Understanding what preference shares are is essential for any UK business owner, investor, or entrepreneur looking to structure their company’s share capital and fund-raising efforts effectively. In this comprehensive guide, I break down everything you need to know about preference shares under UK law, from their fundamental characteristics to their strategic advantages and potential drawbacks.

Chapter 1: What Are Preference Shares?

In my years advising UK businesses on equity structures, preference shares have consistently proven to be one of the most versatile tools in corporate finance. But what exactly are they, and why should you consider them for your company?

The Definition of Preference Shares

Preference shares (sometimes called “preferred shares” or “preferred stock”) are a class of share that gives the holder certain preferential rights over other classes of shares. These preferential rights are usually detailed in the company’s articles of association and typically relate to priority in dividend payments, capital distribution on a winding up, or both. Preference shares are usually structured to provide investors with fixed-income security, offering stability and predictable income, and generally rank above ordinary shares in terms of dividends or capital return.

In short, it means that owners of preference shares are guaranteed a certain amount of dividends every year, and would usually be paid first (before any other shareholders) if the company goes insolvent.

According to HMRC’s Corporate Finance Manual, preference shares “do not normally give the holder the right to vote” and “carry a right to a fixed dividend so the preference shareholder does not benefit proportionately if the company’s profits increase,” meaning that even if company profits rise, preference shareholders do not receive additional dividends beyond the fixed amount. This creates a fundamentally different investment profile compared to ordinary shares.

It’s important to note that every company can decide how to structure their preference shares, so the above is not a fixed way that we cannot deviate from. With my clients, I usually try to stay away from stereotypical definitions of share classes and simply focus on what they would like their different classes of shares to look like.

Key Characteristics Under UK Law

As mentioned above, and as confirmed by the Companies Act 2006, companies have significant flexibility in how they structure preference shares. The specific rights attached to these shares are usually clearly set out in the company’s articles of association. Common characteristics of preference shares include:

•       Fixed dividend rights: Preference shareholders typically receive payment of a predetermined dividend (for example, 8% of the subscription price per annum) before any dividends are paid to ordinary shareholders. Receiving dividends in this priority manner is a key benefit of holding preference shares.

•       Priority on liquidation: In the event of a company winding up, preference shareholders are entitled to receive their capital back before ordinary shareholders.

•       Limited or no voting rights: Unlike ordinary shares, preference shares usually carry no voting rights at general meetings, though this can vary. In short, an investor puts in money with the right to be paid fixed dividends, but does not have a say in how the business is run.

•       Cumulative or non-cumulative dividends: If dividends cannot be paid in one year, cumulative preference shares allow those unpaid dividends to accumulate and be paid in future years. This is a key difference to using a loan instead of preference shares, because if you miss interest payments under a loan the lender can take serious action against the company.

Preference shares can generally be divided into four categories, each with distinct features and rights, which will be discussed in the next section. As mentioned above, share classes are very flexible and you can combine any of the below elements as you wish (within the bounds of the law)

For a deeper understanding of how share capital works more broadly, I recommend reading my guide on Share Capital Explained: Issued Capital, Nominal Value & Share Premium.

Types of Preference Shares

There are several variations of preference shares, each designed to meet different commercial objectives:

•       Cumulative preference shares: Also known as cumulative preferred or cumulative preferred stock, if the company cannot pay the fixed dividend in any given year, the entitlement accumulates and must be paid before any dividends to ordinary shareholders in subsequent years. All unpaid dividends must be paid before any payment to ordinary shareholders.

•       Non-cumulative preference shares: Also called non cumulative preferred stock, if a dividend is not paid in a particular year and the company chooses not to pay, that entitlement is lost and does not carry forward. Shareholders cannot claim unpaid dividends at a later stage.

•       Redeemable preference shares: The company can buy back these shares at a future date on predetermined terms. Sometimes, these can also be structured so that the investor can trigger the buyback, demanding that the company buy back his shares and return his investment. For more on this, see my comprehensive guide on Redeemable Shares.

•       Convertible preference shares: Also referred to as convertible preferred stock, these can be exchanged for ordinary shares after a certain date, subject to the terms set out when the company issues the shares. My guide on Convertible Shares covers this in detail.

Preference shares can be attractive to investors seeking fixed income investments, as they offer priority over ordinary shares in dividend payments and, in some cases, liquidation. Additionally, dividends from preference shares may benefit from preferential tax treatment compared to bond interest.

Chapter 2: What’s the Difference Between Preference Shares and Ordinary Shares?

Understanding the distinction between preference shares and ordinary shares is crucial for structuring your company’s equity effectively. While both represent ownership in a company, they confer fundamentally different rights and carry different risk profiles. Ordinary shareholders (holders of ordinary shares) have lower priority in dividend payments and asset distribution compared to preferred shareholders, who enjoy preferential rights to dividends and claims on assets in the event of liquidation.

Comprehensive Comparison Table

The following table summarises the key differences between preference shares and ordinary shares, according to how they are usually structured:

To lear about Good and Bad Leaver provisions, especially in the context of founders, managers and employees, read this blog.

Dividend Priority Explained

One of the most significant differences lies in dividend priority. As the HMRC Stamp Taxes Manual explains, preference shareholders “have prior rights to dividends that rank above those of the holders of ordinary shares.” This means that if a company declares a dividend, preference shareholders must receive their full entitlement before ordinary shareholders receive anything.

For ordinary shareholders, dividend payments are entirely discretionary and depend on the company’s profitability and the directors’ decision to declare a dividend. To understand more about ordinary shares, read my detailed guide on What Are Ordinary Shares? A Complete Guide Under the UK’s Companies Act 2006.

Voting and Control Implications

The absence of voting rights for preference shareholders has important strategic implications. Companies often use preference shares to raise capital from investors without diluting the voting control of existing ordinary shareholders. This makes preference shares particularly attractive for:

•       Family businesses: Where founding family members wish to bring in external capital whilst retaining decision-making control.

•       Venture capital investments: Where investors want preferential returns and downside protection but may accept limited governance rights.

•       Management buyouts: Where preference shares can structure the financing without giving excessive control to financial investors.

Chapter 3: Advantages and Disadvantages of Preference Shares

Like any financial instrument, preference shares come with their own set of benefits and drawbacks. Understanding these is essential for making informed decisions about whether they suit your company’s needs or your investment strategy.

Advantages for Companies Issuing Preference Shares

1. Raising Capital Without Diluting Control

Since preference shares typically carry no voting rights, existing shareholders can raise substantial capital without giving up decision-making power. This is particularly valuable for owner-managed businesses seeking growth funding.

2. Flexible Dividend Obligations

Unlike interest payments on debt, which must be paid regardless of profitability, preference dividends can be deferred if the company lacks sufficient distributable profits. This provides greater financial flexibility during challenging periods.

3. Attractive to Risk-Averse Investors

The fixed dividend and priority on liquidation make preference shares attractive to investors who want more security than ordinary shares offer but potentially better returns than debt instruments.

4. Exit Mechanism Through Redemption

Redeemable preference shares provide a built-in exit strategy for investors, making them easier to market to sophisticated investors such as venture capital funds and institutional investors.

Advantages for Investors Holding Preference Shares

1. Predictable Income Stream

The fixed dividend rate provides certainty of income, similar to bond interest payments. This makes preference shares suitable for income-focused investment strategies.

2. Priority Over Ordinary Shareholders

In a liquidation scenario, preference shareholders receive their capital back before ordinary shareholders. This provides meaningful downside protection, particularly in distressed situations.

3. Potential for Conversion

Convertible preference shares offer the best of both worlds: steady income with the option to participate in the company’s growth by converting to ordinary shares if the business performs well.

Disadvantages for Companies

1. Fixed Dividend Commitment

The expectation to pay dividends can create an ongoing financial obligation that can strain cash flow, particularly for growing companies that need to reinvest profits. This is as opposed to issuing ordinary shares (which, although, usually dilute ownership and voting rights).

2. Complexity in Capital Structure

Having multiple share classes complicates company administration, shareholder communications, and corporate governance. The articles of association must clearly define each class’s rights, and any variation requires formal procedures under the Companies Act 2006. This is usually not a major issue if you instruct a specialist corporate solicitor (like myself).

3. Accounting Treatment Considerations

Depending on their terms, preference shares may be classified as financial liabilities rather than equity under accounting standards (FRS 102 or IFRS). As HMRC’s Corporate Finance Manual notes, if preference shares are mandatorily redeemable, they may be treated as debt on the balance sheet, affecting financial ratios and covenant compliance. You will need advice from your accountant when it comes to complying with these aspects.

Disadvantages for Investors

1. Limited Upside Potential

Unlike ordinary shares, preference shareholders typically do not benefit from the company’s growth beyond their fixed dividend. If the company’s value increases significantly, preference shareholders may miss out on substantial capital gains.

2. No Voting Rights

The absence of voting rights means preference shareholders have no say in major corporate decisions, even those that might affect their investment. They cannot vote on director appointments, major transactions, or changes to the company’s constitution.

3. Subordination to Creditors

While preference shareholders rank ahead of ordinary shareholders, they still rank behind all creditors (including banks, trade creditors, and bondholders) in a liquidation. In an insolvent liquidation, preference shareholders may receive nothing despite their “preferential” status.

When Should You Consider Preference Shares?

Based on my experience advising UK businesses, preference shares are particularly well-suited for the following scenarios:

•       Equity fundraising: When you need to raise capital but want to maintain control of your business.

•       Family succession planning: To transfer wealth to the next generation whilst retaining operational control.

•       Investor protection: When investors require downside protection and priority returns.

•       Management incentivisation: Combined with ordinary shares, preference shares can create effective equity incentive structures.

Need Help Structuring Your Share Capital?

Structuring preference shares correctly requires careful consideration of your commercial objectives, the rights you wish to confer, and compliance with the Companies Act 2006. As a specialist corporate solicitor, I regularly advise UK businesses on creating bespoke share classes tailored to their specific needs. If you’re considering issuing preference shares or restructuring your company’s share capital, I invite you to speak with a corporate lawyer at Zoppi & Co for a no-obligation discussion about how we can help.

Conclusion

Understanding what preference shares are and how they differ from ordinary shares is fundamental knowledge for any UK business owner, investor, or entrepreneur. While preference shares offer significant advantages – including priority dividends, liquidation preferences, and the ability to raise capital without diluting control – they also come with limitations, particularly around growth participation and voting rights.

The key to using preference shares effectively lies in tailoring their terms to your specific commercial objectives. Whether you’re structuring a venture capital investment, planning family succession, or creating management incentives, the flexibility offered by UK company law allows for creative and bespoke solutions.

As always, I recommend seeking professional legal advice before making decisions about your company’s share capital structure. The consequences of getting it wrong can be significant, but with proper planning, preference shares can be a powerful tool in your corporate finance toolkit.