Share capital forms the cornerstone of a company’s financial foundation. It provides the necessary funds for business operations, expansion, and sustenance. Share capital can be broadly categorized into two types: preference share capital and equity share capital. Each plays a distinct role in determining how profits are shared, how capital is returned, and how control is exercised. Preference share capital, by its very nature, offers specific privileges over equity share capital. We explores the detailed concept of preference share capital, its features, classification, and associated statutory provisions under the Companies Act, 2013.
Meaning of Preference Share Capital under Companies Act, 2013
According to Section 43 of the Companies Act, 2013, share capital of a company limited by shares is classified into equity share capital and preference share capital. As per Section 43(2), preference share capital refers to the portion of issued capital that carries preferential rights in comparison to equity shares. These preferential rights relate to two primary aspects:
- The right to receive dividends, either at a fixed amount or fixed rate, before any dividend is distributed to equity shareholders.
- The right to the return of capital in case of liquidation or winding up of the company, before any distribution is made to equity shareholders.
These preferential rights offer a sense of financial security and predictability to investors, making preference shares a hybrid form of financing between debt and equity.
Key Characteristics of Preference Shares
Preference shares possess several unique features that distinguish them from other types of capital instruments. These include:
- Fixed rate of return: Preference shareholders receive dividends at a predetermined rate.
- Priority over equity shareholders: In dividend payments and capital repayment during liquidation, preference shareholders are given preference.
- Limited participation in management: Generally, preference shareholders do not enjoy voting rights on ordinary matters.
- Fixed maturity: Redeemable preference shares must be repaid within a stipulated period.
- Hybrid nature: Preference shares blend the characteristics of both debt (fixed return) and equity (ownership interest).
Classification Based on Dividend Rights
Preference shares can be categorized based on their dividend treatment. The two primary classifications are cumulative preference shares and non-cumulative preference shares.
Cumulative Preference Shares
Cumulative preference shares provide a right to accumulate unpaid dividends. If the company does not earn enough profit in a particular financial year to pay the declared dividend, the unpaid amount is carried forward to subsequent years. These arrears must be cleared before any dividend is paid to equity shareholders. Cumulative preference shares are thus beneficial for investors seeking assured returns over time, even if those returns are deferred.
For example, if a company is unable to pay dividends for two consecutive years due to insufficient profits but earns adequate profit in the third year, it must first pay all outstanding dividends to cumulative preference shareholders before paying anything to equity shareholders.
Non-Cumulative Preference Shares
Non-cumulative preference shares, in contrast, do not carry the benefit of dividend accumulation. If the company does not declare dividends in any financial year due to lack of profits or a board decision, shareholders forfeit their dividend for that year. There is no carry forward, and unpaid dividends lapse.
As a result, these shares are riskier than cumulative shares but may offer a slightly higher dividend rate to attract investors. This type of preference share is suited for companies with consistent profit generation and investors who are comfortable with a degree of uncertainty in returns.
Legal Framework for Issuing Preference Shares
The Companies Act, 2013 lays down specific provisions regarding the issue and treatment of preference share capital. Section 55 of the Act governs the issuance, redemption, and restrictions concerning preference shares.
Prohibition on Irredeemable Preference Shares
Section 55(1) mandates that companies limited by shares cannot issue irredeemable preference shares. All preference shares must be redeemable. This provision ensures that the liabilities associated with preference share capital are time-bound and do not perpetually burden the company.
Conditions for Issuing Redeemable Preference Shares
According to Section 55(2), companies may issue redeemable preference shares provided the following conditions are met:
- The articles of association must authorize the issuance.
- Redemption must occur within a maximum period of twenty years from the date of issue.
- Redemption can be done only out of profits available for dividend distribution or from the proceeds of a fresh issue of shares.
- A capital redemption reserve account must be created if the redemption is made out of distributable profits.
These provisions are designed to ensure that the redemption process does not affect the financial health of the company or compromise the interests of other stakeholders.
Special Provisions for Infrastructure Projects
An exception is made for companies engaged in infrastructure projects. These companies are allowed to issue preference shares with a redemption period exceeding twenty years but not exceeding thirty years. However, such companies are required to redeem at least ten percent of the total issued preference shares annually starting from the twenty-first year. This ensures a gradual and proportional redemption process, balancing long-term funding needs with shareholder interests.
The definition of infrastructure projects is provided in Schedule VI of the Companies Act, 2013. It includes sectors such as power generation, transportation, urban infrastructure, and telecommunication.
Conversion of Equity Shares into Redeemable Preference Shares
One of the complex legal issues that arise in capital structuring is whether already issued equity shares can be converted into redeemable preference shares. This question has been addressed in judicial pronouncements and legal practice.
In the cases of Chowgule & Co. (P.) Ltd. and St. James Court Estates Ltd., it was held that such a conversion constitutes a fundamental alteration of the nature of the shareholding. Therefore, the conversion process must comply with the procedure for reduction of share capital as laid out in Section 66 of the Companies Act, 2013.
Procedure for Capital Reduction
Reduction of share capital involves the following key steps:
- Authorization by the articles of association.
- Passing a special resolution by the shareholders.
- Confirmation by the National Company Law Tribunal (NCLT).
- Filing of approved documents with the Registrar of Companies.
The purpose of these legal safeguards is to ensure that the conversion does not adversely impact the rights of existing shareholders or creditors. It also ensures transparency and fairness in corporate restructuring exercises.
Dividend Distribution Mechanism for Preference Shareholders
Dividends on preference shares are paid before any dividend is declared for equity shareholders. The payment is contingent on the availability of distributable profits. Even though preference shareholders have priority, their dividend is not guaranteed in case of inadequate profits, except for cumulative shares where unpaid dividends are carried forward.
Preference shareholders do not have the authority to compel dividend payment unless the terms of the issue or governing law provide for such a right. The declaration of dividends remains within the discretion of the board of directors, subject to statutory conditions.
Voting Rights of Preference Shareholders
Under normal circumstances, preference shareholders do not possess voting rights on general matters. However, they can vote on resolutions that directly affect their rights. Additionally, if a company fails to pay dividends on preference shares for two or more consecutive years, these shareholders acquire voting rights on all matters of the company until their dues are cleared.
This limited participation in management reflects the nature of preference shares as instruments of fixed return rather than ownership control.
Redemption Mechanism for Preference Shares
Redemption of preference shares must follow strict legal procedures. The key rules include:
- Shares must be fully paid-up before redemption.
- Redemption can be made only out of profits available for distribution or from the proceeds of a fresh issue.
- A capital redemption reserve account must be maintained when redemption is made out of profits.
This process ensures that the company’s capital remains intact after redemption and that creditors are not adversely impacted. It also protects the company from financial strain caused by mass redemption obligations.
Financial Significance of Preference Shares
From a corporate finance perspective, preference shares provide an efficient way to raise capital without significantly diluting ownership. Companies can raise funds by offering fixed returns to investors while maintaining control over management decisions, since preference shareholders typically do not vote on ordinary matters.
Preference shares are especially useful for long-term infrastructure and industrial projects where steady capital input is required without the burden of high-interest debt.
Preference Shares as a Hybrid Instrument
Preference shares combine characteristics of both debt and equity. Like debt, they offer fixed returns and have a maturity period. Like equity, they represent ownership interest and rank after creditors during liquidation. This hybrid nature makes them suitable for both conservative investors seeking stable returns and companies looking for cost-effective funding without compromising ownership.
Legal Meaning of Equity Share Capital
Section 43 of the Companies Act, 2013, defines equity share capital with reference to any company limited by shares. It refers to that part of the issued share capital that is not preference share capital. Equity share capital may include shares with differential rights as to dividend, voting, or otherwise, as permitted by the articles of association and relevant rules.
Unlike preference shares, equity shares do not carry preferential rights regarding dividends or capital repayment. The equity shareholders are considered the true owners of the company, participating in its management and bearing both its profits and losses.
Features of Equity Shares
Equity shares possess certain essential characteristics that define their nature and role in the corporate framework. These include:
- No fixed return: The dividend payable on equity shares is not fixed and depends entirely on the profitability and financial decisions of the company.
- Ownership rights: Equity shareholders are the actual owners of the company and have voting rights on all key matters.
- Residual claim: In the event of winding up, equity shareholders are entitled to the residual assets after all liabilities, including preference shares, are settled.
- Transferability: Equity shares are generally transferable unless restrictions are imposed by law or the company’s articles.
- Perpetuity: Equity shares are not redeemed during the lifetime of the company, ensuring permanent capital.
These features make equity shares attractive for investors seeking long-term ownership and capital appreciation, rather than fixed income.
Classification of Equity Shares
Equity shares can be classified based on the rights attached to them. These include:
- Ordinary equity shares with standard voting and dividend rights.
- Equity shares with differential voting rights (DVR), which offer reduced or enhanced voting power along with a compensating variation in dividends.
Companies may issue equity shares with differential rights in accordance with Rule 4 of the Companies (Share Capital and Debentures) Rules, 2014. However, such issuance is subject to conditions including profitability, compliance status, and approval by shareholders through a resolution.
Rights of Equity Shareholders
Equity shareholders enjoy a broad set of rights, both financial and managerial. These include:
- Right to vote on all company matters including appointment of directors, approval of financial statements, mergers, and alterations of capital.
- Right to receive dividends as and when declared by the board, subject to availability of profits.
- Right to participate in surplus assets upon winding up, after preference shareholders and creditors are paid.
- Right to inspect statutory registers and receive copies of financial statements.
- Right to transfer shares, subject to applicable rules and conditions.
These rights are central to the ownership role of equity shareholders and form the basis for their influence on company decisions.
Financial Return on Equity Shares
Unlike preference shares, equity shares do not carry a fixed dividend. The return on equity shares depends on the profits earned by the company and the dividend policy adopted by the board. Some companies may choose to retain profits for expansion or future contingencies, while others may distribute a portion to shareholders.
The dividend yield on equity shares can fluctuate significantly from year to year. Additionally, capital appreciation through an increase in market price of shares is another important source of return for equity shareholders.
Risk Profile of Equity Shareholders
Equity shareholders bear the maximum risk in a company. They are last in line to receive any payment in the event of liquidation. If the company performs poorly, shareholders may not receive any dividends, and their investment value may decline. However, in times of strong performance, they stand to gain the most in terms of both dividend and share price growth.
The risk-return profile of equity shares makes them suitable for investors with a long-term investment horizon and higher risk tolerance.
Voting Rights and Control
One of the most significant aspects of equity shareholding is the right to vote. Equity shareholders can vote on all major matters affecting the company, including:
- Election and removal of directors
- Alteration of the company’s capital structure
- Approval of mergers and acquisitions
- Adoption of financial statements
- Decisions related to borrowings and guarantees
This power allows equity shareholders to influence corporate governance and management. In contrast, preference shareholders have voting rights only under limited circumstances, such as when their dividend remains unpaid for two or more years.
Companies may also issue shares with differential voting rights, allowing them to attract investment without diluting promoter control. However, such issuances are closely regulated and require shareholder approval.
Capital Contribution and Permanence
Equity share capital forms the permanent capital base of the company. Once issued, equity shares remain with the company unless bought back under a scheme approved by the law. There is no maturity period or obligation for redemption. This permanent nature supports the long-term financial stability of the business.
Companies may raise additional equity capital through rights issues, private placements, or public offerings. This allows them to expand operations, meet capital expenditure needs, and strengthen their balance sheet without creating a fixed repayment obligation.
Dilution of Control
One of the challenges in issuing additional equity shares is the dilution of existing ownership. When new shares are issued, the percentage holding of existing shareholders decreases unless they participate in the fresh issue proportionately.
To safeguard the interests of existing shareholders, the Companies Act mandates that rights issues must be offered first to existing shareholders in proportion to their holdings. This enables shareholders to maintain their ownership percentage if they choose to subscribe.
Equity Shares and Market Trading
In listed companies, equity shares are traded on stock exchanges, providing liquidity and exit opportunities to investors. Share prices are determined by market forces, influenced by company performance, investor sentiment, and broader economic conditions.
The liquidity of equity shares enhances their attractiveness as an investment class. Investors can easily enter or exit positions, making them more flexible compared to preference shares, which are often non-tradable.
Equity Shareholders and Corporate Governance
Equity shareholders play a crucial role in corporate governance. They elect directors who manage the affairs of the company, approve key financial and strategic decisions, and hold the board accountable through general meetings. Shareholders may also propose resolutions, demand disclosures, and raise concerns during annual general meetings.
Institutional shareholders, such as mutual funds and insurance companies, have emerged as active participants in governance, using their voting power to influence responsible business conduct.
Capital Appreciation and Wealth Creation
Equity shares are primarily a tool for wealth creation. Over time, if the company grows its revenues, profits, and market position, the value of its shares appreciates. This results in capital gains for shareholders. Historical data suggests that equity investments have the potential to outperform most other asset classes over the long term, despite short-term volatility.
Unlike preference shares, which provide fixed income, equity shares offer unlimited upside potential. Investors seeking growth and long-term capital accumulation often prefer equity shares as a core component of their portfolio.
Issuance of Bonus Shares
Companies may issue bonus shares to equity shareholders out of accumulated profits or reserves. Bonus shares are given free of cost and increase the number of outstanding shares without altering the total capital. This results in a proportional dilution of share value but increases liquidity and reflects the company’s confidence in its financial stability.
Bonus issues reward long-term shareholders and are often seen as a positive indicator of company performance.
Rights Issue and Preferential Allotment
Companies may also issue additional equity shares through rights issues or preferential allotment. A rights issue allows existing shareholders to subscribe to new shares in proportion to their current holdings. This helps companies raise capital without changing control dynamics.
Preferential allotment, on the other hand, refers to the issuance of shares to a select group of investors at a predetermined price, subject to approval and compliance with regulatory norms. It is a quicker method to raise funds but may lead to dilution of control if not managed transparently.
Equity Shares and Buy-back Provisions
Companies may buy back their own shares to improve earnings per share, return surplus cash to shareholders, or prevent hostile takeovers. Buy-backs are governed by Sections 68 to 70 of the Companies Act and are subject to regulatory limits and conditions.
A buy-back reduces the number of outstanding shares, thereby improving shareholder ratios. It also signals the company’s confidence in its valuation and future performance.
Role of Equity Share Capital in Business Strategy
Equity share capital plays a strategic role in funding growth, enhancing credibility, and strengthening balance sheets. It provides risk capital that supports innovation and expansion without burdening the company with repayment obligations. Companies can attract investors who share their long-term vision and align financial incentives with business success.
Equity financing is also essential for startups and early-stage businesses that lack the collateral or cash flow required for debt financing. Investors contribute not just funds but also expertise, networks, and mentorship.
Comparative Understanding with Preference Shareholders
While equity shareholders enjoy higher control and potential rewards, they also bear higher risk. Preference shareholders, in contrast, have fixed income and capital security but limited influence. The distinction becomes particularly relevant in scenarios such as dividend declaration, capital restructuring, and liquidation.
Understanding the different rights, roles, and expectations of each category helps investors make informed choices and companies design balanced capital structures.
Legal Provisions Governing Equity and Preference Share Capital
Companies Act, 2013 – Key Sections
Several key sections under the Companies Act, 2013, govern the issuance, rights, and conversion of equity and preference shares.
- Section 43 outlines the classification of share capital into equity share capital (with or without differential voting rights) and preference share capital.
- Section 55 prohibits the issuance of irredeemable preference shares and prescribes a maximum redemption period of 20 years, extendable to 30 years for infrastructure projects.
- Section 66 deals with reduction of share capital, which becomes relevant when companies consider converting equity shares into preference shares.
These provisions ensure that the rights of shareholders are preserved and that companies maintain financial discipline while raising or modifying their capital structure.
Role of Articles of Association
The Articles of Association (AOA) of a company play a critical role in determining whether a company can issue or convert shares into a particular class. The AOA must specifically authorize the issuance of preference shares or provide for conversion mechanisms. Any amendment to the AOA requires a special resolution, reflecting the consent of shareholders and ensuring transparency in the capital structuring process.
Strategic Use of Preference and Equity Shares in Corporate Financing
Equity Shares for Long-Term Growth and Risk Capital
Equity shares are typically issued to raise long-term capital without the obligation to repay or offer fixed returns. The funds obtained are used for expansion, innovation, or acquisitions. Equity investors are willing to take on higher risk in return for potential capital appreciation and dividend income. In startups and high-growth companies, equity shares form the primary source of funding due to their flexibility and the absence of repayment obligations.
Preference Shares for Structured Financing
Preference shares, on the other hand, are strategically used when companies seek to raise funds with minimal dilution of control and predictable cost of capital. Preference shareholders are entitled to a fixed dividend and receive repayment before equity shareholders in a winding-up situation. These features make preference shares attractive to conservative investors, such as pension funds or institutional investors looking for steady returns without active participation in management.
Dividend Policies and Profit Allocation
Equity Dividend – Linked to Profit Availability
Equity shareholders are entitled to dividends only after preference dividends are paid. However, the rate and quantum of dividend on equity shares are not fixed and depend entirely on the company’s profitability and the discretion of the board. If a company performs exceptionally well, equity shareholders may receive higher returns through increased dividend payouts and appreciation in share value.
Preference Dividend – Fixed and Prioritized
In contrast, preference shareholders receive a predetermined dividend amount or rate, which may be cumulative or non-cumulative. Even in years of low profits, companies are obligated to pay accumulated dividends to holders of cumulative preference shares before declaring any equity dividend. This creates a priority claim on the company’s distributable profits and often restricts equity holders from enjoying profits until such obligations are cleared.
Voting Rights and Corporate Control
Equity Shareholders – Full Voting Power
Equity shareholders are the actual owners of the company and enjoy full voting rights on all matters, including policy decisions, election of directors, and changes to the Memorandum and Articles of Association. They also hold sway over dividend declarations and major business combinations.
Their influence on corporate governance is considerable and often exercised through shareholder meetings, proxy voting, and activist campaigns. Hence, raising equity capital leads to a dilution of promoter control unless differential voting rights are used.
Preference Shareholders – Limited Voting Rights
Preference shareholders, by default, do not enjoy voting rights in routine business matters. Their voting rights are limited to resolutions that directly affect their interests, such as those relating to the variation of their rights or non-payment of dividend for two or more consecutive years. This limited role provides companies with an opportunity to raise funds without offering significant control to external investors.
Redeemability and Financial Planning
Equity Shares – Permanent Capital
Equity share capital generally remains with the company for its entire life, unless reduced through buy-back, capital reduction, or other corporate actions. This permanent capital offers financial stability but also raises concerns related to control and profit sharing over time.
Because equity capital cannot be redeemed, it adds to the long-term equity base of the company, which supports borrowing capacity and buffers financial risk.
Redeemable Preference Shares – Financial Flexibility
Preference shares, especially redeemable ones, provide greater flexibility in financial planning. The company can choose to redeem them at the end of the term or earlier, based on cash flows, interest rate scenarios, or changes in capital structure strategy.
This ability to time the redemption allows companies to manage their leverage ratios, return metrics, and shareholder expectations more efficiently. Redeemable preference shares are commonly used in financing buyouts, recapitalizations, and by companies aiming to stagger their capital obligations over time.
Conversion and Capital Restructuring
Conversion of Equity to Preference – Requires Capital Reduction
The conversion of already issued equity shares into preference shares is a significant alteration in capital rights. Such a change impacts dividend expectations, repayment priorities, and voting entitlements. As a result, courts and regulatory frameworks require that this process be undertaken only through formal capital reduction procedures under Section 66. This ensures that all shareholders are treated fairly and that the rights of minority shareholders are safeguarded.
Conversion of Preference to Equity – Possible via Issue Terms
While converting equity to preference is complex, some companies offer convertible preference shares that automatically convert into equity after a specific time or on the occurrence of certain events. This arrangement allows investors to initially enjoy fixed dividends and later participate in capital appreciation. Such instruments are widely used in venture capital funding, private equity deals, and startup financing to align the interests of promoters and investors.
Impact on Financial Ratios and Market Perception
Equity Capital and Dilution Metrics
An increase in equity capital directly impacts earnings per share (EPS), return on equity (ROE), and book value per share. As more equity is issued, existing shareholders experience dilution in ownership and earnings. This can affect the company’s market perception and share price performance if not backed by proportional growth in profits.
Equity issuances are generally welcomed when done for growth initiatives but viewed skeptically when used to meet operational shortfalls.
Preference Capital and Leverage Considerations
Since preference shares are treated as a hybrid between equity and debt, their impact on financial statements varies. While they appear under share capital in the balance sheet, the fixed dividend acts like interest in the income statement. Credit rating agencies may consider large preference capital as quasi-debt, thereby influencing the company’s leverage metrics.
However, from a market standpoint, the use of preference capital is often considered prudent when used to avoid excessive dilution or to fund specific asset-heavy projects.
Use in Specific Sectors and Case-Based Applications
Infrastructure and Capital-Intensive Industries
Preference shares are particularly useful in infrastructure, power, and capital-intensive sectors where the gestation period is long, and cash flows are delayed. The extended redemption period of up to 30 years, permitted for infrastructure companies, allows them to align funding obligations with project completion timelines and revenue inflows.
This tailored capital structuring is critical for viability and helps such companies attract long-term investors with appetite for low-risk, fixed-return instruments.
Startup Ecosystem and Venture Capital
Startups frequently use convertible preference shares as part of their funding strategy. These instruments balance the investor’s need for downside protection (through fixed dividends or liquidation preference) with the upside potential (via conversion into equity). Investors like venture capital firms prefer such arrangements as they offer influence without immediate voting control, while founders retain operational authority during early stages.
Regulatory Compliance and Reporting
Disclosure in Financial Statements
Both equity and preference share capital must be disclosed separately in the balance sheet under shareholders’ funds. Companies are also required to report any changes in share capital, terms of issue, dividend obligations, and redemption schedules in the notes to accounts.
This transparency is crucial for financial statement users to understand the nature of funding and the associated obligations. Inadequate disclosures may attract penalties and impact investor confidence.
Adherence to SEBI and ROC Requirements
For listed companies, any issuance, conversion, or redemption of shares must comply with SEBI regulations, including disclosure, pricing, and shareholder approval norms. Additionally, filings with the Registrar of Companies (ROC) must be made for changes in share capital, including Form SH-7, MGT-14, and PAS-3 as applicable.
Non-compliance with such procedures may result in penalties, disqualification of directors, or cancellation of the issue itself.
Corporate Governance and Shareholder Protection
Preference Shares and Governance Checks
Though preference shareholders have limited voting rights, their consent becomes mandatory in situations that directly affect their rights. This provides a safeguard mechanism, especially in events like mergers, restructurings, or default in dividend payments. Any variation of terms must be approved by a special resolution passed in a separate meeting of preference shareholders.
Equity Shareholders and Control Mechanisms
Equity shareholders can influence the company’s future through voting, nomination of directors, and participation in annual general meetings. Institutional equity shareholders, in particular, exert significant pressure on management to improve performance, adhere to ESG norms, and enhance transparency. This creates a dynamic governance framework where accountability and stewardship coexist.
Conclusion
The distinction between preference share capital and equity share capital forms a foundational aspect of corporate finance and shareholder rights under the Companies Act, 2013. While both types of share capital represent ownership in a company, their roles, rights, and obligations vary significantly.
Preference shares offer a degree of security and predictability to investors by providing fixed dividends and preferential treatment during the distribution of assets upon winding up. They serve as an effective means for companies to raise capital without diluting voting power, given that preference shareholders have limited or conditional voting rights. This feature makes preference shares particularly attractive for investors who prioritize steady income and capital protection over control.
In contrast, equity share capital is associated with ownership that carries residual rights. Equity shareholders are the ultimate risk bearers, but they also enjoy the potential for higher returns in the form of fluctuating dividends and capital appreciation. Their voting rights enable them to participate actively in the decision-making processes of the company, including the election of directors and approval of key policies.
Companies must carefully evaluate their financial goals, long-term strategy, and capital structure while deciding the proportion of preference and equity share capital. Legal considerations, compliance with statutory provisions such as Section 43, Section 55, and Section 66 of the Companies Act, 2013, and shareholder expectations must be factored in while structuring the share capital.
In summary, the choice between issuing preference shares or equity shares is not merely a financial decision but a strategic one, impacting investor perception, capital cost, corporate control, and long-term sustainability. A balanced approach, aligned with regulatory norms and business requirements, ensures the optimal use of both forms of share capital in corporate financing and governance.