Preferred Stock Dividends may be reinvested

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By STARTUPS.CH, September 18, 2019

ChemChina has acquired the Swiss agrochemical company Syngenta for 44 billion US dollars. To finance this purchase price, ChemChina has planned to issue preference shares at a subsidiary. The issue of preference shares does not only make sense in large corporations. Preferred shares can also be used in a variety of ways in the SME sector. But when does the use of preference shares make sense? How can preference shares be structured? What else has to be considered? This article aims to answer these questions with a view to SMEs.

Preferred shares grant a certain group of shareholders a privilege. This privilege is usually of a financial nature and relates to the dividend, the liquidation share or the subscription right. The principles for handling preference shares are regulated in Articles 654 and 656 of the Code of Obligations.

Preference shares can be designed both as registered and as bearer shares. A preferred shareholder has the same rights and obligations as a "normal" shareholder (by a "normal" shareholder we mean a shareholder who does not own preferred shares). Preference shares are to be distinguished from voting shares, which grant the shareholder a preferential position in terms of voting rights, but not a financial one. In Switzerland, preference shares can be combined with voting shares, which can result in a group of shareholders with a lot of power.

Design options

In practice, there are various options for structuring preferred shares. The specific application depends on the particular situation in the company. The preference shareholders are given privileged treatment compared to normal shareholders, for example in the distribution of dividends. This privilege can be done in two ways:

  • Advance compensation for preferred shareholders compared to normal shareholders
  • Preferred shareholders generally receive a larger share of the dividend than ordinary shareholders

In the first option, the preferred shareholders are served first before the portion above is divided among all shareholders. If, for example, a dividend of CHF 120,000 is resolved and the preference shareholders are entitled to a dividend of CHF 100,000, then CHF 100,000 will first be distributed to the preference shareholders.
The remaining CHF 20,000 will be shared among all shareholders.

With the second option, for example, the preferred shareholders each receive a multiple of the dividend compared to normal shareholders. If, in turn, a dividend of CHF 120,000 is distributed and the preference shareholders are entitled to double the dividend payment compared to normal shareholders, CHF 80,000 will be distributed to the preference shareholders and CHF 40,000 to the ordinary shareholders. The specific design depends essentially on the specific situation of the company and the needs of the individual stakeholders. Preferred shares offer an opportunity to take the interests of the various stakeholder groups into account and to achieve a desired asymmetrical distribution of profits. A binding regulation of the design has to be made in the statutes.

In all cases, however, it should be noted that a profit may only be distributed if there is actually a profit from previous years or if such a profit was generated in the financial year. In this regard, the commercial law regulations on the appropriation of profits in accordance with the Code of Obligations must be observed. If there is no freely distributable capital, no dividend may be resolved. A guarantee for the payment of a dividend to preferred shareholders is therefore not possible.

Possible applications

The possible uses for the use of preference shares are diverse and depend on various influencing factors. In the following, three examples are described in which the use of preference shares can make sense.

Succession plan

For a number of years, a company has regularly offered executive employees employee participation opportunities as part of an upcoming succession, which they have also taken advantage of. As part of the retirement of the main shareholder, a senior employee takes over his share of the shares. However, it is currently not possible for this executive employee to pay the purchase price in full. For this reason, preference shares could be generated, which guarantee the new main shareholder a higher level of financial compensation so that the debt arising from the purchase of the shares can be successively repaid.

In the case described, the preference shares would be structured in such a way that the new main shareholder is served before the other shareholders. Any tax issues or stumbling blocks would have to be analyzed in detail in this case.

Compensation for start-up expenses

When founding a new company, the founders invest a lot of money, commitment and passion over a long period of time. As the activity progresses, the company works successfully and with the need for additional capital, the group of shareholders is expanded. In order to compensate for the expenses in the start-up phase, preference shares are issued. In the event of future dividend payments, the founders will be compensated for their initial expenses by means of higher dividend payments based on preferred shares issued.

Preferred shares in a restructuring

A company has financial difficulties (liquidity problems, over-indebtedness, etc.) and needs to be restructured. As a rule, the search for new donors is relatively difficult in this situation. With the introduction of preference shares, it is now possible to use preference shares to compensate new investors for their increased risk. When future dividends are distributed, the new donors would then receive privileged compensation.

What has to be considered?

Preference shares can be introduced when the company is incorporated or at any later point in time. In the event of a later introduction, it should be noted that the introduction of preference shares must be in the interests of the stock corporation. Unjustified discrimination against other shareholders due to the introduction of preference shares is not permitted. For example, if a major shareholder converts his shares into preference shares for no apparent reason, this is not permitted.

In order for preference shares to be issued, this must be anchored in the articles of association. On the basis of the Articles of Association, the General Meeting decides to issue preference shares. This can be done by means of a capital increase or conversion of existing shares. In addition, the existence of preference shares is entered in the commercial register. It is advisable to plan this process at an early stage and - if necessary - to call in the necessary support. A preliminary clarification with the responsible commercial register office can eliminate misunderstandings and accelerate the process.

We recommend that our customers draw up a shareholders' agreement in connection with preferred shares. The relationship between shareholders and the relationship between shareholders and the company are regulated by means of a shareholders' agreement. The relationships are specified and regulated in a clear and binding manner. In the event of extraordinary events, there is a binding document that can be used. When introducing preference shares, it makes sense to draw up a shareholders' agreement or, if such a document already exists, it must be updated.

The instrument of preference shares can be used in many ways and can be used as a solution to various problems in the SME environment, in particular it can be used to give shareholders a differentiated share of the profits for whatever reasons. Financial incentives can be created by giving financial preference to a specific group of shareholders. The exact introduction, however, depends on the specific situation of the company and on the needs and demands of the respective shareholder groups.

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