What are the different types of shares and why retail investors should care?

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Till now, we’ve been restricting our discussions to just equity shares alone. However, equity shares are not the only type of shares that are authorised to be issued by a company registered in India. Intrigued and want to know more? In this chapter, we’ll delve into the various types of shares, their significance, and the rights associated with them. So, without further ado, let’s get right to it.  

Different types of shares issued by companies in India

According to the provisions of the Companies Act, 2013, a company registered in India is authorised to issue two primary types of shares - equity shares and preference shares. These two types of shares have various subcategories and sub-types, all of which we will be discussing in the forthcoming segments of this chapter. Since you’ve already been introduced to equity shares, we’ll start off with them first. 

Equity shares

Also known as ordinary shares, equity shares represent the ownership in a company. That’s probably why the funds raised through the issue of equity shares are known as owner’s funds. Holders of equity shares of a company are commonly referred to as equity shareholders.  

Equity shares possess voting rights that allow the holders of the shares to attend the general meetings of the company and vote on business decisions. Since equity shareholders are considered as owners of the company, they are entitled to a dividend, which is essentially the distribution of the profits earned by the company. Aside from that, equity shares also come with a residual claim on the company, which we’ve already discussed in the previous modules of Smart Money.

However, given all of this, equity shares also possess a couple of drawbacks. The dividend that the equity shareholders are entitled to are not fixed. It is dependent on the profits earned by the company during a specified period of time. Therefore, in the event of the company not performing well during a specific period, the equity shareholders may either not get any dividends at all or may get a reduced rate of dividend. With respect to the residual claim, equity shares always get the last preference in the event of liquidation of a company.

Dilutive shares

You might remember seeing the line item ‘Earnings per share - Diluted’ when we were analysing the profit and loss statement of Hindustan Unilever Limited in an earlier module of Smart Money. Dilutive shares are essentially a type of equity shares that are just categorised as such. But why are these shares categorised as dilutive shares? 

A company, during the course of its business, may issue securities such as Employees Stock Option Plans (ESOPs), stock warrants, convertible debentures, or even convertible preference shares. These issued securities come with a special provision that allows the holders to convert the securities into equity shares of the company at a predetermined date. 

When a holder exercises this provision and converts these securities to equity shares at the predetermined date, the number of outstanding shares of the company tends to increase. This sudden increase would therefore decrease (or dilute) the earnings per share (EPS) value, right? That’s exactly why these securities are known as dilutive securities or dilutive shares. 

Since these securities have the potential to dilute the EPS when converted to shares, a company accounts for its effect by including it under the ‘earnings per share’ section of its profit and loss statement.     

Dilutive shares enjoy all of the rights and benefits as that of regular equity shares and are in no way different from them.

Equity shares with differential voting rights (DVR)

Now, these are a special type of equity shares. Equity shares with differential voting rights are quite similar to ordinary shares, but with a couple of differences. 

The primary difference is with the voting rights. Normal equity shares have a 1:1 voting ratio. This effectively means that for every equity share held by an owner, there is one vote. For instance, if you hold 100 equity shares in a company, you essentially get 100 votes. But with equity shares with DVR, you give up some of your voting rights. According to the company’s rules and regulations, if you possess equity shares with DVR, you might either be restricted from voting on certain specified business decisions or face a reduction in your voting power. Typically, companies adopt the latter approach. They tend to reduce the voting power of holders of equity shares with DVR. Generally, the voting power of such shares is reduced to 10:1, which means that for every 10 equity shares with DVR, you get one vote.

Okay, so this actually puts the holder of such shares at a disadvantage, right? So, who would want to opt for such shares and what would they get in return for giving up their voting rights? Here’s where the second difference comes into the picture. 

In exchange for giving up the voting rights, the company basically rewards the holders of equity shares with DVR with a rate of dividend that’s higher than those enjoyed by ordinary equity shareholders. Again, as with all equity shares, the dividend is dependent on the profits of the company.  

Another advantage that equity shares with DVR possesses is that it trades at a lower value than normal equity shares in the stock exchange. This allows investors and traders to pick up more shares with the same amount of investment. For instance, the regular equity shares of Tata Motors Limited are trading at around Rs. 105 in the stock market, while the equity shares with DVR of Tata Motors Limited are trading at around Rs. 40. Such is the price difference between these two types of equity shares. 

In India, apart from Tata Motors Limited, Jain Irrigation Systems Limited is another popular company that has issued equity shares with DVR. 

Preference shares 

As the name itself suggests, preference shares are shares that hold a higher preference with respect to the dividend payouts and residual claim when compared with ordinary equity. Companies are not required to compulsorily issue preference shares. Unlike equity shares, holders of preference shares are not entitled to any voting rights. But in exchange for this, they get to enjoy a fixed rate of dividend that a company is obligated to pay the holders irrespective of whether it earns a profit or not. 

Also, during the liquidation process, higher priority is given to preference shareholders. A company can distribute the residual assets to its equity shareholders only after clearing all the pending dues of preference shareholders.  

There are as many as 8 different types of preference shares. Here’s a quick look at the various types of preference shares.  

  • Cumulative preference shares
  • Non-cumulative preference shares
  • Participating preference shares
  • Non-participating preference shares
  • Convertible preference shares
  • Non-convertible preference shares
  • Redeemable preference shares
  • Irredeemable preference shares

Why should retail investors care about the different types of shares?

If you’re going to invest in a company for the long term, it is essential to know the different types and categories of shares that a company can issue. This is because these various categories of shares can impact an investor like you. Here’s how. 

As we’ve already discussed in a previous segment of this chapter, if a company goes under or liquidates, preference shareholders get higher preference over equity shareholders. And so, it becomes important for you to know whether the company you’ve invested in or is planning to invest in has issued preference shares. This assessment would give you a more accurate idea of where you stand with respect to the residual claim that you tend to gain in the event of liquidation of the company. 

Also, since preference shareholders get to enjoy a higher preference with respect to dividend as well, companies generally tend to pay them off first with the profits earned. So, once the fixed dividends are all paid out to preference shareholders, only then the company would pay dividends to the equity shareholders. If the company isn’t left with any distributable profits after paying off its preference shareholders, then the equity shareholders wouldn’t receive any dividend for that particular period. Or, if the distributable profits are not very high after paying off preference shareholders, equity shareholders might have to contend with a reduced rate of dividend. Since this significantly affects the equity shareholders’ earnings, as a retail investor, it is imperative that you look into such issues. 

Now, as a retail investor looking to go long-term, your main contention would be to earn a higher rate of dividend. In such a case, you could consider investing in equity shares with differential voting rights instead of ordinary equity shares. Sure, you would have to make peace with lowered voting rights, but you also get to enjoy higher dividends if that’s what you’re looking for. Therefore, it becomes important for you to carry out an assessment to see if the company you’re interested in investing has issued any DVRs in addition to regular equity shares. Also, by investing in equity shares with DVRs, you get to purchase more shares, which ultimately has the effect of increasing the dividend payouts.  

Finally, you should also care about the number of dilutive shares issued by the company that you’re planning to invest in since they can impact your EPS. If a company has issued a high number of ESOPs, stock warrants, or convertible debt instruments, its EPS is likely to take a hit if the holders of such instruments choose to exercise them. 

Wrapping up

Nowadays, except for ordinary equity shares, companies hardly issue the other types. This is primarily because of the high level of popularity that equity shares seem to enjoy. So then, that’s about it for this chapter. In the next, we’ll delve into the exciting process of investing in an IPO. Here’s a quick hint to keep you guessing - there’s more than one way to apply for and invest in an IPO. See you in the next chapter!

A quick recap

  • A company registered in India is authorised to issue two primary types of shares - equity shares and preference shares.
  • Also known as ordinary shares, equity shares represent the ownership in a company.
  • Holders of equity shares of a company are commonly referred to as equity shareholders.
  • Equity shares possess voting rights that allow the holders of the shares to attend the general meetings of the company and vote on business decisions.
  • Equity shareholders are entitled to a dividend, which is essentially the distribution of the profits earned by the company.
  • Dilutive shares enjoy all of the rights and benefits as that of regular equity shares and are in no way different from them.
  • Equity shares with differential voting rights are quite similar to ordinary shares, except that they possess lowered voting rights. 
  • In exchange for giving up the voting rights, the company rewards the holders of equity shares with DVR with a rate of dividend that’s higher than those enjoyed by ordinary equity shareholders.
  • Equity shares with DVR trades at a lower value than normal equity shares in the stock exchange.
  • Preference shares are shares that hold a higher preference with respect to the dividend payouts and residual claim when compared with ordinary equity.
  • Holders of preference shares are not entitled to any voting rights. 
  • Preference shareholders enjoy a fixed rate of dividend that a company is obligated to pay whether it earns a profit or not.
  • There are as many as 8 different types of preference shares. 
    1. Cumulative preference shares
    2. Non-cumulative preference shares
    3. Participating preference shares
    4. Non-participating preference shares
    5. Convertible preference shares
    6. Non-convertible preference shares
    7. Redeemable preference shares
    8. Irredeemable preference shares
  • If a company liquidates, preference shareholders get higher preference over equity shareholders.
  • Also, since preference shareholders get to enjoy a higher preference with respect to dividend as well, companies generally tend to pay them off first with the profits earned.
  • If the company isn’t left with any distributable profits after paying off its preference shareholders, then the equity shareholders wouldn’t receive any dividend for that particular period.
  • If a company has issued a high number of ESOPs, stock warrants, or convertible debt instruments, its EPS is likely to take a hit if the holders of such instruments choose to exercise them.
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