Table of Contents
When raising capital through a share issuance, there are different kinds of shares you can allot. The two most common shares you are likely to issue are ordinary shares and preferred shares. This article will explain what preferred shares are and how they differ from ordinary shares so you can determine if you wish to issue preferred shares.
What are Shares?
Shares are a proxy for ownership in a company. By holding a share, you gain certain rights in the company, like the right to vote at meetings and receive dividend payments. By issuing shares, your company receives cash in exchange for giving ownership rights to the new shareholders.
If you are considering a new share allotment, you may want the new shareholders to have different rights from the ones you have. Alternatively, your investors may demand that they obtain different rights in the company than the ones you enjoy. To distinguish between the different sets of rights, you would need to issue shares of a different class.
What are Preferred Shares?
Preferred shares, also called preference shares, are one of the most common classes of shares. They typically exist in contrast to ordinary shares and are most commonly issued as part of seed-stage funding and series financing. Ordinary shareholders typically refer to the company’s founding members.
As the name suggests, preference shares grant the shareholders enhanced rights, usually to dividend payments. This means that preference shareholders have the first claim to dividend payments. Only after all the preference shareholders have received their dividends can the company issue dividends to ordinary shareholders.
The dividend amount a preference shareholder is entitled to is usually expressed as a fixed amount per share. This is why you may hear preference shares referred to as fixed-income shares. It follows that each preferred share grants the shareholder a fixed amount if any dividend is issued, for example, £0.10 per share. Therefore, if a shareholder holds 10,000 preferred shares, they receive £1,000 when a dividend is announced.
Most preference shares do not give shareholders the right to vote at shareholder meetings. That said, no rule prevents you from issuing preference shares with voting rights.
Continue reading this article below the form
Call 0808 196 8584 for urgent assistance.
Otherwise, complete this form and we will contact you within one business day.
Advantages of Preferred Shares
From the perspective of your potential investors, having preference shares enhances their position. They know that they will receive a dividend payment before the ordinary shareholders. Thus, if there is a limited amount to distribute, they get it first. Additionally, this encourages ordinary shareholders to maximise the business’ performance so that they can participate in the dividends.
From your perspective as a founding member, offering preference shares makes it easier to raise cash because of the benefits to the investors.
Additionally, you may wish to issue preference shares as an alternative to debt finance, such as borrowing money. This is because preference shares create less onerous obligations compared to debt.
Most notably, your company is not obligated to repay preference shareholders on a regular basis as it would a bank. Instead, it only has to pay preference shareholders when it issues a dividend — and dividends require a profit. As such, if your business is running at a loss (as is common for startups), your company does not have to repay its investors.
Finally, if you issue preference shares without voting rights, you do not dilute the ordinary shareholders’ control in the company. However, in practice, investors may require that you appoint them as directors, which means they will have influence over day-to-day management.
Different Types of Preferred Shares
The law does not define preference shares. Instead, preferred shares is a term that refers to classes of shares that commonly give shareholders preferential rights. Below are a few examples of the different forms preferred shares can take.
|
Convertible preferred shares |
This entitles the shareholder to convert the preference shares to ordinary shares in the future.
Usually, if the preference shareholder does not exercise the convertible right, they receive back their initial investment. In this sense, convertible preferred shares operate more similarly to a loan. |
|
Cumulative preferred shares |
A company can only issue dividends if it makes a profit. Thus, if your company does not make a profit, your preference shareholders do not receive any return on their investment. To compensate for this, at the point the company makes a profit, the preferred shares may entitle the holder to be paid for all the previous periods where there were no dividends.
For example, say each preference share grants the holder £0.10 per share and the company pays dividends once a year. The first two years, the company did not make a profit. In the third year, it does. Cumulative preferred shareholders would be entitled to £0.30 per share. |
|
Exchangeable preferred shares |
Similar to convertible preferred shares, these entitle the holder to convert the shares into another interest in the company. |
|
Perpetual preferred shares |
Where the company pays the preference shareholder a fixed dividend for as long as they own the shares. That is, the shares do not have a maturity date. However, these shares frequently have a redemption date, and thus behave somewhat like convertible preferred shares. |
Your company is free to create preference shares that combine these different rights.
Key Takeaways
As a business owner issuing shares in your company, you may find it helpful to appreciate the key features of preference shares. preference shareholders will have priority on dividend payments in advance of ordinary shareholders. Usually, preferred shares do not grant the shareholder voting rights. Issuing preferred shares can be a good way of incentivising investors to participate in a share allotment.
If you need help with your business, our experienced corporate 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 at 0808 196 8584 or visit our membership page.
Frequently Asked Questions
A share (also called stock represents a piece of ownership in a company, which grants the holder various rights in the company. Different shares grant different rights.
Preferred shares grant the holder priority over ordinary shareholders when it comes to dividend payments. In many cases, preference shares do not have any voting rights.
We appreciate your feedback – your submission has been successfully received.
