Difference between Equity share and Preference share: A Complete Guide

Shares represent ownership in a company and can be bought, sold, or exchanged in the open market. The value of these shares is influenced by the performance of the company, market sentiment, and external economic factors. As per Section 43 of the Companies Act, 2013, the share capital of a company can be divided into two main categories: equity shares and preference shares. Understanding the distinction between these two types of shares is essential for investors and companies alike. The two key areas where equity shares and preference shares differ significantly are voting rights and dividend distribution.

What Are Equity Shares? - Difference between Equity share and Preference share

Equity shares are the most common type of shares issued by companies to raise capital for various business needs, including expansion, research and development, and general operational costs. Equity shares are typically issued to the public through an initial public offering (IPO) or via rights issues. The capital raised through the sale of equity shares is used to finance long-term growth, and these shares do not have a fixed redemption date, making them a permanent source of finance for companies.

Characteristics of Equity Shares

1. Ownership and Risk

   • Ownership: When investors buy equity shares, they become partial owners of the company, holding a proportionate stake in the company's overall equity capital. The number of shares an investor holds determines their level of ownership in the company. For example, owning 10% of the total shares would mean a 10% ownership in the business.

   • Risk: Equity shareholders bear the highest level of risk compared to other shareholders, as they are last in line to receive their share of the company’s assets in the event of liquidation or bankruptcy. This means that if the company faces financial distress, equity shareholders may not receive any payment, or they may only receive a partial return after all liabilities have been cleared. The risk is mitigated to some extent by the potential for high returns.

2. Voting Rights

   • Equity shares come with voting rights, allowing shareholders to participate in decision-making processes. Shareholders can vote on important matters such as electing board members, approving mergers and acquisitions, and influencing corporate governance decisions. The voting power is proportional to the number of shares held by each investor. This makes equity shareholders an active part of the company's management and strategic direction.

3. Dividend Payments

   • Unlike preference shares, the dividends paid to equity shareholders are not fixed. The dividend rate fluctuates based on the company’s performance, profitability, and the discretion of the board of directors. Equity shareholders receive dividends after all other liabilities have been paid, including payments to debt holders, preference shareholders, and operational costs. In times of good financial performance, equity shareholders can expect higher dividends, while in years of lower profitability, the dividends may be reduced or entirely omitted.

4. Transferability

   • Equity shares are freely transferable, meaning that they can be bought or sold on the stock exchange without requiring the company’s approval. Investors can easily liquidate their equity holdings if they choose to exit their investment, making equity shares a liquid asset class. This is a major advantage for investors who seek flexibility in their investment portfolio.

5. Capital Appreciation

   • One of the key benefits of equity shares is the potential for capital appreciation. As the company grows and becomes more profitable, the value of its shares can increase, providing investors with significant returns on their initial investment. This growth is typically reflected in the stock price, which is influenced by various factors such as earnings reports, market sentiment, and broader economic conditions.

Types of Equity Shares

While equity shares are generally classified as ordinary shares, they can be categorized into various types depending on the company's financial structure. The primary types of equity shares include:

• Authorized Share Capital: The maximum amount of share capital that a company can issue, as defined in its articles of association.

• Subscribed Share Capital: The portion of the authorized share capital that has been subscribed by shareholders.

• Issued Share Capital: The total capital raised through the issuance of shares.

• Paid-Up Capital: The portion of the issued capital that has been paid by shareholders.

• Bonus Shares: Shares given to existing shareholders for free, based on their current holdings.

• Right Shares: Shares offered to existing shareholders to buy additional shares at a discounted price.

• Sweat Equity Shares: Shares issued to employees or directors in exchange for their services or expertise.

Equity shares offer substantial dividends to shareholders, but the dividends are not guaranteed and depend on the company’s performance. Investors in equity shares also benefit from price appreciation, especially in high-growth companies. Furthermore, equity shares allow investors to be part of the decision-making process, influencing the direction in which the company moves.

What Are Preference Shares? - Difference between Equity share and Preference share

Preference shares, on the other hand, are a hybrid form of capital that combines elements of both equity shares and debt instruments. They are issued by companies to raise funds, but preference shareholders do not have voting rights, and their dividends are paid out before equity shareholders receive theirs. Preference shares are considered a safer investment compared to equity shares because they offer a fixed dividend and have priority in terms of asset claims during liquidation.

Characteristics of Preference Shares

1. Dividend Payments

   • Preference shares come with a fixed rate of dividend, which is decided by the company at the time of issuance. The rate of return on preference shares is generally fixed, providing investors with a more predictable income stream compared to the fluctuating dividends of equity shares. However, it is important to note that the company is not obligated to pay dividends if it faces financial difficulties or losses. If dividends are not paid in a given year, they may accumulate and be paid out in subsequent years, depending on the terms of the preference shares.

2. Priority Over Equity Shares

   • In the event of liquidation, preference shareholders have priority over equity shareholders when it comes to receiving a share of the company’s assets. This means that if the company is dissolved, preference shareholders are paid out before equity shareholders. However, preference shareholders are still ranked below debt holders, such as bondholders or lenders.

3. No Voting Rights

   • Unlike equity shareholders, preference shareholders do not have voting rights in the company. They cannot influence corporate decisions or participate in the management of the company. This lack of control is one of the main differences between equity and preference shares, as equity shareholders have a significant say in the company’s operations.

4. Convertibility

   • Some preference shares are convertible, meaning that preference shareholders have the option to convert their preference shares into equity shares at a later date. This feature allows preference shareholders to participate in the potential upside of the company’s growth by converting their preferred shares into equity if the company performs well. However, not all preference shares are convertible, and the terms for conversion vary from one company to another.

5. Redemption

   • Preference shares may be redeemable, meaning that the company can buy back the shares at a predetermined price and time. Redemption provides the company with flexibility, allowing it to repurchase shares if needed. On the other hand, equity shares are typically non-redeemable, meaning that once issued, they remain outstanding until they are sold or transferred by the shareholder.

6. Fixed Dividend

   • Unlike equity shares, which have a fluctuating dividend, preference shares offer a fixed dividend rate. This fixed income makes preference shares an attractive option for risk-averse investors who seek stable returns. However, the downside is that if the company performs well and generates higher profits, preference shareholders do not benefit from the upside as much as equity shareholders.

Types of Preference Shares

Preference shares can be classified into various categories based on their features. Some of the main types of preference shares include:

• Cumulative Preference Shares: These shares accumulate unpaid dividends and are paid out in subsequent years, even if the company does not declare a dividend in a given year.

• Non-Cumulative Preference Shares: These shares do not accumulate unpaid dividends. If the company does not declare a dividend, preference shareholders lose their right to that dividend.

• Redeemable Preference Shares: These shares can be repurchased by the company at a specified time, allowing the company to manage its capital structure.

• Non-Redeemable Preference Shares: These shares cannot be redeemed by the company and remain outstanding indefinitely.

• Convertible Preference Shares: These shares can be converted into equity shares at a later date, allowing shareholders to benefit from the company's growth.

• Participating Preference Shares: These shares entitle holders to receive additional dividends if the company’s profits exceed a certain level.

• Non-Participating Preference Shares: These shares do not entitle holders to participate in the company’s extra profits.

Key Differences Between Equity and Preference Shares

Here’s a detailed comparative analysis of the primary distinctions between equity shares and preference shares:

To Sum Up

Both equity shares and preference shares offer distinct advantages to investors, depending on their risk tolerance, financial goals, and preference for control. Equity shareholders benefit from voting rights and have the opportunity to participate in the company’s growth and decision-making. They also have the potential for higher returns through capital appreciation and dividend payouts. However, they face greater risks, especially if the company faces financial distress.

On the other hand, preference shareholders enjoy more predictable returns due to fixed dividends and have priority in the event of liquidation. However, they lack voting rights and cannot participate in management decisions. Preference