What are preference shares?
In most ways, preference shares are identical to ordinary shares. Holding 50 preference shares gives you no more percentage ownership in a company than holding 50 ordinary shares and entitles you with the same ability to vote on matters put to shareholders.
The main difference between the ordinary shareholder and the preference shareholder is their rights when it comes to company money. Preference shareholders have the right
- to be paid any company dividends first, and
- have priority in any exit or liquidation event
Startups can be volatile, and the majority don’t succeed, so VC funds and angel investors who make a living out of funding them have a strong incentive to only buy shares that guarantee them more security.
What are the advantages and disadvantages of issuing them?
The groups most interested in obtaining preference shares are venture capitalists, because it ensures they have a higher chance of success no matter what happens to the startup or company they have invested in. Let’s examine three potential outcomes:
- They fail
- They do just okay
- They succeed
Let’s take Company X Pty Ltd as an example, and see how preference shareholders benefit in each scenario. Company X is a tech startup with 20 shareholders, including two founders and four VC shareholders who all came on board in the last Series Seed fundraising round and own 10% of the Company each. The founders and the 14 regular investors all have ordinary shares (or ‘founder’ shares - which are equivalent to ordinary shares) and the VC funds have preference shares.
Despite having a few promising fundraising rounds, Company X is struggling to get traction in the market and is no longer able to pay employees or generate VC interest in another fundraising event. Eventually, Company X is forced to close down for insolvency and liquidate any assets it has. This is where the preference shareholders come in. With any money that is left, preference shareholders must be paid back the amount of their investment first - even before the founders. So in the event that Company X is not able to recover the total amount that was invested by every shareholder but is able to recover some, ordinary shareholders will not get their money back and preference shareholders will be repaid in the priority order of who has the most preference shares. For the three main players: the ordinary shareholder, the founder and the VC fund, this outcome leaves them in the following position:
- VC fund: gets either the full amount of their investment back, or part of their investment back
- Ordinary shareholder: gets nothing
- Founder: gets nothing
Company does okay:
What about if Company X doesn’t totally fail but also doesn’t live up to its initial hopes? Say Company X has managed to maintain its value and is up to date on all of its debt so seeks out a sale offer. They are approached by Google, who’d like to buy it for $10 million and because they have no other offers and it seems a fairly good deal, Company X agrees. Whilst they have not totally failed, their liquidation preference was $12 million, meaning there will not quite be enough to go around. In this instance, the preference shareholders will take the entire $10 million sale value, ahead of both the founders and the ordinary shareholders. The outcomes here are as follows:
- VC fund: gets their investment back
- Ordinary shareholder: gets nothing,
- Founder: gets nothing, and has to move on with the knowledge that they were very close to succeeding.
Let’s now take a look at the last (and rarest) scenario, where Company X does very well and sells to Google for $50 million with multiple other interested buyers. Here, a bit of extra nuance comes into play. Preference shares are typically issued as either convertible or non-convertible shares. Non-convertible preference shares entitle the shareholder to priority on company dividends and liquidation money in scenarios 1 and 2, but do not entitle the shareholder to any company surplus. Convertible preference shares can be exchanged for ordinary shares subject to the terms of Company X’s shareholders deed, meaning that the shareholder will get a higher return on their surplus when they exchange. All parties receive a positive outcome when the startup succeeds, but in Company X, the four convertible VC shareholders receive the best outcome of all:
- If they are a participating preferred shareholder, they will receive the amount of their investment plus 10% of the surplus (equivalent to the amount of the Company they own).
- If they are a non-participating preferred shareholder, they can choose between receiving their investment back or 10% of the 50 million dollar sale.
- Ordinary shareholder: receives their pro-rata share of the remaining profit from the sale.
- Founders: receive their pro-rata share of the remaining profit from the sale. If the founders own 20% of the company each, they will get 20% of the money left once the participating preferred shareholders have taken their initial investment back.
Having preference shares in play is a complicated calculation for founders, but the issuing of them to VC funds is often a non-negotiable condition of their investment, making it necessary for the success of many high growth companies. When deciding to issue preference shares, startup founders should be careful when negotiating with VC funds to ensure that they get a deal that won’t backfire on them when it's time to exit.