What Are the Differences Between Preference Shares and Debt Financing?

If you are a startup owner considering different financing options, raising capital by issuing preference shares might seem ideal. Alternatively, you might consider raising capital by borrowing money via debt financing. While preference shares and debt financing might seem dissimilar, they also share some key characteristics that will likely inform how you decide to finance your startup. This article will explain the similarities and differences between preference shares and debt financing. 

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What Are Preference Shares?

We tend to think of preference shares as a form of equity financing. This is because your startup issues shares in exchange for cash. However, preference shares are separated from normal shares because they entitle the preference shareholder to a fixed dividend amount. As the name suggests, preference shareholders are entitled to this payment before ordinary shareholders. 

Hence, if your startup makes no profit, it cannot declare a dividend. But if your startup makes a profit, it must pay all preference shareholders their full entitlement before any ordinary shareholders receive a pence. Therefore, if the preference shares entitle each preference shareholder to 10p per share and there are 100,000 preference shares, your startup must make at least £10,001 before ordinary shareholders receive anything.

What Are the Key Characteristics of Preference Shares?

Some preference shares entitle preference shareholders to a share of the profit above their preference rights. Usually, in this case, they have an equal claim to the share of profits as the ordinary shareholders. Thus, preference shareholders get the first £10,000, and any amount above this is split equally between preference and ordinary shareholders. 

For example, assuming a £10,001 profit and the directors declare a full dividend, £1 would be split between all preference shareholders. 

What Are the Similarities Between Preference Shares and Debt Financing? 

Non-participating preference shares have more in common with debt financing than equity financing. This is because the fixed dividend payments on the shares are functionally identical to interest payments received on a loan. The law does not class non-participating preference shares that limit the rights to a return of capital upon a winding up as part of a company’s share capital. They are effectively treated as a kind of loan. 

Thus, lenders obtain more certainty that they will receive a fixed return on their loan amount. However, preference shares can have a cumulative effect, which means that for each period the company does not pay the fixed preference dividend in full, this amount accrues until the directors declare a dividend. At this point, they must pay all dividends owed to preference shareholders before then. 

Further Considerations For Equity and Debt Financing

A company must pay all dividends out of post-tax profits. Additionally, interest payments are tax-deductible. Therefore, all other things being equal, a company pays comparatively more to pay dividends on preference shares than to make interest payments. 

However, from the perspective of an ordinary shareholder, the cost of paying more for dividends may be worth not having interest obligations, which require you to generate a sufficient return on total capital employed unless you default. 

Nevertheless, participating preference shares behave as equity. This is because preference shares entitle the holder to participate in the profits, as with ordinary shareholders. 

Key Takeaways 

Preference shares have specific characteristics in common with debt. In some cases, where preference shares do not entitle the preference shareholder to any surplus profits aside from a fixed dividend, the law does not consider preference shares part of your startup’s profits. However, dividends issued under preference shares still constitute profit from HMRC’s perspective, which means these earnings are taxed at the corporation tax rate (19-25%, depending on your startup’s size). Therefore, financing your company through a loan can be more tax advantageous than preference shares. 

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