Updated July 10, 2023
Definition of Redeemable Preference Shares
Redeemable preference shares are those types of preference shares wherein the prospectus of the issue specifies a pre-determined price at which the share will redeem at the choice of the issuer at any time before the specified date in such prospectus, with the condition that all the conditions mentioned in the prospectus will be fulfilled & shares will be paid in full.
Explanation
- The ordinary meaning of the word “preference” is “having priority over others.”. So, the term “preference shares” means the holders of such shares prioritize payment of dividends and any other payment in the event of liquidation of the company.
- Now, by adding the word “redeemable,” such shares become automatically eligible to be called by the issuer company. This ensures that the company plays safe by retaining the right to buy back the shares as and when required.
- Such an option is called a callable option at the choice of the company. Once redeemed, such shares are required to be canceled.
- However, such an arrangement is altogether different than the traditional way of buyback of shares. In any way, the company can return cash to the existing shareholders. Also, this gives the company much-needed flexibility in deciding whether to buy back the ordinary shares or choose the redemption option.
- Now the question remains what price is considered for such redemption? This is pre-decided in the prospectus shared by the company at the time of the issue. Thus, there is no ambiguity regarding the same.
Redeemable Preference Shares Process
- The company must ensure that the shares are redeemed out of profits or proceeds of the new issue of shares. In addition, such shares should be fully paid up.
- The company is required to issue notice & agenda of the Board meeting, which shall consider the redemption proposal of preference shares.
- The Board of directors will convene the meeting to approve the redemption of preference shares (specifying the premium payable, mode & date of redemption, etc.)
- The draft of the minutes of the meeting is circulated to all the directors of the company.
- In some cases, the company is required to transfer a nominal amount of shares to a special account.
- Then, the actual amount is transferred to the shareholders & the company is required to make changes in the register of members.
Example of Redeemable Preference Share
Examples of Redeemable Preference Share are given below:
| Redeemable Preference Shares Issued | 80,000 |
| Predetermined call price | $150 |
Scenario 1: Shares Trading at Higher Price
| Current Market Price | $190 |
| The preferable option for the company | Redeem @ 180 |
| Price to be paid ($150*80000) | $1,20,00,000 |
| Notional Saving (190-150)*80000 | $32,00,000 |
Scenario 2: Shares Trading at Lower Price
| Current Market Price | $120 |
| The preferable option for the company | Repurchase @ 120 |
| Price to be paid (120*80000) | $96,00,000 |
| Notional Saving (150-120)*80000 | $24,00,000 |
Explanation: Let’s say in Scenario 2, in any way company is unable to repurchase the shares. It can still redeem the shares at $ 150. In such a situation, the company will not save the notional amount, but it still gets the flexibility to redeem the shares. In this way, the reduction of share capital is possible for the company at its wish.
When Be Preference Shares Redeemed?
- The timing of redemption of preference is known as the maturity date of redeemable preference shares.
- However, the company can redeem such shares only based on the terms on such the issue was made earlier.
- At the time of redemption, the company must pay the full amount. i.e., the shares are required to be fully paid up.
- The last question that remains is how the company will finance the redemption? For this purpose, the company can use the proceeds of the new issue of shares (the prospectus needs to mention that the proceeds will be used to redeem redeemable preference shares) or use current profits.
- The issue of the new shares route helps the company to prevent the reduction of the company’s capital. Reduction in capital affects the confidence level of major stakeholders (i.e., employees, creditors, finance providers, existing shareholders, etc.).
Advantages
The advantages of redeemable preference shares are listed below-
- As discussed earlier, the issuer is at the advantage of whether to exercise the call option now or later.
- Also, the issuer-company can decide whether to go for a normal buyback of shares or choose this option to redeem the shares.
- Redemption of preference shares reduces the number of shares outstanding as of the closing date. Sometimes companies choose this option also to reduce the over-capitalization done earlier.
- A reduction in the number of shares affects the company’s earnings positively since the reduction in the denominator increases the per-share ratio. In addition, such change positively impacts the analysis of the company’s fundamentals since the increase in EPS is linked to an increase in share price & thus an increase in market capitalization.
- Timely redemption of preference shares helps the company to reduce the fixed coupon payments, which may be higher than the normal market rates prevailing at the present date. In addition, the company can save on future payments of higher preference dividends.
- The savings in preference dividends increase the surplus at the end of the company, which positively impacts the wealth of the existing shareholders.
- One of the advantages flows to the venture capital funds, which can exit the position at the pre-determined price. This feature is normally embedded in the issue of every redeemable preference share.
Disadvantages
Every coin has two sides. Thus, the disadvantages of redeemable preference shares are listed below –
- As you can observe, the call option is available only with the company. Therefore, the issuer-company will benefit by exercising the option only when the share’s current market price is higher than the redemption price in the call option.
- The date of redemption is specified in the prospectus & the company cannot redeem the shares before that. Hence, it is required to pay higher fixed dividends till the date of redemption, even if the interest rates are reduced in the market now.
Key Terms of Redeemable Pref Shares
A few important terms of the issue of redeemable preference shares are listed below:
- The preference shares may be kept redeemable at the option of the company or the shareholder’s option or a specific date or contingent upon the happening of a certain event.
- The company must pass a special resolution to issue the prospectus for redeemable preference shares.
- Thus, the special resolution specifies the important terms of the issue of redeemable preference shares.
- The terms of preference shares usually clarify the buzz around these issues:
- Whether or not the preference shareholders have any voting rights.
- Whether the preference shares issued have cumulative or non-cumulative dividends.
- Process of repayment of capital
- Priority ranking of payment for the dividend amount or capital amount of the preference shares
- Whether or not the preference shareholders can participate in the surplus of the company assets or profits or reserves as a specific date.
- One obvious question here is what if the preference shares’ redemption occurred in a situation wherein the company could not satisfy the redemption terms. In such a situation, the transaction is not treated as invalid, i.e., redemption is still allowed subject to infringements by the persons behind the non-compliance.
Conclusion
In a concluding thought, we can say that company can easily get out of the commitment to pay higher dividend rates & pursue paying lower interest rates to debt-holders or lower variable dividends to ordinary shareholders after redemption of redeemable preference shares. Also, the redemption causes the share price to increase in the short term due to the EPS effect.
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