Limited companies, whether public or private, can issue shares of different classes. These shares represent part-ownership of the company and are normally issued in return for cash (known in this context as capital).
Ordinary shares are the most common type of share class and are usually issued to the original founders, employees and investors claiming SEIS or EIS relief. You can find out more about EIS relief and how to apply in our article.
Companies often introduce preference shares as they grow and need new investment so preference shares are typically issued to new, external investors like venture capital funds who will be looking for first dibs on the profits of the company and options for a smooth exit.
In this article, we take a high-level look at preference vs ordinary shares and examine the material differences between these two share classes. It’s always wise to speak with experienced funding round lawyers before accepting investment – and we’re here to help when you’re ready.
Contents:
What are ordinary shares?
When you incorporate a limited company, the first members will normally be the founders of the company who are issued with shares in proportion to their agreed ownership rights. For example, if two individuals decide to start a company on an equal footing, they’ll be given a number of ordinary shares on a 50/50 basis. These ordinary shares are issued at a nominal value per share, often £1.
Ordinary shares will have certain rights including voting rights which give ordinary shareholders a say over decisions proposed by the board of directors of the company. The owners also have the right to share in the profits of the company by receiving dividends which are generally paid half-yearly or quarterly. The level of dividend will depend on how well the company is performing and whether the directors decide to pay the profits to shareholders rather than re-investing the cash in the business.
Ordinary share ownership, as a form of investment, is relatively risky as if the company doesn’t succeed, the ordinary shareholders stand to lose the value of their shares. On liquidation, ordinary shareholders are the last to get paid after all outstanding debts and the payment of any preference to the holders of the preference shares so risk ending up with nothing.
What are preference shares?
Some companies issue preference shares in addition to ordinary shares, typically once they start to grow and need additional investment. Preference shares are shares which take priority over ordinary shares with respect to the payment of capital and dividends. These priority or preferred rights which attach to the preference shares will be set out in the company’s articles of association. Preference shares do not normally carry voting rights unless in exceptional circumstances, such as non-payment of their dividends. There are no set requirements as to what preferences are attached to the preference shares, but they often have the following rights:
Liquidation preference rights
Liquidation preference rights entitles the holder of the preference shares to be paid out ahead of the holders of the ordinary shares on a liquidation. Liquidation preferences can be structured as participating or non-participating.
A participating liquidation preference entitles the holder of the preference share to receive back the amount paid for the preference share ahead of the ordinary shareholders plus a further distribution alongside the ordinary shareholders on a pro rata basis.
A non-participating liquidation preference entitles the holder of the preference share to receive the amount paid for the preference share ahead of the ordinary shareholders only. Any further amount available for distribution is allocated to the ordinary shareholders.
Preferential dividend rights
Preferential dividend rights allow the holders of the preference shares to receive a fixed dividend each year in priority to the holders of the ordinary shares. The right to receive a dividend will always to be subject to the company having sufficient distributable profits.
Who issues preference shares?
Preference shares are usually issued by companies whose owners are looking to raise additional capital to finance their business, often as part of a funding round. Issuing preference shares gives founders the ability to get cash without giving up control of the company but only if the preference shares are non-voting.
Types of preference shares
Cumulative and non-cumulative preference shares
If dividends are not paid in a certain year then upon payment of a subsequent dividend, cumulative preference shareholders would be entitled to receive the current dividend plus any dividends they missed from previous years. Non-cumulative preference shareholders would lose any right to missed dividends from previous years.
Convertible preference shares
Convertible preference shareholders have the option to exchange their shares for ordinary shares at a set price after a specified date depending on the terms agreed in advance. Conversion to ordinary shares typically affords voting rights and so these preference shareholders may have a view to becoming more involved in the management of the company at a later stage. Convertible loan notes are a popular option when raising investment, and we talk more about them in this article.
Participating preference shares
Participating preference shareholders have the right to ‘participate’ in the performance of the company once profits hit a certain level. They do this by receiving an additional dividend over and above their basic dividend.
Redeemable preference shares
Redeemable preference shareholders may redeem their shares on a certain date when the value of the shares will be paid back to the shareholder and the shares cancelled. They are often used by investors to allow an easy exit route from a company at an agreed point in time. The company’s articles of association should set out the terms and manner of the redemption and whether the shares are redeemable at the option of the company or the shareholder or both.
Who invests in preference shares?
Preference shares are normally bought by investors like venture capital firms who want a fixed income investment, the potential for capital growth and a smooth exit route.
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