Demystifying Preferred Shares
“How do preferred shares differ from common shares? Where do preferred shares fall in the capital structure? What rights do preferred shareholders have? What terms and conditions attach to preferred shares?”
These are questions I am often asked by founders and business owners seeking to gain a better understanding of preferred shares.
To begin with, there is no “one size fits all” model for preferred shares. The unique circumstances and desires of both a prospective investor and an issuing company will dictate the terms and conditions attaching to a certain class of preferred shares. In the case of venture capital investments, the specific terms of a preferred share investment are, often times, heavily negotiated between both parties though the entering into of a term sheet, which sets out the financial terms of the deal.
This article provides a general overview and describes some specific characteristics of preferred shares. As you will see, the terms and conditions which attach to preferred shares can be customized in many different permutations.
- Capital Structure
Preferred shares represent equity ownership in a company, but at the same time, have debt-like qualities through an investor’s redemption, liquidation and dividend rights. In the capital structure of a company, preferred shares sit above common shares but below debt – i.e., preferred shareholders have preferential treatment vis-à-vis common shareholders, but their rights are inferior to those of debtholders in respect of any payments made by the company to its financial stakeholders.
Dividends may be fixed or discretionary. Fixed dividends may be set as a fixed amount per share or may be calculated as a percentage of the purchase price (e.g., 6% per annum). These dividends may be paid out as cash or in-kind (i.e., paid in shares), and the payments could be made annually, quarterly or at any other stipulated time.
Alternatively, dividends could be paid out at the discretion of the board of directors.
Preferred shareholders typically have priority over common shareholders with respect to the payment of dividends, which means that preferred shareholders would first receive their dividends before any dividends are paid out to common shareholders.
- Repayment of Capital
In the event of a liquidation, dissolution or winding-up of a corporation, preferred shareholders would be paid out assets of the company before any remaining property is distributed to common shareholders. The corporation’s articles will set out the quantum of money that preferred shareholders would be entitled to receive in such an event. For example, investors may be entitled to receive their purchase price amount or a certain multiple of that amount (e.g., 2 times), plus any declared and unpaid dividends.
In some instances, in addition to a fixed payout, preferred shareholders may also have the right to receive further proceeds of distribution on an “as converted” basis alongside common shareholders. This right would obviously be favourable for preferred shareholders.
Preferred shares may carry voting rights or no voting rights. If a class of preferred shares has voting rights attached to it, each share may come with one vote or any number of specified votes. For example, each Class A preferred share may entitle the holder to one vote at a meeting of shareholders.
The company may decide not to give voting rights to passive investors who will have no “say” on the affairs of the company. On the other hand, active investors, such as venture capital funds, would request voting rights as a condition to making an investment.
Notwithstanding any voting rights set out in a company’s articles, under the corporate statutes in Ontario and Canada, the holders of a class or series of shares are entitled to vote separately as a class or series if there is a proposal to amend the company’s articles and such amendment would adversely affect the rights of the holders of such class or series of shares.
- Redemption Rights
Investors may be granted the right to compel the company to redeem (or repurchase) their preferred shares for a predetermined price. The redemption price could be equal to the original purchase price of a share or a certain percentage of that price (e.g., 150%), plus any declared and unpaid dividends.
Conversely, the company may be provided with a redemption right, thereby having the option to redeem its preferred shares at a stipulated price.
In a situation where a corporation is facing insolvency, the corporate statutes prohibit a corporation from redeeming its shares.
Preferred shareholders may be given the right to convert their shares into common shares or any other class of shares at a predetermined conversion ratio or conversion price. For instance, one Class A preferred share could be converted into one common share at the investor’s option at any time. This option would allow preferred shareholders to participate in the upside in the value of a company’s common shares by providing them with the ability to convert their preferred shares into common shares as the value of the common shares rises over time.
A mandatory conversion provision would force the preferred shareholders to convert their shares into common shares or any other class of shares upon the occurrence of a certain event, such as an initial public offering of the company’s common shares.
- Anti-Dilution Rights
An anti-dilution right provides investors with price protection in the situation where a company issues shares at a lower price in a future financing round; in venture capital terms, this scenario would be referred to as a “down round.” In a down round, an anti-dilution right (if in place) would be triggered to cause an automatic downward adjustment of the conversion price of preferred shares issued in a prior financing round, with the effect being an increase in the number of common shares to be received upon conversion.
In conclusion, preferred share provisions are highly customizable and can be constructed in such a way as to meet the unique needs and preferences (no pun intended!) of both the company and its investors.
This article is for informational purposes only and does not constitute legal advice.