Session 3: Mezzinine Finance and Other Unusual Types of Shares

Learning Outcomes
At the end of this session, Learners should be able to have an understanding of the preference shares as a source of finance for a company.

Important Learning Terms

• Preference shares
• Mezzanine financing
• Unusual types of shares

Introduction
Mezzanine finance is unsecured debt (or preference shares) offering a high return with a high risk.
This type of debt generally offers interest rates two to five percentage points more than that on senior debt and frequently gives the lenders some right to a share in equity values should the firm perform well.

Mezzanine finance tends to be used when bank borrowing limits are reached and the firm cannot or will not issue more equity. The finance it provides is cheaper (in terms of required return) than would be available on the equity market and it allows the owners of a business to raise large sums of money without sacrificing control. It is a form of finance which permits the firm to move beyond what is normally considered acceptable debt/equity ratios (gearing or leverage levels).

Preference Shares

• Preference shares usually offer their owners a fixed rate of dividend each year. However if the firm has insufficient profits the amount paid would be reduced, sometimes to zero.
• The dividend on preference shares is paid before anything is paid out to ordinary shareholders.
• Preference shares are attractive to some investors because they offer a regular income at a higher rate of return than that available on fixed interest stocks (bonds).
• Preference shares are part of shareholders’ funds but are not equity share capital. The holders are not usually able to benefit from any extraordinary good performance of the firm – any profits above expectations go to the ordinary shareholders. Also preference shares usually carry no voting rights, except if the dividend is in arrears or in the case of liquidation.

Advantages to the Firm of Preference Share Capital

a) Dividend “optional”
There is no legal obligation to pay preference dividends every year which gives the company more flexibility and greater chance of surviving a downturn in trading.

b) Influences over management
Preference shares are an additional source of capital, which, because they do not (usually) confer voting rights, do not dilute the influence of the ordinary shareholders on the firm’s direction.

c) Extraordinary profits
The limits placed on the return to preference shareholders means that the ordinary shareholders receive all the extraordinary profits when the firm is doing well.

d) Financial gearing consideration
There are limits to safe levels of borrowing. Preference shares are an attractive, if less effective, shock absorbers to ordinary shares because of the possibility of avoiding the annual cash outflow due to dividends. In some circumstances a firm may be prevented from raising finance by borrowing as this increases the risk of financial distress and the shareholders may be unwilling to provide more equity risk capital. If this firm is determined to grow by raising external finance, preference shares are one option.

Disadvantages to the firm of preference share capital

a) High cost of capital
The higher risk attached to the annual returns and capital cause preference shareholders to demand a higher level of return than debt holders.

b) Dividends are not tax deductible
Because preference shares are regarded as part of shareholders’ funds the dividend is regarded as an appropriation of profits. Tax is payable on the firm’s profit before the deduction of the preference dividend. In contrast, lenders are not regarded as having any ownership rights and interest has to be paid whether or not a profit is made. This cost is regarded as a legitimate expense reducing taxable profit.

Types of Preference Shares

a) Cumulative
If dividends are missed in any year the right to eventually receive a dividend is carried forward. The prior-year dividends have to be paid before any payout to ordinary shareholders.

b) Participating
As well as the fixed payment, the dividend may be increased if the company has high profits.

c) Redeemable
These have a finite life, at the end of which the initial capital investment will be repaid. Irredeemable preference shares have no fixed redemption dates.

d) Convertibles
These can be converted into ordinary shares at specific dates and on pre-set terms (for example, one ordinary share for every two preference shares). These shares often carry a lower yield since there is the attraction of a potentially large capital gain.

Some Unusual Types of Shares
In addition to ordinary and preference shares there are other, more unusual, types of shares:

1. Non-voting shares
   These are sometimes issued by firms (especially family-controlled) which need additional equity finance but wish to avoid the diluting effects of an ordinary share issue. They are often called “A” shares and usually get the same dividends, and the same share of assets in a liquidation as the ordinary shares.
2. Preferred ordinary shares rank higher than deferred ordinary shares for an agreed rate of dividend.
   So, in a poor year the preferred ordinary holders might get their payment while deferred ordinary holders receive nothing. However in an exceptionally good year the preferred ordinary holders may only receive the minimum required while the deferred ordinary holders are entitled to all profits after a certain percentage has been paid to all other classes of shares.
3. Golden shares
   These are shares with extraordinary special powers, for example the right to block a take-over. Golden shares are also useful if a company wishes to preserve certain characteristics it possesses.