The first and most basic question is, what are preference shares?
Preference shares, more commonly referred to as preferred stock, are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, or wounds up, the shareholders with preferred stock are entitled to be paid from company assets first. Most preference shares have a fixed dividend, while common stocks generally do not. Preferred stock shareholders also typically do not hold any voting rights, but common shareholders usually do.
Convertible preferred stock includes an option that allows shareholders to convert their preferred shares into a set number of common shares, generally any time after a pre-established date. Under normal circumstances, convertible preferred shares are exchanged in this way at the shareholder’s request. However, a company may have a provision on such shares that allows the shareholders or the issuer to force the issue. How valuable convertible common stocks are based, ultimately, on how well the common stock performs.
Notwithstanding a company may buy back its shares, it may issued preference shares upon terms that they may be redeemed at the option of the company, provided that the requirement of sec 61 of the Companies Act are complied with. The redemption of such preference share does not reduce the capital of the company. Redeemable preference shares are only one among many other types of preference shares, such as cumulative, participating and convertible preference shares.
Redeemable preference shares, as per Companies Act 2013, are those that can be redeemed after a period of time (not exceeding twenty years). The issue of such shares (preference) must be authorized by the articles.
Redeemable preference shares are often used to raise capital in venture capital companies. This mechanism allows an investor more security than an equity shareholder and more participation in the company than a creditor. A redeemable preference share may be issued with full voting rights. If they do carry full voting rights, they are not deemed to be preference shares for the purposes of sec 4(1) of the Act.
Redeemable preference shares may only be redeemed in accordance with the articles of association. They have to be fully paid up before they are redeemed.
Redemption may take one of two ways:
(a) Firstly, the company may redeem the shares out of profits which would have otherwise been available for payment of a dividend. Where this is done, a sum equal to the nominal value of the redeemed shares must be transferred to a ‘capital redemption reserve’, which is treated as if it were paid up capital of the company for the purposes of reduction of capital. No actual transfer of funds takes place, the matter being handled as an accounting entry. This capital redemption reserve may be applied in paying up unissued shares to be issued to members as fully paid bonus shares. This would merely involve a book keeping transaction, the capital redemption reserve being reduced and the paid up capital correspondingly increased.
(b) Secondly, the company may redeem the shares out of the proceeds of a fresh issue of shares made for the purpose of redemption. If the shares are redeemable at a premium, the share premium account may be reduced to reflect this.
If it is desired to reduce the capital redemption reserve in any other way, the proper procedure for capital reduction will have to be followed.