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  • Writer's pictureRajvin Singh Gill

Utilising Preference Shares to raise funds

Updated: Jun 27, 2023

Raising Funds

If a company requires additional capital to maintain its operations or boost its development, it can opt for two methods: either by issuing shares to raise equity or by taking on debt through loans. Alternatively, the company may choose a hybrid approach, such as issuing preference shares that combine characteristics of both equity and debt, to secure funding.

If a company is in its initial stages and lacks a demonstrated record of its business model, it may encounter challenges in securing a loan from a bank. Conversely, if the company decides to raise funds through equity, it could result in a reduction in the founders' or current shareholders' ownership stakes, which may ultimately diminish their control over the company.


Hence, Preference Shares

Preference shares present a desirable option that allows founders to access capital without surrendering their hold on the company, while also guaranteeing investors priority in receiving returns on their investment through dividend payments and, in the event of liquidation, priority in receiving distributions.


Section 2 of the Companies Act 2016 of Malaysia defines “preference share” as “a share, by whatever name called, which does not entitle the holder to the right to vote on a resolution or to any right to participate beyond a specific amount in any distribution whether by way of dividend, or on redemption, in a winding-up, or otherwise.”


From the company's perspective

Advantages:

Retaining control: By utilizing preference shares, the founders or current shareholders can maintain their authority over the company because (i) the issuance of preference shares does not dilute their voting rights, and (ii) preference shareholders are typically not authorized to vote except in specific situations that concern them.


No security needed to be offered: When obtaining financing through a loan, it is common for collateral or security to be necessary, which could come in the form of a debenture, charge, or mortgage over the company's assets. Alternatively, a corporate guarantee from the parent or holding company, or personal guarantees from the company's directors may be required. On the other hand, preference shares are typically issued without such security requirements, allowing a company to obtain funds without having to pledge or create any security over its or its shareholders' assets.


No negative covenants or pledges: In contrast to a loan, there are no commitments or negative pledges that the company must follow when utilizing preference shares. Therefore, the company can operate and manage its affairs without the constraints typically included in financial agreements.


No fixed liability: Unlike with loans, where interest must be paid regardless of the company's profitability, preference shares do not impose a mandatory dividend payment. Therefore, if the company is experiencing losses and no dividend is declared, it is not obligated to pay out any dividends and will not incur any liability. In such instances, the company can maintain sufficient reserves to ensure its financial stability. In situations where the company is facing financial difficulties, it may defer dividends related to cumulative preference shares, meaning that the preference shareholder's entitlement to a dividend for one year may be carried over to the following year.


Lower debt-to-equity ratio: Utilizing equity financing will reduce the company's debt-to-equity ratio, which will present a positive perception of a well-managed company. A high debt-to-equity ratio would suggest that the company's financial position is unstable and thus considered risky. If a company is excessively leveraged, it will likely face challenges when it comes to growth and expansion, as servicing their debt obligations will come at a high cost.


Disadvantages:


Higher rate: Typically, the dividend rate on preference shares is higher than the interest rate on loans, so companies tend to seek loans from lenders first before considering raising funds from investors through preference shares. If a company issues preference shares, it will have to pay dividends at rates that exceed the interest charged by banks.


Accumulation: When it comes to cumulative preference shares, any unpaid or deferred dividends must be paid, which could become a financial burden on the company.


Dividend payment not a productive purpose: The company may be obligated to pay the dividend owed to preference shareholders, even if doing so limits the funds available for the ongoing needs of the business.


Financial status affected: The presence of preference shares may impact the company's creditworthiness, potentially deterring prospective buyers if the terms of the preference shares are unfavorable.



Investor's viewpoint

There are pros and cons to holding preference shares from an investor's viewpoint. The main benefit is that preference shareholders receive dividends before common shareholders. On the other hand, the major drawback is that preference shareholders don't have the right to vote in the company


Advantages:

Priority in dividend payments: Preference shareholders are entitled to receive dividend payments before ordinary shareholders, and cumulative preference shares allow the deferral and accumulation of unpaid dividends when the company is not profitable. When the company becomes profitable, any accumulated unpaid dividends must be paid to preference shareholders before any dividends are distributed to ordinary shareholders.


Attractive dividend: Investors may perceive preference shares with a high and/or fixed dividend rate as a favorable investment opportunity


Appealing features: Preference shares that offer redeemable, convertible (to ordinary shares), and participative features provide investors with the opportunity to participate in the company's growth and are thus seen as a potentially profitable option, particularly when the company's value increases.


Dividend received not taxable: According to the Income Tax Act 1967, capital gains on shares are not taxed. However, if shares are traded frequently, the tax authority may view the gains as revenue gains and subject them to taxation. Despite this, investors are not taxed on dividend yields since the dividends have already been taxed at the company level as a final tax..


Priority in liquidation: Preference shareholders have a priority claim on the company's assets in the event of liquidation and winding-up.


Disadvantages:

No voting rights: Preference shareholders do not typically have the right to vote, unless it pertains to specific matters such as the winding-up process, issues that arise during the winding-up, selling the entirety of the company's assets or business, unpaid dividends, reducing the company's share capital, or any proposals that affect the rights attached to the preference shares


Dividend declaration not certain: The payment of dividends on preference shares is not guaranteed and may be sporadic, leading to uncertainty in potential earnings and returns for investors.


Risk of winding-up: A company that lacks sufficient funds to grow or maintain operations faces a high risk of insolvency, liquidation, or closure. In such cases, secured creditors such as lending banks would have priority in receiving payment in the event of liquidation





How does my company start issuing preference shares?

To issue preference shares, a company must have provisions for it in its constitution. The following steps are typically taken for the issuance of preference shares:


(1) Negotiate and document the agreed terms and features of the preference shares in a subscription agreement.


(2) Take note of any pre-emptive rights, which are the offer of new shares to existing shareholders first, and exercise these rights according to Section 85 of the Companies Act 2016, the constitution, or the shareholders agreement, etc.


(3) Pass a resolution of shareholders in a general meeting to amend the company's constitution to incorporate the features of the preference shares.


(4) Pass a resolution of the board of directors to amend the company's constitution to incorporate the features of the preference shares.


(5) Pass a resolution of shareholders in a general meeting to authorize the board of directors to issue the preference shares.


(6) Pass a resolution of the board of directors for the allotment and issue of the preference shares.


(7) Issue certificates for the preference shares to each of the preference share subscribers, if required.


In a nutshell

The benefits and drawbacks of issuing and holding preference shares vary based on the specific terms of those shares. These terms will dictate the return on investment and have substantial consequences for the company, its founders, and existing shareholders. Any errors in negotiation or improperly drafted terms can result in severe outcomes for the company and its shareholders. Therefore, if a company plans to issue preference shares, all parties involved should have a thorough understanding of the rights associated with those shares

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