Summary
- Preference shares are a form of equity that give investors fixed dividends and priority over ordinary shareholders, while debt financing involves borrowing money that must be repaid with interest.
- Debt is typically more tax-efficient because interest payments are deductible, whereas dividends on preference shares are not.
- Preference shares can avoid immediate repayment obligations but dilute ownership, while debt preserves ownership but increases financial risk and repayment pressure.
- This guide explains preference shares and debt financing for startup founders and business owners in the UK, prepared by LegalVision, a commercial law firm that specialises in advising clients on startup funding and corporate structuring.
- It provides a practical explanation of how each funding option affects tax, cash flow, risk and control when raising capital.
Tips for Businesses
Compare how each option affects cash flow, control and tax. Use debt for predictable repayments and tax efficiency, but ensure you can meet obligations. Consider preference shares if you want flexibility and can accept dilution. Align your funding choice with growth plans, risk tolerance and future financing needs.
Preference shares are a type of equity that give investors priority returns, often with fixed dividends, while debt financing involves borrowing money that must be repaid with interest. For your business, choosing between them affects cash flow, tax efficiency and control, as debt requires regular repayments but preserves ownership, whereas preference shares reduce repayment pressure but may impact profit distribution and investor rights. You must assess your financial position and growth strategy before deciding. This article explains the key differences between preference shares and debt financing and how each option affects your business.
LegalVision’s Startup Manual is essential reading material for any startup founder looking to launch and grow a successful startup.
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.
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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.
If you need help with your startup, LegalVision provides ongoing legal support for businesses through our fixed-fee legal membership. Our experienced startup lawyers help businesses manage contracts, employment law, disputes, intellectual property, and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision’s legal membership, call 0808 196 8584 or visit our membership page.
Frequently Asked Questions
No, dividends on preference shares are paid from post-tax profits. In contrast, interest payments on debt are tax-deductible, making loans more tax-efficient.
Participating preference shares allow shareholders to share in profits beyond the fixed dividend, behaving more like ordinary equity. Non-participating shares limit returns to the fixed dividend.
No, payment depends on profits. Directors have discretion to declare dividends, unlike debt where interest payments are contractually required.
Preference shares allow you to raise capital without giving up significant control. They often limit voting rights while still providing investors with financial returns.
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