Preference shares (prefs) are legally shares, but they are very different from ordinary shares. The economic effect of prefs is more like that of bonds. Like convertibles, they are regarded as hybrids of debt and equity:
- Dividends on preference shares have to be paid before dividends on ordinary shares.
- Dividends on ordinary shares may not be paid unless the fixed dividends on preference shares is paid first.
- Dividends are fixed like bond coupons, although there are usually provisions to not pay, or delay payments.
- Preference shareholders have a higher priority if a company is liquidated than ordinary shareholders, although a lower priority than debt holders.
- In the case of cumulative prefs, if the dividend is not paid in full, the unpaid amount is added to the next dividend due.
- Preference dividends are fixed, so they do not participate in increases (or decreases) in profits as ordinary shareholders do.
The effect of these is to make the income stream from preference shares more similar to that from debt than that from ordinary shares. Most importantly, fixed dividends are similar to interest payments. However, they are legally shares and are subject to the same tax treatment.