payments
- Voting Rights
- Liquidation Preferences
- Convertible Preferences
- Redemption Rights
Sources for More Information
- Investopedia – One of the leading sources of financial information on the internet.
- Financial Express – A comprehensive source for a wide array of financial news and analysis.
- The Balance – A personal finance website with advice on how to manage your money.
- Economic Times – A well-respected news outlet with a section dedicated to financial education.
