Venture investors commonly require that they receive preference shares when investing in startups. Accordingly, it is critical for startups, founders and venture investors to understand the rights attaching to the preference shares.
These rights will dictate the return on investment to which an investor will be entitled upon the occurrence of certain events (which in turn will have an impact on the return on investment for the other shareholders).
What are preference shares?
Preference shares provide the holders of the preference shares with a preference or priority over the holders of ordinary shares on a winding up of the company, although the “liquidation events” are usually extended to certain exit events (such as a share sale or a business sale). The priority in relation to these distributions is customarily known as a “liquidation preference”. If preference shares carry a right for the holder to have their investment repaid, that is referred to as a “1 x liquidation preference”.
The exact formulation of the rights attaching to preference shares varies from company to company and it is not unusual for companies to have multiple classes of preference shares on issue.
Different types of preference shares
Whilst all preference shares provide the holders with a preference or priority, the other rights attached to them can vary and can be subject to negotiation between the company and potential investors. We look at some of these different rights below.
Convertible vs. non-convertible
Convertible preference shares may be converted into ordinary shares, either by the holder electing to convert, or upon certain triggers that are set out in the terms of the preference shares. These triggers often include:
- an initial public offering by the company; and
- a certain percentage of the preference shareholders deciding to convert all preference shares in that class.
If preference shares carry a 1 x liquidation preference, but no right to any surplus above that amount, convertible preference shareholders will convert to ordinary shares leading up to a liquidation event if they will receive a higher return as ordinary shareholders (or, on an “as converted” basis). Convertible preference shares can also carry a liquidation preference that is equal to the higher of these two amounts – that is, a 1 x liquidation preference, or the amount they would receive “as converted” to ordinary shares.
Non-convertible preference shares cannot be converted into ordinary shares.
Cumulative vs. non-cumulative
Preference shareholders can have priority over ordinary shareholders on dividend payments, although not always. If a dividend is not declared in a particular year, preference shareholders with non-cumulative rights to dividends will not be entitled to a dividend for that year. Holders of preference shares with cumulative rights to dividends are entitled to a dividend for that year at some point in the future (in priority to the payment of dividends to ordinary shareholders). Non-cumulative rights to dividends are more common in the Australian market where preference shares carry a dividend preference.
Redeemable vs. non-redeemable
The company may “redeem” redeemable preference shares, meaning that the company may cancel the shares (usually in return for a payment from the company to the holder) at:
- a fixed time or on the happening of a particular event;
- the company’s option; or
- the holder’s option.
The company cannot redeem non-redeemable preference shares (unless the company utilises another mechanism, such as a share buy-back or capital reduction).
Participating vs. non-participating
On a liquidation event, the holders of participating preference shares are entitled to receive their liquidation preference, and also to participate with ordinary shareholders on a pro-rata basis in any surplus assets once all liquidation preferences have been satisfied.
The holders of non-participating preference shares are not entitled to participate with ordinary shareholders once they have received their liquidation preference.
Participating preference shares are rare in venture deals in Australia.
Whilst this is ultimately a matter for negotiation between the company and potential investors, it is not unusual for the terms of preference shares to include an anti-dilution mechanism. Anti-dilution mechanisms protect investors against dilution if the company conducts a subsequent fundraising at a lower valuation (known as a “down-round”). They do this by adjusting down the share price of the preference shares, and thereby increasing the number of ordinary shares into which they convert – i.e. the number of preference shares increases on an “as converted” basis. There are two main types of anti-dilution mechanisms:
- full ratchet anti dilution: this mechanism drops the investor’s share price to the share price of the down-round; and
- weighted average anti dilution: this mechanism reduces the investor’s share price only partly to the share price of the down-round and takes into account the number of shares issued at the reduced price. Weighted average anti dilution mechanisms can be either narrow or broad, depending on whether the weighting takes into account:
- broad: all equity previously issued and currently under issue; or
- narrow: only the total outstanding preference shares,
when determining the new price for the old preference shares.
A broad-based weighted average anti-dilution mechanism is more favourable to the company and its ordinary shareholders and is more common in the Australian market.
Multiple classes of preferences shares
It is not unusual for startups to create a new class of preference shares for each new funding round, resulting in multiple classes of preference shares, each with different terms. The layering of rights can create a good deal of complexity. When a startup is considering creating and issuing a second or subsequent class of preference share, it is important that the terms of the new class are properly drafted to take into account the terms of the existing class(es), so as not to create inconsistencies and potential disputes between different share classes in relation to matters such as priority, liquidation preference and conversion.
Ultimately, the terms of the preference shares will dictate the investor’s return on investment, which in turn will have an impact on the return on investment for other shareholders, including the founders. Mistakes in negotiating the terms of the preference shares, or failing to ensure those terms are properly configured with existing preference shares, can have significant consequences for both investors and existing shareholders of a startup, so it is essential that both startups and investors fully understand the rights attaching to the relevant preference shares.
If you are a startup, founder or investor and have questions relating to preference shares please contact the Corporate Advisory team for assistance. You may also be interested in the upcoming online event ‘The joys and challenges of co-funding‘ hosted by Tech23.