‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from venture capital investors. Further information about The VC Series can be found here.
A VC will often subscribe for a form of preference share in the company. This article explores what preference shares are, why VCs subscribe for them, and what their key features are.
A preference share is a class of share that benefits from certain preferential rights that are not shared by the ordinary shares that are held by the founder(s) and other shareholders.
VCs require preference shares to reflect the fact that they are typically investing larger sums than other investors (and the founder(s)), and at a higher valuation than shareholders who have invested previously.
Where there is already a VC shareholder that holds a class of preference shares, then on a new investment round an incoming VC would expect a new class of preferred shares to be created to ensure seniority to the other classes of shares previously issued.
As referred to above, the rights that attach to the preference shares will vary depending on the VC and the negotiating position, but some of the key features are:
In terms of voting, you would typically expect the preferred shares to have identical voting rights as the ordinary shares.
Preference shares will often be entitled to a fixed rate of dividend which is paid out to preference shareholders in priority to any other shareholders. The rate of the dividend is typically by reference to the value that the VC had paid up on the shares.
VCs will typically expect the preferential dividend to be cumulative – this means that, where the company does not have sufficient available profits in any given financial year, the dividend will accumulate until it is paid.
This is often the most important preferential right as it determines in what order proceeds will be returned to shareholders on an exit or a winding up of the company. The starting point is that investors who hold preferred shares will have the right to get a certain amount of money back in priority to the other shareholders – you can find out more about the different types of liquidation preference in our dedicated article here.
When a company issues new shares, it has the effect of diluting the ownership percentages of the existing shareholder.
Anti-dilution protection serves to mitigate this dilutive effect for preferred shareholders, most commonly where there is a new issue of shares at a price which is less than that which the preferred shareholder had previously invested (otherwise known as a down-round). More details on the different types of anti-dilution protections can be found here.
If an investor has not been able to realise a return on its investment by a sale or a listing, then redemption provisions provide another avenue by which an investor can “exit”.
It operates by way of granting the investor the ability to require that the company redeems (i.e. buy-back) its preference shares at a previously agreed price (which is often an amount equal to its original investment).
Often the right of redemption is only available if an exit has not been achieved by other means within a certain period of time (five years for example).
Redemption provisions are rarely relied upon and in practice would likely be difficult to enforce, on the basis that the company would need to have sufficient distributable profits in order to fund the redemption (which in these circumstances might be unlikely).
Redeemable shares can also cause accounting issues for UK companies, as they might need to be treated as a debt item on the company’s balance sheet.
It is a common feature of preference shares that the investor can convert them into ordinary shares at any time, typically on a one-to-one basis.
The most likely scenario in which an investor would exercise this right is immediately prior to a sale of the company, where holding ordinary shares would allow them to achieve greater returns. This occurs where there is a non-participating or capped participating liquidation preference, the effect of which would have capped the amount they would have received on the sale if they continued to hold preference shares – more detail can be found in our article on liquidation preferences here.
There is typically also an automatic conversion immediately prior to a listing of the company, as listings can be complicated by having different classes of shares in issue.
The next article in The VC Series explores liquidation preferences in more detail.
You can find details of all the different articles in the VC Series here.
If there is anything that we have not covered which you would find useful, then please let us know.