If you are raising capital from a venture capitalist, then you are almost certainly going to have to issue them with preference shares as opposed to ordinary shares. While the rights attaching to preference shares can differ, venture capitalists are most likely to ask for preference shares which attach the following rights:
1x Purchase Price Liquidation Preference
Preference shares will attach a particular type of liquidation preference. In a seed round, a venture capitalist will most likely expect to be issued with shares attaching a 1x purchase price preference. Hence, in the occurrence of a liquidation event (such as a sale of the company), the venture capitalist will receive the amount of money it invested in the company (assuming there are sufficient funds) before ordinary shareholders get anything. If a venture capitalist asks for a higher liquidation preference (for example a 2x purchase price preference which would entitle it to twice the amount of money it invested in the company before ordinary shareholders get anything), you should try to negotiate with them down to a 1x purchase price preference.
If a venture capitalist is issued with non-participating preference shares then it will not be entitled to participate in any surplus funds, once all shareholders have been repaid. While a participating preference share is more advantageous for the shareholder (as it would mean they can participate in the surplus funds) it is not very common for a venture capitalist to ask for this. If they do, you should try to negotiate a non-participating preference share.
Preferential Non-cumulative Dividend
Preference shares generally have a preferential dividend, where on the occurrence of a liquidation event, the preferential shareholders will receive any outstanding dividends before ordinary shareholders are paid anything. Preferential dividends can be cumulative or non-cumulative. While a non-cumulative dividend lapses if it is not declared in respect of a particular year, a cumulative dividend, can be carried over to the next year (and so on) until paid. In seed rounds, venture capitalists generally receive a preferential non-cumulative dividend. Obviously, a cumulative dividend would be better but because this is not typical, if a venture capitalist asks you for a cumulative dividend, you should try to negotiate a non-cumulative dividend instead.
A venture capitalist will usually want the option to convert its preference shares into ordinary shares if it is in its interests to do so. Although it may sound strange, there are occasions when it would be beneficial for a venture capitalist to do so. For more information, please see our article titled: Why would I convert my preference shares into ordinary shares?
A venture capitalist will almost certainly want voting rights attached to its preference shares so that it can attend and vote at general meetings. Additionally, a venture capitalist will likely also want a board seat, even if it is not a majority investor, to ensure the company is running properly and their investment protected.
When raising external investment, it can be difficult to know what to offer in terms of shares. If you require any help with capital raising, do not hesitate to contact one of our capital raising specialists to assist with the legal documentation process.
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