Equity securities differ from debt in that a company is obligated to pay back the principal amount in case of debt to the debtors together with periodic interest, but the shareholders get no such commitment, rather, they have a residual claim on assets and earnings of the company.
Equity securities are broadly classified into common shares (also called ordinary shares) and preference shares (also called preferred stock).
Common shares are the most common type of equity securities which represent an ownership interest in a company. Common stockholders have (a) voting rights, (b) a claim on the net assets of the business (in the event of liquidation) and (c) may receive dividends.
Shareholders can vote, either in person (in the annual general meeting) or through a proxy, in respect of the election of directors, mergers and acquisitions, selection of auditors, etc.
Statutory voting vs cumulative voting
There are two mechanisms for voting: statutory voting and cumulative voting. In statutory voting, a shareholder gets one vote per share and he cannot cast more than one vote per share for each director. In cumulative voting, a shareholder’s total votes equal the product of the number of directors and number of shares that he holds and he can cast all his entitled votes for a single director. Even though statutory voting is more common, cumulative voting best protests the interest of minority shareholders.
Common shares may have more than one class which may differ depending on their voting rights, dividend rights, their share in the liquidation proceeds, conversion or redemption option, etc.
Callable and putable common shares
Callable common shares are shares that entitle the issuer to buy the shares back with a specified time period at a predefined call price. A company has an incentive to call shares when its market price is higher than the call price.
Putable common shares have an embedded put option, i.e. it entitles the shareholders to put the stock back to the issuer at a specified put price. This feature guarantees shareholders a minimum price below which the stock price will not fall.
Preference shares (also called preferred stock) have a ‘preferred’ claim on dividends and net assets of a company but they typically lack voting rights.
Preference shares have both debt-like and equity-like features. Preference shares are similar to debt in that they typically get fixed dividends and in the event of a liquidation, they must be paid in full before anything can be distributed to common stockholders. Just like common stock, they are typically perpetual in existence (like common stock) but maybe callable or putable and in most cases, their dividends are not contractual obligations.
Depending on whether their dividends accumulate if not paid in a period and whether they participate in the operating performance of a company, preference shares are categorized as cumulative and non-cumulative and participating and non-participating.
Cumulative vs non-cumulative preference shares
Unpaid accumulated dividends on cumulative preference shares must be paid before any dividends may be paid to common stockholders. Non-cumulative preference shares have no such guarantee.
Participating vs non-participating preference shares
Participating preference shares have a fixed dividend plus an additional share if net income exceeds a certain level. They may also have an additional share in the distribution of net assets left-over. They are most common in case of small, riskier companies. Non-participating preference shares have no such additional share.
A share can be cumulative participating and non-cumulative participating and so on.
Convertible preference shares
Holders of convertible preference shares have an option to convert their shares to a specified number of common shares.
Advantages of convertible preference shares
Advantages of convertible preference shares for investors include (a) a higher dividend than straight common shares, (b) an opportunity to share in the net income, (c) ability to benefit from an increase in common share price (through conversion option), and (d) less volatility. Convertible preference shares are common in private and venture capital transactions in which the companies are relatively high risk.