Types of Equity Securities

Unlike debt securities, equity securities do no impose an obligation on the issuer to repay the amount financed. Instead, shareholders act as owners of a company with a claim on the company’s net assets and expect that management will act in the shareholders’ best interests. Equities can be split into two main categories: common securities and preference securities.

Common Shares

Common shares represent an ownership interest in a company. Similar to preferred shareholders, common shareholders have a claim to the company’s net assets in the event of a liquidation. Unlike preferred shareholders, however, common shareholders share in the company’s operating performance and participate in the governance process through voting rights. Since it is often not feasible for common shareholders to attend shareholder meetings in person, they can designate another party to vote for them (vote by proxy). Statutory dictates that each share represents one vote, while cumulative voting is often used to allow smaller shareholders to vote multiple times for a single candidate with each share.

A company can issue multiple common shares with different voting rights and/or other ownership rights. For example, callable common shares give the issuing company the option of buying back the shares at a certain price (typically done when market price rises above strike price), and putable common shares give investors the option of selling back to the company at a certain price (typically when the market price drops below strike price).

Preference Shares

Preference shares have priority to common shares with respect to the payment of dividends and claim on net assets upon liquidation but do not share in the company’s operating performance and do not typically have voting rights. While preference shares differ from debt securities in that the issuing company is not obligated to pay dividends, preference share dividends are often fixed like interest payments on debt securities and generally yield more than dividends paid on common shares.

With cumulative preference shares, the accrued preference dividend payments must be paid before any dividends go out to common shareholders. With participating preference shares, shareholders receive an additional dividend if the company’s profits exceed a pre-specified level. Preference shares may also be convertible, meaning they can be converted into common shares at a certain ratio determined at issuance.

Question

What is the most likely reason for an investor to choose a company’s preference shares over its common shares?

1. The preference shares offer increased voting rights.
2. The preference shares usually have a higher dividend yield than the common shares.
3. The preference shares give the investor more exposure to the company’s upside potential.

Solution

The correct answer is B.

The preference shares usually have a higher dividend yield than the common shares to make up for the fact that they don’t offer voting rights.

A is incorrect. Preference shares usually do not have voting rights.

C is incorrect. Since even participating preference shares offer limited upside potential, common shares should offer investors more exposure on the upside.