Startup investors are almost always aiming to invest in start-ups through “preferred” equity, typically referred to as preference shares. Preference shares rank in preference to ordinary shares, as the holders of preference shares normally receive preferential treatment in the event of a liquidation of the business, with a liquidation event being either an insolvency, a dissolution, or a sale of the company.
High-growth companies looking to raise finance, typically start off with term sheets. A term sheet is a precursor to final and definitive legal documents. The term sheet serves as the tool to get the parties on the ‘same page’ as to the commercials of the deal, so to speak.
Term sheets often come with a plethora of terms regarding the structure of the preference shares. As a first-time entrepreneur, it can be a daunting task to understand which terms are “standard”. Experienced investors have the upper hand and this is when and where you really need your startup lawyer on speed-dial.
What are preference shares?
The main characteristic of preference shares is that they provide for the preferential treatment of their holders and rank above ordinary shares in the event of a liquidation event. This means that if a company is unable to pay its debts or its business is sold, the investor will have a first claim on the company’s assets or sale proceeds over ordinary shareholders i.e. the founders. This is a protection mechanism given to the investor in return for the risk incurred when investing in the company. This is called a liquidity preference.
Preference shares may further entitle the holder to preferential dividends, based on the profits of the company. Preferred dividends are normally fixed at a certain annual percentage. As a preference shareholder, the investor will receive dividends ahead of ordinary shareholders when dividends are declared by the board of the company. This is called dividend preference.
The liquidation preference determines how the proceeds of the company are shared in a liquidation event. Preference shares almost always come with a liquidation preference, but the multiple can differ. For example, the investor’s preference shares may come with a multiple of 1x the purchase price. This means that upon a liquidation event, the investor will be paid 1x the issue price of his shares before the ordinary shareholders get anything. (For example, if the investor invested R1 million into the company, the investor wants R1 million paid back to him before the founders receive anything.) Similarly, if the investor’s liquidation preference is 2x purchase price, the investor will receive a multiple of 2x the issue price of his shares before the ordinary shareholders get anything.
As a start-up founder, you need to know what you are committing to. You might realize, when it’s too late, that you have granted the investor an unfair preference on liquidation, leaving you and your co-founders with little to show for your efforts.
Participating and non-participating
Generally, as seen above, the preference shareholders receive preferential returns. This means that they are paid back their initial investment plus some preferential payment (the liquidation preference multiple) before any other proceeds are disbursed. The extent to which additional funds, beyond this preference, are disbursed to investors depends on whether the equity is participating or non-participating preference shares. Participating preference shares take a share of the additional proceeds, along with ordinary shareholders, after receiving their preferential returns. For example, the preference shareholder participates in the equity apportionment in addition to receiving his liquidation preference. Holders of non-participating preference shares, however, only receive the preference plus any accrued dividends.
For example, an investor invests R2 million into a company at a 2x liquidation preference and at a post-money valuation of R10 million (giving the investor a 20% stake in the company). The company is sold for a net sale price of R20 million. Therefore, the investor receives his 2x R2 million liquidation preference (receiving R4 million) and a R16 million surplus remains. If the preference shares are participating preference shares, the investor will receive an additional 20% of the surplus amount (a further R3.2 million). Alternatively, if the shares are non-participating preference shares, the other shareholders, i.e. the founders, will distribute the surplus among themselves according to their shareholding percentages.
An important point to note is that “participation” in venture capital deals generally refers to capital, however, it may also refer to participation in pro rata dividends beyond the fixed preference dividend. As a founder, you must have clarity on this from the start.
Dividend preference: cumulative and non-cumulative
Preference shares often provide for a preferential dividend as well – investors with preference shares are entitled to receive dividends before ordinary shareholders.
Dividends increase the total return for the investors and decrease the total return for ordinary shareholders. Dividends are often stated as a percentage of the share issue price for the preference shares (for example, 8% of the total share issue price). There are at least three general ways dividends are structured in venture capital deals: (i) cumulative dividends; (ii) non-cumulative dividends; and (iii) dividends on preference shares only when paid on the ordinary shares.
Dividend structures (i) and (ii): If a company does not declare a dividend in respect of a particular year, then preference shareholders with a right to non-cumulative dividends would lose the right to receive a dividend for that year. However, preference shareholders with a right to cumulative dividends would be able to carry over their right to receive a dividend for that year, entitling them to receive that dividend in the future, together with the dividend declared in that next year (before any dividends are payable to ordinary shareholders). Clearly, cumulative dividends are the most beneficial to the investor and the most burdensome on the founders (being ordinary shareholders).
Dividend structure (iii): Where dividends are paid on the preference shares only if paid on the ordinary shares, the preference shares are treated as if they had been converted into ordinary shares at the time the dividend is declared. This is the least beneficial to the investor and the most beneficial to the founders.
If not clearly understood, agreeing to a cumulative dividend can lead to significant and unexpected monetary burdens on the available and distributable profits for you and your co-founders. As a start-up founder, you must understand the different ways in which dividends can be structured. You need to consider the company’s projected cash flow from now until the expected exit and the impact the dividend preference has on shareholders.
We trust that the issues highlighted above will give you some insight and guidance as to why it is so important to have a good understanding of the preference share terms you are likely to find in a term sheet. If you would like to discuss any of these topics in more detail, please feel free to contact our team and we’ll gladly assist.