Participating Preference Shares

When it comes to investing in shares, not all are created equal. Beyond the popular equity shares, investors often come across preference shares, a category offering fixed dividends and priority in profit distribution. Among them, participating preference shares stand out as a unique hybrid, blending stability with the potential for extra rewards.

In this blog, we’ll explain what is a participating preference share, how they work, their key features, benefits, drawbacks, and how they differ from non-participating preference shares.

What Is a Participating Preference Share?

A participating preference share is a special type of preference share that gives shareholders the right to receive a fixed dividend and an additional share of the company’s surplus profits. In other words, these shareholders not only enjoy a stable income like regular preference shareholders but can also “participate” in extra earnings when the company performs exceptionally well.

Suppose a company declares a fixed dividend of 10% on its preference shares with a face value of ₹100, which equals ₹10 per share. Later, the company announces an equity dividend of 5% on the face value.

Since the participating preference shares have a clause stating “same as equity dividend,” the preference shareholders are entitled to an additional ₹5 (5% of ₹100) on top of their fixed dividend.

Total dividend for that year = ₹10 (fixed) + ₹5 (participation) = ₹15 per share.

During liquidation, these shareholders may also be entitled to a portion of the remaining assets after all debts and obligations are cleared, once again giving them an advantage over non-participating preference shares.

How do Participating Preference Shares Work?

The process of obtaining and benefiting from participating preference shares typically follows a structured sequence. Here’s how it works, step by step:

1. Issuance of Shares:

• A company raises funds by issuing participating preference shares through an official offering.
• The specific terms, such as the fixed dividend rate, the extent of profit participation, and any other conditions, are clearly outlined in the prospectus or offering document provided to investors.

2. Regular Dividend Payment:

• Investors holding these shares receive their fixed dividends at regular intervals, as per the terms of issue (e.g., quarterly, semi‑annual, or annual). Dividend payment depends on distributable profits approved by the board.
• These payments are made before any dividends are distributed to equity (common) shareholders, ensuring priority income for preference shareholders.

3. Activation of Participation Clause:

• The participation feature becomes active when the company reports profits beyond a certain threshold or achieves earnings higher than expected.
• In such cases, participating preference shareholders are entitled to an additional dividend, which is typically calculated as a percentage of the dividend paid to equity shareholders.

4. Calculation of Additional Dividend:

• The formula or method used to compute the extra dividend varies depending on the specific terms mentioned in the issue document.
• Therefore, it’s essential for investors to review and understand the participation terms carefully, as they determine the potential for earning extra returns in profitable years.

Key Features of Participating Preference Shares

Participating preference shares come with a unique blend of fixed-income stability and performance-based rewards. Below are the key features that define them:

1. Fixed Dividend Rate:

Holders receive a predetermined dividend before any dividend is distributed to equity shareholders. This ensures a steady and predictable income stream, even during moderate profit years.

2. Right to Additional Profits:

Beyond the fixed dividend, participating preference shareholders have the right to share in surplus profits after equity shareholders have received their dividends. This feature distinguishes them from non-participating preference shares, which do not enjoy this benefit.

3. Priority in Dividend and Liquidation:

They hold preferential rights over equity shareholders when it comes to dividend payments and asset distribution during liquidation. This makes them relatively safer compared to ordinary shares.

4. Participation in Residual Assets:

In the event of company liquidation, after paying off debts and obligations, participating preference shareholders may receive a portion of the remaining assets, in addition to their original capital. However, it is important to note that preference shareholders are paid before equity shareholders but after secured and unsecured creditors. Participation in any residual assets depends on the terms of issue.

5. Limited Voting Rights:

Typically, these shareholders do not have voting rights in company matters. Preference shareholders vote on resolutions that directly affect their rights and on winding up/repayment of capital. If dividends remain unpaid for two years, they gain voting rights on all matters until arrears are cleared.

6. Hybrid Nature:

Participating preference shares combine the fixed-income characteristics of preference shares with the profit-sharing potential of equity shares. This makes them a balanced investment option for investors seeking both stability and growth.

7. Defined Terms of Participation:

The extent of participation, how much extra dividend or residual share a holder gets, is clearly stated in the company’s Articles of Association or the share issuance document.

Advantages of Participating Preference Shares

Below are some of the key advantages that make participating preference shares attractive to both investors and companies:

1. Dual Benefit of Fixed and Additional Returns: Investors receive a fixed dividend regularly, ensuring income stability. In addition, they can earn extra dividends when the company reports higher-than-expected profits, providing an opportunity for increased returns.

2. Priority in Profit and Asset Distribution: Participating preference shareholders are paid before equity shareholders when dividends are declared. In case of liquidation, they have priority claims over the company’s assets, making them a safer investment compared to ordinary shares.

3. Attractive for Conservative Investors: These shares appeal to investors who prefer low-risk, income-generating instruments but still want a chance to benefit from the company’s growth. They offer a balanced mix of security and performance-based upside.

4. Stability During Market Volatility: Since participating preference shares offer fixed dividends, investors enjoy consistent earnings even during periods of market fluctuation or slow business performance.

Note: It’s important to note that participating preference shares are relatively uncommon in public markets; they are more typical in private deals or specific corporate financing structures where customised terms can be negotiated.

5. Enhanced Investor Confidence: The combination of fixed dividends and the potential for additional participation can enhance investor confidence and make these instruments appealing to long-term investors.

6. Corporate Advantage: For companies, issuing these shares allows them to raise capital without giving away full ownership control, unlike equity shares. It also helps maintain financial flexibility while rewarding loyal investors during profitable periods.

Disadvantages of Participating Preference Shares

While participating preference shares offer several benefits, they also come with certain limitations that investors and companies should consider before investing or issuing them. Here are the key disadvantages:

1. Limited or No Voting Rights:

Participating preference shareholders typically do not have voting rights in the company’s management decisions. They can only vote in specific situations, such as when dividends remain unpaid for a defined period. This limits their influence over company policies.

2. Variable Returns Based on Company Performance:

Although investors enjoy fixed dividends, the additional profit participation depends on the company’s financial performance. If the company fails to generate surplus profits, investors receive only the fixed dividend, reducing the potential upside.

3. Complex Valuation and Terms:

The terms of participation, like the percentage of extra dividend or profit-sharing ratio, vary across companies. This can make it difficult for investors to compare or assess the true value of participating preference shares.

4. Lower Returns in Poor Market Conditions:

During periods of low profitability, investors may earn less compared to equity shareholders, who might still benefit from share price appreciation.

5. Higher Cost of Capital for Companies:

From the company’s perspective, issuing participating preference shares can be more expensive than non-participating preference shares due to the additional dividend obligations during good financial years.

6. Dividend Payments Are Not Guaranteed:

While preference shareholders have priority, dividend payments are not obligatory if the company has insufficient profits or faces liquidity constraints. And subject to profits and board declaration.

7. Execution and Liquidity Risks:

Participating preference shares often come with complex terms and conditions, making them harder to analyse or price accurately. Additionally, if these shares are not actively traded, investors may face illiquidity risk, meaning it could be difficult to sell them at a fair price when needed.

Difference Between Participating and Non-Participating Preference Shares

While both participating and non-participating preference shares fall under the broad category of preference shares, they differ in how profits and surplus assets are shared.

Conclusion

Now that you understand what are participating preference shares, it’s easy to see why they’re considered a hybrid between debt-like stability and equity-like growth. These shares appeal to investors who prefer steady dividends with a chance to benefit from company success.

However, like any investment, they’re not entirely risk-free. It’s essential to compare them with non-participating preference shares, equity shares, and other types of shares before deciding.

FAQs

1. What are non-participating preference shares?

Non-participating preference shares entitle holders only to a fixed dividend and repayment of capital upon liquidation. They do not receive any share of surplus profits or residual assets.

2. What is a participating shareholder?

A participating shareholder is an investor who holds participating preference shares and thus receives both fixed dividends and a portion of surplus profits.

3. How are participating preference shares different from ordinary preference shares?

Ordinary (non-participating) preference shares offer only fixed dividends, whereas participating ones allow additional participation in profits.

4. Do participating preference shareholders have voting rights?

Generally, they do not have voting rights, except under special circumstances, like when dividends remain unpaid for a specified period.

5. Are participating preference shares risk-free?

No investment is entirely risk-free. While these shares offer dividend security and liquidation preference, their additional profit participation depends on company performance.

6. Why would investors choose participating preference shares?

Investors prefer them for their combination of fixed income and potential for higher returns when the company performs well, making them suitable for balanced investment strategies.