Shares of a Company: 4 Types | Financial Management

The following points highlight the four main types of shares offered by a company. The types are: 1. Equity Shares 2. Preference Shares 3. Non-Voting Shares (NVS) 4. Other Forms of Shares.

Type # 1. Equity Shares:

An equity interest in a company may be said to represent a share of the company’s assets and a share of any profits earned on those assets after other claims have been met. The equity shareholders are the owners of the business; they purchase shares, the money is used by the company to buy assets, the assets are used to earn profits, which belong to the ordinary shareholders.

After satisfying the rights of preference shares, the equity shares shall be entitled to share in the remaining amount of distributable net profits of the company. The dividend on equity shares is not fixed and may vary from year to year depending upon the amount of profits available.

The rate of dividend is recommended by the board of directors of the company and declared by shareholders in the annual general meeting. Equity shareholders have a right to vote on ever}’ resolution placed in the meeting and the voting rights shall be in proportion to the paid-up capital. As a source of long-term finance, ordinary shares carry a number of advantages and disadvantages for a company.

Advantages:

The advantages from raising capital through issue of equity shares are as follows:

i. There are no fixed charges attached to ordinary shares. If a company generates enough earnings it will be able to pay a dividend but there is no legal obligation to pay dividends.

ii. Ordinary shares carry no fixed maturity.

iii. They provide a cushion against losses for creditors, thus the sale of ordinary shares rather than other securities increases the creditworthiness of the firm.

iv. Ordinary shares can often be sold more easily than debentures.

v. Returns from the sale of ordinary shares in the form of capital gains are subject to capital gains tax rather than corporation tax.

Disadvantages:

The disadvantages of equity shares are summarized as follows:

a. The sale of ordinary shares extends voting rights or control to the additional shareholders who are brought into the company.

b. More ordinary shares give more people the right to share with the existing owners in the company profits.

c. The costs of underwriting and distributing new issues of ordinary shares are usually higher than those for underwriting and distributing preference shares or debentures.

d. If the firm has more equity or less debt than is called for in the optimum capital structure, the average cost of capital will be higher than necessary.

e. Dividends payable to ordinary shareholders are not deductible as an expense for the purpose of corporation tax but debenture interest is deductible.

Type # 2. Preference Shares:

Preference shares is a hybrid security because it has features of both ordinary shares and bonds. Preference shareholders have preferential rights in respect of assets and dividends. In the event of winding up the preference shareholders have a claim on available assets before the ordinary shareholders. In addition, preference shareholders get their stated dividend before equity shareholders can receive any dividends.

The dividends on preference shares are fixed and they must be declared as per legal obligation exists to pay them. The fixed nature of dividend is similar to that of interest on debentures and bonds. The declaration feature is similar to that of equity shareholders dividends.

As a hybrid security, the use of preference shares is favoured by circumstances that fall between those favouring the use of ordinary shares and those favouring the use of debentures. The costs of preference share financing follow interest rate levels more than ordinary share prices; in other words, when interest rates are low, the cost of preference shares is also likely to be low.

The companies will issue preference shares when they seek the advantage financial gearing but fear the dangers of the fixed charges on debt in the face of potential fluctuations in income. If debt ratios are already high or the costs of equity financing are relatively high, the case for using preference shares will be strengthened.

Advantages:

The major advantages to the issuing preference shares to the company are:

a. The obligation to pay fixed rate of interest on the security is not binding in the same way as it is with debentures.

b. Preference shares enable the company to avoid dilution of equity capital which occurs when additional ordinary shares are issued.

c. They also permit a company to avoid sharing control through participation in voting.

d. Since many preference shares are irredeemable, they are more flexible than debentures.

The major disadvantage is that dividends paid to preference shareholders are not tax-deductible, consequently the true cost to a company of preference shares is far greater than the cost of debentures.

Forms of Preference Shares:

The general forms of preference shares are as follows:

i. Cumulative and Noncumulative Preference Shares:

Tie cumulative preference share gives a right to demand the unpaid dividend of any year, during the subsequent years when the profits are ample. All preference dividends arrears must be paid before any dividends can be paid to equity shareholders. The noncumulative preference share carry a right to a fixed dividend out of the profits of any year. In case profits are not available in a year, the holders get nothing, nor can they claim unpaid dividends in subsequent years.

ii. Cumulative Convertible Preference Shares:

The cumulative convertible preference (CCP) share is an instrument that embraces features of both equity shares and preference shares, but which essentially is a preference share. The CCPs are convertible into equity shares at a future specified date at a predetermined conversion rate.

Once it is converted into equity shares, it posses all the characteristics of an equity share. Since the CCP share capital would constitute a class of shares, distinct from purely equity and purely preference share capital, the rights of the instrument holders must be stated either in a general body resolution or in the articles of association or in the terms of issue in the offer document viz., prospectus/letter of offer.

iii. Participating and Nonparticipating Preference Shares:

Participating preference shares are those shares which are entitled to a fixed preferential dividend and, in addition, carry a right to participate in the surplus profits along with equity shareholders after dividend at a certain rate has been paid to equity shareholders.

Again, in the event of winding up, if after paying back both the preference and equity shareholders, there is still any surplus left, then the participating preference shareholders get additional share in the surplus assets of the company.

Unless expressly provided, preference shareholders get only the fixed preferential dividend and return as to capital in the event of winding up out of realized values of assets after meeting all external liabilities and nothing more. The right to participate may be given either in the memorandum or articles or by virtue of their terms of issue.

iv. Redeemable and Irredeemable Preference Shares:

Subject to an authority in the articles of association, a public limited company may issue redeemable preference shares to be redeemed either at a fixed date or after a certain period of time during the life time of the company. The Companies Act, 2013 prohibits the issue of any preference share which is irredeemable or is redeemable after the expiry of a period of twenty years from the date of issue.

Type # 3. Non-Voting Shares (NVS):

NVS, as an innovative instrument for raising funds, although prevalent in many developed countries for years. The non-voting shares are closely akin to preference shares which do not carry any voting rights nor is the dividend payable predetermined. However, unlike preference capital, non-voting shares do not carry a predetermined dividend.

The payoff to the investor for the assumption of higher risk levels and the compensation for loss of control is high rate of dividends payable to them. NVS can be found useful by companies which are shy of exposure over leveraged companies, new companies and closely held companies. It may find favour with small investors, nonresident Indians, overseas corporate bodies, mutual funds etc.

The investor gains in terms of higher dividends, purchase at advantageous low price, liquidity and capital appreciation. Under Indian Law, it is not possible for the public limited company in India to issue non-voting shares. Subscribers of such shares have no voting rights and in the process it is almost like preference shares but without any right on dividend.

However, when companies issue such non-voting shares a suitable compensation either in the form of discount in offer price or additional dividend is offered to the subscribers. So far no company has issued such shares, some companies may issue such shares in the future.

Advantages various advantages envisaged for corporate and investors could be as follows:

a. Promoters of companies are likely to find favour with this instrument since it protects their controlling interest.

b. A large number of average investors who hardly exercise their voting rights, especially in the case of companies, with a good dividend track record, or otherwise would find non-voting shares of well-managed companies.

c. NVS can also be used for investment by nonresident Indians/eligible corporate bodies in excess of the portfolio investment limits prescribed for them.

d. The mobilization of funds through this instruments would also help companies to reduce their debt-equity ratio and thereby enhance their financial health and profitability. It will give them more leverage.

e. Increased borrowing power may be granted to companies with low cost of capital.

f. It will give a new financial tool to the management who do not want to shed their control or voting rights, as it enables the promoters to retain control over management while expanding equity base.

Disadvantages:

The NVS suffers from the following drawbacks:

i. Foreign institutional investors and overseas corporate bodies may not be much interested in NVS because in case of liquidation, non-voting shareholders will not enjoy the same rights as equity shareholders do.

ii. NVS on one side provide attraction to the issues but it is an expensive option. The shares remain a permanent liability and may become voting shares by default. Investors have no power to challenge management, will face reduced earning per share and then, there is no guarantee of dividend payment.

iii. Investors may fall prey to the not so consistent profit making companies and there may not be an adequate exit route available to investors in case of poor performing companies.

iv. The creation of new class of equity i.e. NVS will certainly have adverse impact on the earnings of the other members who own equity shares with voting right.

v. Since, the quantum to be distributed as dividend will be higher in the case of NVS, the profits will also get reduced to that extent and correspondingly transfer to reserves may go down.

Type # 4. Other Forms of Shares:

Sweat Equity Shares:

Under section 54 of the Companies Act, 2013, a company can issue sweat equity shares to its employees or directors at discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value addition etc. on the following conditions:

i. The issue of sweat equity shares is authorized by a special resolution passed by the company in the general meeting.

ii. The resolution specifies the number of shares, current market price, consideration, if any, and the class or classes of directors or employees to whom such equity shares are to be issued.

iii. The company is entitled to issue sweat equity shares only after completion of one year from the date of commencement of business.

iv. The equity shares of the company must be listed on a recognized stock exchange.

v. The issue of sweat equity shares must be in accordance with the regulations made by SEBI in this behalf.

vi. An unlisted company can issue sweat equity shares in accordance with the prescribed guidelines made for this purpose.

vii. All the limitations, restrictions and provisions relating to equity shares shall be applicable to sweat equity shares.

Puttable Common Shares:

Some companies in US and West have issued puttable common shares in which the holders of the equity shares have right to surrender the equity shares at a predetermined price on a predetermined date. It is somewhat equal to buyback of shares or selling puts. Good companies gain by charging more premium for such shares because of less risk associated with such shares. There is no loss to the company since the shareholders will not exercise their right if the company performs well. Companies like INTEL have issued ‘put option’ shares instead of puttable common shares.

Tracking Stocks:

Dr JJ Irani headed for the expert committee constituted by the Government on Company Law has recommended a novel instrument called ‘tracking stocks’ for introduction in the Indian Capital Market. A tracking stock is a type of common stock that ‘tracks’ or depends on the financial performance of a specific business unit or operating division of a company, rather than the operations of the company as a whole.

As a result, if the unit or division performs well, the value of tracking stocks may increase, even if the company’s performance as a whole is not up to mark or satisfactory. The opposite may also be true. A tracking stock is a special type of stock issued by a publicly held company to track the value of one segment of that company.

By issuing a tracking stock, the different segments of the company can be valued differently by the investors. Tracking stocks are issued by a parent company in order to create a financial vehicle that tracks the performance of a particular division or subsidiary. Tracking stocks carries divided rights tied to the performance of a targeted division without transferring ownership or control over the divisional assets.