Most people know that preference shares come with a liquidation preference. If the company becomes insolvent, the preference shareholders will be paid out before the ordinary shareholders. However, preference shares will have other rights attached to them and potentially be the subject of much negotiation. It is, therefore, worth knowing what the different options of preference shares are and what they mean.
As discussed, all preference shares come with a liquidation preference, but the amount of the liquidation preference can differ. For example, your preference shares may come with a 1x purchase price liquidation preference. Therefore, if the company becomes insolvent, you will get 1x the issue price of your shares back before the ordinary shareholders get anything. Alternatively, if a 2x purchase price liquidation preference is issued to you, then you will get 2x the issue price of your shares back before the ordinary shareholders get anything. Obviously as a preference shareholder, the higher the liquidation preference, the better. Currently, a 1x purchase price liquidation preference is standard in the Australian market.
Participating versus Non-Participating
If you are issued with non-participation preference shares, you will not be entitled to participate in the surplus assets and profits of the company once all of the shareholders are paid back. Conversely, if you are issued with participating preference shares, you will be entitled to participate in the surplus assets and profits of the company once all of the shareholders have been paid back.
As a shareholder, it is obviously more advantageous to have participating preference shares. However, non-participating preference shares are currently more standard in the Australian market.
Cumulative versus Non-cumulative Dividends
Preference shares usually come with a preferential dividend and so the shareholders with preference shares are entitled to receive dividends before ordinary shareholders.
Rights to dividends can be cumulative or non-cumulative. If a company does not declare a dividend payable 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, and it would be entitled to receive that dividend in the future before any dividends are payable to ordinary shareholders.
As a shareholder, it is more advantageous to receive cumulative dividends, but non-cumulative dividends are currently more prevalent in the Australian market.
While voting rights are generally attached to preference shares, it is possible for such rights not to be attached. Obviously, it favours the shareholder if voting rights are attached.
Convertible versus Non-Convertible
Preference shares may be convertible or non-convertible. If they are non-convertible, the shareholder has no option to convert them into ordinary shares. If they are convertible, then the shareholder will have the choice to convert them to ordinary shares, generally at a pre-agreed time. On conversion, all of the preferential rights of the preference shares (such as the liquidation preference) disappear, and the shares become ordinary shares. For more information on why a shareholder might want to convert preference shares into ordinary shares, please see our article: Why would I convert my preference shares to ordinary shares? Convertible preference shares are better for the shareholder as they provide them with the flexibility to convert their shares if it is in their interests to do so.
Redeemable versus Non-Redeemable
Redeemable preference shares are shares which a company can redeem. Therefore, the company can buy the shares back, on the term on which they are on issue, using either: (i) profits which would otherwise have been used to pay dividends; or (ii) the proceeds of a new issuance of shares. Generally, redeemable preference shares can be redeemed either at a fixed time; on the occurrence of a pre-determined event; at the company’s option; or at the shareholder’s option. On redemption, the shares are cancelled.
On the other hand, non-redeemable preference shares cannot be redeemed by the company. Non-redeemable preference shares are therefore generally better for the shareholder. However, it is possible that such shares may be subject to buy back provisions set out in the company’s shareholders agreement. It is likely that such provisions would have a similar consequence for the shareholder, especially when they are a key person within the company, such as a founder on whom the company is heavily reliant and whom investors want to lock into the company using vesting shares or leaver provisions.
There are various types of preference shares and the rights attached to them are of great significance. It is, therefore, crucial to have a clear understanding of what such rights mean before issuing or accepting a particular type of preference share. If you would like more information on preference shares or would like to discuss what type of preference share you should issue or accept, contact one of our lawyers.