Legal News & Analysis – Asia Pacific – India – Capital Markets
22 December 2021
As companies grow, the need for greater amounts of capital to conduct their operations may arise. Thus, there will be a need for a wide array of capital instruments. In this article, we analyse the preference share as a capital instrument and the statutory framework under the Companies Act, 2013 (“Act”) governing preference shares.
Definition of Preference Share
As per Explanation(ii) to Section 43 of the Act, the term “preference shares” which carries or would carry a preferential right with respect to:
(a) payment of dividend, either as a fixed amount or an amount calculated at a fixed rate, which may either be free of or subject to income-tax; and
(b) repayment, in the case of a winding up or repayment of capital, of the amount of the share capital paid-up or deemed to have been paid-up, whether or not, there is a preferential right to the payment of any fixed premium or premium on any fixed scale, specified in the memorandum or articles of the company.
1. Kind of Preference Share
Preference shares can be classified into the following types based on the rights:
- Cumulative: All dividends are carried forward until specified and paid out only at the end of the specified period.
- Non-Cumulative: Dividends are paid out of profits for every year. There are no arrears carried over a time period to be paid at the end of the term.
- Convertible: The shares can be converted into equity shares after a time period, or as per the conditions laid down in the terms.
- Non-Convertible: Non-convertible preference shares cannot be, at any time, converted into equity shares
- Participating: Such shares have the right to participate in any additional profits, after paying the equity shareholders. The surplus of profit is apart from the fixed dividend paid up for preference shares
- Non-Participating: Non-participating preference shares do not possess any right to participate in surplus profits or any surplus gained at the time of liquidation of the company.
- Redeemable: Redeemable preference shares are those shares that can be repurchased or redeemed by the issuing company at a fixed rate and date. Such preference shares can be claimed after a fixed period or after giving due notice.
- Irredeemable: Non-redeemable preference shares are those shares that cannot be redeemed or repurchased by the issuing company at a fixed date. Such shares cannot be redeemed during the lifetime of the company but can only be obtained at the time of winding up (liquidation) of assets.
- Issuance and Redemption of Preference Share
The Act prohibits issuance of irredeemable preference shares. The Act provides that a company limited by shares may issue preference shares which are liable to be redeemed within a period not exceeding twenty years from the date of their issue. However, a company engaged in setting up and dealing with ‘infrastructural projects’ (may issue preference shares for a period exceeding 20 years but not exceeding 30 years, subject to the redemption of a minimum 10% of such preference shares per year from the 21st year onwards or earlier, on proportionate basis, at the option of the preference shareholders.
Further, the Act provides that:
- no such shares shall be redeemed except out of the profits of the company which would otherwise be available for dividend or out of the proceeds of a fresh issue of shares made for the purposes of such redemption;
- no such shares shall be redeemed unless they are fully paid;
- in case of companies other than NBFCs, the premium if any payable on redemption shall be provided out of the profits, of the company or out of the company’s securities premium account before such shares are redeemed;
- where any such shares are proposed to be redeemed out of the profits of the company, there shall, out of such profits, be transferred, a sum equal to the nominal amount of the shares to be redeemed, to a reserve, to be called the “Capital Redemption Reserve Account” a sum equal to the nominal amount of the shares redeemed.
Issue of preference shares may be made through the following:
- Rights issue only to the existing equity shareholders; or
- Employee stock options to employees; or
- Preferential allotment of further issue of shares;or
- Private placement basis.
2. Conditions for Issuance of Preference Shares
A company may issue preference shares subject to the following conditions
- the articles of association of the company authorises the issuance of preference shares;
- the authorized capital of the company has been bifurcated into equity shares and preference shares; and(iii) there is no subsisting default in the redemption of preference shares or in payment of dividend due on any preference shares.
3. Conversion of Preference Shares
Conversion is an investor protection mechanism which allows the preference share to be converted into equity shares. If the prescribed milestones are not met the conversion ratio will be higher i.e., the preference shares will convert into a higher number of equity shares. When the milestones are met the preference shares will convert into a lower number of equity shares.
Conclusion: Preference shares are thus a suitable instrument for capital raising. Since they do not carry any voting rights, there is no interference by preference shareholders in the operations and management of the company. Further the convertible option of the preference share makes it suitable to minimize investment risks in a venture capital or private equity transaction.