When a company has a debt, and wants to reduce it or would like to expand the existing business, there are many methods to raise the required funds. But of all, the easiest one is the allotment of preferential shares. Through the allotment of preferential shares companies can raise debt, without much must to follow norms /paper work. Whereas, the other methods of acquiring capital, needs procedural enhancement of norms and time. That means, they are very time consuming and complicated in comparison with an allotment of preferential shares directly to the second party.
Preferential allotment of Shares is the process, through which shares are allotted to the selected group of investors /institutions /companies on a preferential basis. Under this process shares are allotted to the investor with an agreement that, whenever the company decides to pay dividends, the holders of the preference shares will be the first to be paid.
Types of Preferred Stock (Shares)
- Cumulative Preferred stock,
- Non-Cumulative Preferred stock,
- Participating Preferred stock,
- Convertible Preferred Stock. This is also simply called as the preferred stock.
Benefits and Drawbacks to the Preferential Share Holder
- No brokerage expenses
- Preferential shares are preferred over the common shares, while allotting dividend
- In the case, if the company is not able to pay a dividend in the current year, the preferred shareholder has the right to claim that dividend in the subsequent years.
- In the event of liquidation of a company, preferential shares takes precedence over the common stock. That is, in the case company goes bankrupt, preferred shareholders are paid off first, before the common stockholders. Capital is secure.
- The first and the foremost drawback is that, the preferred shareholder possesses limited voting rights while passing resolutions of the company. Whereas an equity share confers on its holder, a right to vote on all resolutions that require shareholder approval under the relevant act /law /the articles of association of the company. Also enjoy the right to appoint or remove the directors and auditors of the company, as well as approve the company accounts.
- Preference shares are riskier than bonds, but less riskier than equity.
- Preferential shares are preferred after the NCDs during company bankruptcy and the consequential liquidation.
How it Affects the EPS and the Stock Price
Few companies start to perform well after the allotment of preferred stock. This depends on the factors like, whom the stock is allotted and how successfully the raised fund is utilized for the growth of the business. If, the stock is issued to ‘well informed veteran investors’, then their participation will definitely drive the business towards its growth.
- Diluted Earnings Per Share takes into account all the outstanding convertible securities, like convertible debentures, convertible preferred shares, stock options and warrants. Hence diluted EPS gets affected by the preferred stock if it is convertible.
The preferred stockholders, usually exercise their right to convert the preferred stock into the common stock at a pre-agreed ratio. They do so, if stock price hikes after the issuance of preferred stock. Due to which, the number of shares increases. Thereby, reducing the EPS and in turn the stock price.
Hence, a convertible preferred stock can be considered as a dilute, which increases the number of shares, reduces EPS and hence the stock price.
- Preferential shares are not accessible to common investors. Companies prefer high net worth individuals, institutions and other companies for preferential allotment. And, the whole process is carried out privately through a private placement of the offer. Hence available for only high net worth individuals. The minimum threshold amount to invest is Rs.10, 00,000 (Rs.10 lakhs). This can be considered as one of the distinctive features of a Preferential allotment of shares by the companies.