PREFERENCE SHARES – IS IT EQUITY OR DEBT/LIABILITY?

Share Capital has traditionally been seen as equity. But is this always right? Most probably not in the case of preference shares, one should consider the substance and not just the legal form of the transaction.

Let’s have a look of what equity is. Put in layman’s terms “Equity = Assets – Liabilities”, more formally it is any contract that evidences residual interest in the assets of an entity after deducting all the liabilities.  But what happens if we issue a class of share and there are obligations to repay (redeem) at a certain date or price or that the entity is obliged to pay a return on the investment (dividends). The moment there are obligations to repay then there is a possibility that this share might not be equity any more but it might be a liability.

Let’s have a look of what a liability is.

A Liability is a present obligation as a result of past events, settlement is expected to result in an outflow of resources (payment).

So, what about Preference shares

Therefore, if as a result of a preference share transaction, a present obligation is created, that will result in payment, the nature of the of the share can change from equity to a liability or even a hybrid between a liability and equity.

The common types of preference shares are part of or a combination of the following:

Redeemable/Non-Redeemable

Convertible/Non-Convertible

Cumulative/Non- Cumulative

Participating/Non-Participating

Callable

The following characteristics of the above will result in the preference share being a liability or a hybrid between a liability and equity:

It is mandatorily redeemable or redeemable at the option of the holder at a fixed or determinable amount at a fixed or future date.

It is Non-Convertible to ordinary shares of the entity.

The dividends should have a Cumulative nature.

It should be Non-Participating in the residual reserves after all preference share benefits has been paid.

Benefits

The structure of the share capital of a company can have a severe impact on the valuation of the company and if structured correctly the desired valuation of the company can be achieved.

Other benefits are:

Fixed income

Preference over Ordinary shareholders at liquidation

Preference over Ordinary shareholders when dividends are paid

Conversion to Ordinary shares if Ordinary Shares rise (Equity not Debt)

You are welcome to contact our offices should you think the correct structuring of your share capital could be of benefit to you.

Louis Meyer (CA)SA, MCom

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

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