Shares represent units of ownership in a company, signifying a proportional claim on the company’s assets and earnings. Issuing shares is a fundamental method for companies to raise capital from investors, allowing them to finance operations, expansion, and other strategic initiatives without incurring debt that requires regular interest payments. Investors, in turn, purchase shares with the expectation of receiving returns, either through dividends (a share of the company’s profits) or capital appreciation (an increase in the share’s market price). The nature of these rights and expectations, however, varies significantly depending on the type of share held.

Within the broader category of equity, two principal types of shares stand out: Ordinary Shares (also known as Common Stock) and Preference Shares (often called Preferred Stock). While both represent equity ownership, they are distinguished by a suite of divergent features concerning voting rights, claims on income and assets, and their overall risk-return profiles. Understanding these distinctions is crucial for both companies seeking to optimize their capital structure and investors aiming to align their investments with their financial objectives and risk tolerance.

Ordinary Shares (Common Stock)

Ordinary shares represent the true residual ownership in a company. Holders of ordinary shares are the ultimate owners and therefore bear the ultimate risk and enjoy the ultimate potential rewards. They are the last in line to receive payment in the event of liquidation, meaning all creditors and preference shareholders must be paid in full before ordinary shareholders receive anything. This residual claim also implies that their returns are not fixed but are contingent on the company’s performance.

Key Features and Rights of Ordinary Shares:

  1. Voting Rights: The most distinguishing feature of ordinary shares is the right to vote on significant corporate matters. Each ordinary share typically carries one vote, though some companies may issue different classes of ordinary shares with varying voting powers (e.g., Class A with more votes, Class B with fewer or none). These voting rights allow ordinary shareholders to:

    • Elect the board of directors, who are responsible for the strategic management of the company.
    • Approve major corporate actions, such as mergers, acquisitions, sales of substantial assets, and changes to the company’s articles of incorporation.
    • Vote on executive compensation plans and other corporate governance issues. This direct involvement in corporate governance empowers ordinary shareholders to influence the company’s direction and hold management accountable.

  2. Residual Claim on Assets and Earnings: Ordinary shareholders have a residual claim, meaning they are entitled to a share of the company’s assets only after all creditors (including bondholders) and preference shareholders have been paid in full during liquidation. Similarly, dividends are paid to ordinary shareholders only after all obligations to creditors and preference shareholders have been met. This puts ordinary shareholders at the highest risk but also gives them access to unlimited upside potential.

  3. Variable Dividends: Dividends paid to ordinary shareholders are not fixed or guaranteed. The decision to declare and pay dividends rests with the company’s board of directors, who consider factors such as profitability, cash flow, future investment needs, and legal restrictions. Dividends can vary significantly from year to year, or even be suspended entirely during periods of poor performance or when the company decides to reinvest all earnings for growth. This variability means that ordinary shares are less suitable for investors primarily seeking stable income.

  4. Capital Appreciation Potential: The primary source of return for ordinary shareholders often comes from capital appreciation, which is the increase in the market price of their shares. As a company grows, becomes more profitable, and its prospects improve, the demand for its shares tends to increase, driving up the stock price. This potential for significant long-term capital gains makes ordinary shares attractive to growth-oriented investors.

  5. Pre-emptive Rights: In many jurisdictions and company charters, ordinary shareholders have pre-emptive rights, also known as subscription rights. This right allows existing ordinary shareholders to purchase newly issued shares on a pro-rata basis before they are offered to the general public. The purpose is to protect existing shareholders from dilution of their ownership percentage and voting power.

  6. Risk and Return Profile: Ordinary shares typically carry the highest level of risk among all corporate securities because their returns are uncertain and they are last in line for claims. However, commensurate with this higher risk is the potential for the highest returns, especially if the company performs exceptionally well and its share price appreciates significantly over time.

Role in Corporate Finance:

Ordinary shares are the cornerstone of a company’s equity capital. They represent the fundamental ownership structure and are the primary long-term source of capital for many businesses, particularly those in their growth phases. Issuing ordinary shares allows companies to raise funds without incurring debt obligations, thereby reducing financial leverage and increasing financial flexibility.

Preference Shares (Preferred Stock)

Preference shares are a unique type of equity security that possesses characteristics of both equity and debt. While they represent ownership in the company, they typically do not carry voting rights and offer a fixed dividend payment, similar to interest on a bond. They are often referred to as a “hybrid security” because of this blend of features.

Key Features and Rights of Preference Shares:

  1. Fixed Dividends: The most defining characteristic of preference shares is their fixed dividend rate. This dividend is usually expressed as a percentage of the share’s par value (e.g., 5% preference shares with a par value of $100 would pay a $5 annual dividend). Unlike ordinary share dividends, preference share dividends are generally mandatory once declared by the board, and they must be paid before any dividends can be distributed to ordinary shareholders.

  2. Priority in Dividend Payments: Preference shareholders have priority over ordinary shareholders when it to dividend payments. If a company declares dividends, preference shareholders must receive their full fixed dividend payment before any ordinary shareholders can receive theirs. This provides a more stable and predictable income stream for preference shareholders.

  3. Priority in Liquidation: In the event of a company’s liquidation, preference shareholders have a claim on the company’s assets that is superior to that of ordinary shareholders but subordinate to that of creditors (including bondholders). This means they will be paid out of the company’s remaining assets before ordinary shareholders, providing a greater degree of security.

  4. Limited or No Voting Rights: Generally, preference shares do not carry voting rights. This is a significant trade-off for their dividend priority and liquidation preference. However, some preference share agreements might grant voting rights under specific circumstances, such as if the company defaults on preference dividend payments for a certain period. This exception is designed to protect preference shareholders when their fixed income stream is jeopardized.

  5. Types of Preference Shares: There are several variations of preference shares, each with distinct features:

    • Cumulative Preference Shares: If the company misses a dividend payment, the unpaid dividends accumulate and must be paid in full to cumulative preference shareholders before any dividends can be paid to ordinary shareholders in subsequent periods. This offers greater protection for investors.
    • Non-Cumulative Preference Shares: If a dividend is missed, it is lost forever and does not accumulate. These are less common as they offer less protection to the investor.
    • Redeemable Preference Shares: The company has the option or obligation to buy back these shares from shareholders at a predetermined price and date. This makes them similar to debt.
    • Irredeemable Preference Shares: These shares have no maturity date and remain outstanding indefinitely, similar to ordinary shares.
    • Convertible Preference Shares: These shares can be converted by the holder into a fixed number of ordinary shares at a specified conversion ratio during a certain period. This provides investors with the potential for capital appreciation if the ordinary share price rises significantly.
    • Participating Preference Shares: In addition to their fixed dividend, these shares may receive extra dividends if the company’s profits exceed a certain level or if ordinary shareholders receive dividends above a certain amount. This allows them to “participate” in the company’s success beyond their fixed return.
    • Callable Preference Shares: The company has the right, but not the obligation, to repurchase these shares from the holders at a specified price after a certain date. This feature benefits the issuing company if interest rates fall or if they wish to restructure their capital.

  6. Risk and Return Profile: Preference shares generally carry a lower risk than ordinary shares due to their dividend priority and liquidation preference. Consequently, their potential returns are also typically lower and more predictable, primarily consisting of the fixed dividend yield rather than significant capital appreciation. They are often attractive to income-oriented investors.

Role in Corporate Finance:

Companies issue preference shares to raise capital without diluting the voting control of existing ordinary shareholders. They can also be attractive when a company needs capital but does not want to incur the fixed legal obligation of debt, or when it wants to offer a security that is more appealing to certain types of investors (e.g., institutional investors or those seeking stable income).

Distinguishing Between Ordinary Shares and Preference Shares

The fundamental differences between ordinary shares and preference shares lie in their rights, claims, and the returns they offer to investors. These distinctions are critical in determining their appeal to different types of investors and their role in a company’s capital structure.

1. Voting Rights:

  • Ordinary Shares: Carry full voting rights, empowering shareholders to elect directors and approve major corporate decisions. This is the cornerstone of their ownership interest and control over the company.
  • Preference Shares: Typically carry no voting rights. This absence of control is traded for priority in dividend payments and liquidation claims. Exceptions exist, such as when preference dividends are in arrears, where temporary voting rights may be granted to protect their interests.

2. Dividend Payments:

  • Ordinary Shares: Dividends are variable, not guaranteed, and declared at the discretion of the board of directors. Payment is contingent on profitability and the company’s financial policy. They are paid only after all obligations to creditors and preference shareholders are met.
  • Preference Shares: Dividends are fixed (usually a stated percentage of par value) and have priority over ordinary share dividends. In the case of cumulative preference shares, any missed dividends accumulate and must be paid before ordinary shareholders receive anything. This provides a more stable and predictable income stream.

3. Claim on Assets in Liquidation:

  • Ordinary Shares: Have a residual claim. They are last in line to receive any assets after all creditors and preference shareholders have been fully paid. This exposes them to the highest risk of loss in case of bankruptcy.
  • Preference Shares: Have priority over ordinary shares in the event of liquidation. They are paid out of the company’s assets before ordinary shareholders but after all creditors. This offers a higher degree of security than ordinary shares.

4. Return Potential:

  • Ordinary Shares: Offer unlimited potential for capital appreciation if the company’s value grows. While dividends can be a source of income, the primary return often comes from an increase in share price. This makes them attractive to growth investors.
  • Preference Shares: Primarily offer a fixed dividend income. Their potential for capital appreciation is generally limited, as their price tends to be more sensitive to interest rate changes rather than earnings growth. Convertible preference shares offer some upside potential if converted into ordinary shares. They appeal to income-seeking investors.

5. Risk Profile:

  • Ordinary Shares: Carry the highest financial risk. Their returns are uncertain, and they bear the greatest loss in liquidation.
  • Preference Shares: Have a lower financial risk compared to ordinary shares due to their fixed dividend priority and liquidation preference. However, they are still equity, meaning their claims are subordinate to those of creditors, making them riskier than debt.

6. Nature of Security:

  • Ordinary Shares: Pure equity. They represent true ownership and are fundamental to the company’s capital structure.
  • Preference Shares: Hybrid security. They possess characteristics of both equity (representing ownership, dividends are not a legal obligation like interest on debt, no fixed maturity for irredeemable) and debt (fixed returns, priority claims, often no voting rights).

7. Pre-emptive Rights:

  • Ordinary Shares: Often come with pre-emptive rights, allowing existing shareholders to maintain their proportional ownership by subscribing to new share issues.
  • Preference Shares: Rarely carry pre-emptive rights, as their focus is on income and security rather than maintaining proportional control.

8. Callability and Convertibility:

  • Ordinary Shares: Typically not callable or convertible.
  • Preference Shares: Often callable (company can buy them back) and/or convertible (can be converted into ordinary shares), adding flexibility for both the issuer and the investor. These features are rare for ordinary shares.

9. Impact on Cost of Capital:

  • Ordinary Shares: The cost of ordinary equity is generally higher than that of preference shares or debt, reflecting the higher risk borne by ordinary shareholders. It’s often calculated using models like the Dividend Growth Model or the Capital Asset Pricing Model (CAPM).
  • Preference Shares: The cost of preference shares is typically lower than ordinary equity but higher than debt, as preference dividends are not tax-deductible for the company (unlike interest payments on debt).

10. Investor Appeal:

  • Ordinary Shares: Attract investors who are comfortable with higher risk in exchange for potentially higher returns through capital growth and a say in company management. They are favored by growth-oriented investors and those seeking long-term wealth accumulation.
  • Preference Shares: Appeal to more conservative, income-oriented investors seeking stable, predictable income and a higher degree of safety compared to ordinary shares. They are often favored by institutions or individuals prioritizing income over capital growth.

11. Market Volatility:

  • Ordinary Shares: Their market prices are generally more volatile, reacting strongly to company performance, economic news, industry trends, and investor sentiment.
  • Preference Shares: Their market prices tend to be less volatile, behaving more like bonds, with their value primarily influenced by changes in interest rates rather than company-specific performance or growth prospects.

12. Accounting Treatment:

  • Ordinary Shares: Explicitly classified as equity on the balance sheet, forming the core of the company’s net worth.
  • Preference Shares: While generally classified as equity, complex preference shares (e.g., mandatory redeemable preference shares) may be treated as a form of debt under certain accounting standards (e.g., IFRS) or for specific financial ratios.

The choice between issuing ordinary shares and preference shares depends on a company’s specific financing needs, capital structure objectives, and desire to balance control, cost of capital, and investor appeal. For investors, the decision hinges on their risk tolerance, income needs, and investment horizon.

In essence, ordinary shares embody the pure form of equity ownership, granting voting rights and the potential for significant capital appreciation, albeit with the highest associated risk and variable returns. They are the true backbone of a company’s ownership and are fundamental for long-term growth and strategic direction. Their value is directly tied to the company’s long-term success and market perception.

Conversely, preference shares represent a hybrid financial instrument that bridges the gap between traditional equity and debt. They offer investors a more stable and predictable income stream through fixed dividends and a superior claim in liquidation compared to ordinary shareholders, but at the cost of control and limited upside potential. This makes them particularly appealing to risk-averse investors seeking regular income, and a useful tool for companies looking to raise capital without diluting control or incurring fixed debt obligations. While both are integral components of a company’s capital structure, their distinct characteristics cater to different investor profiles and corporate financial strategies.