Preference shares typically have attributes of both debt and equity instruments.
It resembles equity in the following ways :
- Dividend on these shares are payable out of distributable profits
- Dividends are not an obligatory payment and are entirely at the discretion of the directors
- Dividends are not tax deductible payment
Preference shares are similar to debt in many ways :
- Dividend rates are fixed similar to any debt instrument
- In case the company goes into liquidation, the claim of preference share holders precede the claims of equity share holder
- Preference share holders normally do not enjoy the right to vote
From the perspective of angel investors, investing through the preference share route provides the investor certain benefits without directly exposing to the risk of the equity shareholders who normally are the promoters. The investors have the comfort of getting a minimal return on their investment and a priority over the equity shareholders out of the liquidation proceeds.
From the perspective of the promoters of the company, the burden of servicing high cost debt is not there as the dividend on preference shares are typically not guaranteed and often lower than the cost of debt for an early stage company and in the absence of voting right, the promoters face minimal interference from the financiers in the regular management and operation of the company.
One can structure the instrument to include additional features such as accumulation of dividends, call option, convertibility to normal equity shares, redeemable such as in any debt instrument and power to vote.
Convertible notes on the other hand are structured as a debt instrument but comes with an option for it to be converted into equity shares on a given future date or within a specified time frame at a pre-specified price.
Angel investors find comfort in this instrument as it comes with certain advantages which are :
- A fixed interest payment till conversion which is assured
- The conversion price is normally at a discount to the estimated value of the company, hence the investor can take part in the upside
- The conversion is normally at the option of the investor which gives the investor a protection from the downside
From the perspective of the company the promoters enjoy the following advantages :
- The interest payment are at rates lower than a regular debenture because of the convertible feature which offers upside to the investor
- As there are no voting rights attached, the company can operate with minimal external intervention.