In Short
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Ordinary shares usually come with voting rights and entitle holders to dividends after preference shareholders.
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Preference shares have priority over ordinary shares for dividend payments and during company liquidation, often without voting rights.
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Ordinary shares are typically held by founders and employees, while investors often prefer preference shares for added security.
Tips for Businesses
When deciding on share classes, match them to your business goals. Use ordinary shares to maintain control and motivate your team, and preference shares to attract investors who want more certainty. Make sure your company’s constitution clearly sets out each share class’s rights, and review your structure regularly to stay aligned with your needs.
Table of Contents
Your startup can secure capital by issuing two different classes of shares. These are either ordinary shares or preference shares. Each share gives different rights to investors. Generally, a business will issue ordinary shares to founders and employees. On the other hand, preference shares are suitable for investors who wish to secure their return. This article will explore the difference between ordinary and preference shares, specifically regarding three key characteristics of voting rights, dividend rights and rights during liquidation.
Ordinary Shares
It’s important to note that not all ordinary shares have the same rights. The ordinary shares in one company may have entirely different rights from the ordinary shares in another. Ultimately, the rights attaching to ordinary shares in a particular company will be set out in the Corporations Act, as well as that company’s governance documents, such as its Constitution and Shareholders Agreement (if applicable).
Voting Rights
An ordinary share typically grants the shareholder the right to vote on matters presented to all of the company’s shareholders. The weight of a particular shareholder’s vote typically depends on the percentage of ownership they hold in the company. Typically, one share equals one vote, but this is not always the case. Voting entitlements may differ on a case-by-case basis.
Dividend Rights
Ordinary shares often give the shareholder the right to receive a share of the company’s profits through dividends if and when the company decides, in its discretion, to declare dividends in accordance with its dividend policy. The dividends of an ordinary shareholder will typically fluctuate in line with the company’s performance and profits.
Liquidation
A liquidation event often refers to, among other similar events, a sale of all or substantially all of the company’s shares or assets, a liquidation or insolvency, a merger, or a listing of the company’s shares on a publicly recognised stock exchange.
If a company can no longer pay its debts when they fall due, the company is insolvent. Accordingly, the business may proceed into liquidation.
During this liquidation process, the typical order of repayment is as follows:
- secured creditors;
- unsecured creditors;
- preferential shareholders; and
- ordinary shareholders.
The holders of ordinary shares generally rank last in receiving any funds from the company in the event of a liquidation. As we discuss below, this is because the holders of preference shares often have a “liquidation preference.”
Unfortunately, this means that holders of ordinary shares may not receive any proceeds if the funds available for distribution in a liquidation event are insufficient to first repay the company’s creditors and preferred shareholders.
Preference Shares
As the name suggests, a preference share gives the shareholder preferential treatment over the ordinary shareholders. Accordingly, preference shareholders have different rights than ordinary shareholders.
Conversion
Preference shares are often made convertible into ordinary shares, providing flexibility. This feature allows investors to protect against the ‘downside’ through preferential treatment attached to the preference shares, while also maintaining the option to participate in the company’s potential growth, being the ‘upside.’
The conversion right typically becomes attractive when the company performs well and the value of ordinary shares surpasses that of the preference shares or if the conversion is necessary to facilitate effective participation in an exit event (such as a sale of the Company’s shares or a listing of those shares on a publicly recognised stock exchange). In such scenarios, investors can convert their preference shares to ordinary shares to capitalise on growth opportunities and the company’s success.
Voting Rights
Preference shareholders typically have the right to vote as if their securities had already been converted into ordinary shares. This means that the voting rights of preference shares are equivalent to those of ordinary shares. However, it is not uncommon for the holders of preference shares to seek special ‘veto rights’ on critical decisions.
The term “veto rights” in this context typically refers to decisions that require a degree of approval from the holders of preference shares, allowing them to block the decision if they disagree with it. While such rights are beneficial to investors, they can pose challenges for companies, particularly if investors holding those rights block decisions because they are not strategically aligned with the company’s goals.
The types of matters in respect of which preference shareholders may have veto rights vary on a case-by-case basis. For example, it is not uncommon for preference shareholders to be required to approve decisions which would, among other things, result in:
- a material change to the business;
- changes to the rights belonging to their shares;
- the issuance of a new class of shares with superior rights;
- incurring debt or capital expenditure above a certain amount; and
- an exit such as a disposal of all, or substantially all, of the company’s shares or assets.
This is because such decisions may materially impact the rights of those shareholders, and in turn, the likelihood of a positive return. In this sense, veto rights, when used responsibly and appropriately, can serve to maintain accountability of the company’s board of directors.
Dividend Rights
In Australian venture capital, preference shares often have the same dividend entitlements as ordinary shares; however, in some cases, they may be entitled to priority dividend rights based on a fixed percentage of the share’s value, which is cumulative, meaning that unpaid dividends accumulate over time. This is more common in mature companies undertaking later-stage funding rounds.
Liquidation Preference & Ranking
Preference shares, unlike ordinary shares, often have a ‘liquidation preference.’
A liquidation preference refers to the order and manner in which the proceeds available for distribution are apportioned amongst the company’s shareholders if the company experiences a “liquidation event”. A liquidation event often refers to, among other similar events, a sale of all or substantially all of the company’s shares or assets, a liquidation or insolvency, a merger, or a listing of the company’s shares on a publicly recognised stock exchange.
The most common form of liquidation preference in the Australian venture capital market is a ‘1x non-participating liquidation preference’. That is, if a liquidation event occurs, investors holding these rights are usually entitled to receive an amount of money equal to the greater of:
- 1 x initial investment; or
- their pro-rata proportion of the proceeds available for distribution.
This is before any funds are distributed to other shareholders, such as the holders of ordinary shares. If there are leftover proceeds available for distribution, then the holders of ordinary shares will receive their portion of those proceeds. The “non-participating” component means that the holder of the liquidation preference cannot “double-dip” by receiving both their initial investment back and then also a proportion of the remaining proceeds.
As noted above, preference shares typically rank ahead of ordinary shares in the event of a liquidation.
LegalVision’s Employee Share Schemes Guide is a comprehensive handbook for any startup founder or business owner looking to attract and motivate top employees with an Employee Share Scheme.
Anti-dilution Protection
Preference shares often have ‘anti-dilution’ rights, which aim to safeguard an investor’s ownership percentage if the company issues new shares at a lower price than the price paid by the investor who holds the anti-dilution right (known as a ‘down-round’). Ordinary shares generally do not have such rights.
In summary, if a “down round” occurs, the price at which the investor’s preference shares will eventually convert into ordinary shares (the “conversion price”) is adjusted downward, effectively giving them more shares. The new conversion price is typically situated between the down-round price and the price at which the investor initially purchased its shares. This right is designed to strike a balance between investor protection and fairness to other shareholders, making it a common feature in venture financing agreements.
Continue reading this article below the formKey Takeaways
Ultimately, the key difference between ordinary and preference shares is in the right to vote, receive dividends and receive money during liquidation. A business generally issues ordinary shares to the founder and employees. Meanwhile, investors are likely to seek preference shares, as this offers preference in the event of liquidation. Thereby, the investor is more likely than an ordinary shareholder to receive their money back.
If you need help determining which shares to issue for your business, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
Ordinary shares refer to a type of shares a business offers. Generally, if you have an ordinary share, you will have a voting right on matters put before all company shareholders. This vote is proportional to the number of shares you hold in the company. Additionally, you may receive dividends. The exact figure you receive depends on company performance and profits. As an ordinary shareholder, you are also likely to be in the last category of individuals receiving money if the company goes into liquidation.
Liquidation is a process where a company is wound up, typically because it is insolvent. In this scenario, a liquidator is appointed and sells company assets to generate cash to repay creditors. In this process, the creditors of the business will receive money before the shareholders.
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