Why do angel investors and VC funds ask for preference shares in a funding round?

In this blog, we will discuss the reasons why investors ask companies to issue preference shares during their funding rounds. We’ll also cover what preference shares are, their features, and their types.

Section 43 of the Companies Act, 2013 states that

(ii) “preference share capital‘‘, with reference to any company limited by shares, means that part of the issued share capital of the company which carries or would carry a preferential right with respect to— (a) payment of dividend, either as a fixed amount or an amount calculated at a fixed rate, which may either be free of or subject to income-tax; and

(b) repayment, in the case of a winding up or repayment of capital, of the amount of the share capital paid-up or deemed to have been paid-up, whether or not, there is a preferential right to the payment of any fixed premium or premium on any fixed scale, specified in the memorandum or articles of the company;

(iii) capital shall be deemed to be preference capital, notwithstanding that it is entitled to either or both of the following rights, namely: —

(a) that in respect of dividends, in addition to the preferential rights to the amounts specified above, it has a right to participate, whether fully or to a limited extent, with capital not entitled to the preferential right aforesaid;

(b) that in respect of capital, in addition to the preferential right to the repayment, on a winding up, of the amounts specified above, it has a right to participate, whether fully or to a limited extent, with capital not entitled to that preferential right in any surplus which may remain after the entire capital has been repaid.”

From the above definition, we can understand that Preference Shares are those shares that are given priority over other equity shares. Preference Shares are held by preference shareholders who get the right to receive the first payouts in case the company decides to pay its investors any dividends. Another way to understand preference shares is those shares whose shareholders have the right to claim dividends during the lifetime of a company. The same shareholders also can claim repayment of capital in case the company is wound up or liquidated. These shares combine the characteristics of debt and equity both.

Preference shares are given priority over other equity shares and are held by preference shareholders who receive the first payouts in case the company pays its investors any dividends. These shares also provide a preferential right to claim dividends during the lifetime of a company and the repayment of capital if the company is liquidated. The features of preference shares:

1. Dividend payouts: Preference shares allow holders to receive dividend payouts when other stockholders may not receive any dividends or receive them later. The payouts can be fixed or floating based on the interest rate benchmark.
2. Preference in assets: When the company is liquidated or wound up, preference shares get priority over non-preferential shareholders when claiming the company’s assets.
3. Voting rights: Preference shares generally do not carry voting rights, but preference shareholders may be allowed to vote in specific events that directly affect their rights as holders of preference shares.
4. Convertibility: Preference Shares can be converted into ordinary equity shares. They are typically converted into a predetermined number of non-preference shares after certain trigger events.

Types of preference shares:

1. Convertible preference shares: Convertible Preference Shares allow shareholders to convert their Preference Shares into equity shares at a fixed rate after a specified period.
2. Non-convertible preference shares: These shares cannot be converted into equity shares and only receive fixed dividend payouts.
3. Redeemable preference shares: Redeemable Preference Shares can be repurchased or redeemed by the company at a fixed rate and date.
4. Irredeemable preference shares: Irredeemable Preference Shares cannot be redeemed during the company’s lifetime.
5. Participating preference shares: These shares allow shareholders to demand a part in the surplus profit of the company at the event of liquidation after the dividends have been paid to other shareholders.
6. Non-participating preference shares: These shares only offer fixed dividends and do not provide shareholders with the additional option of earning dividends from the surplus profits earned by the company.

The prime reason investors ask for Preference Shares is the security it offers them, especially when investing in early-stage startups. Preference Shares provide a participating liquidation preference that grants the investor a right to receive its funds in a liquidation event, with the balance of the proceeds being shared ratably amongst the holders of the equity shares and Preference Shares. In a non-participating liquidation preference, the preference holder will receive its predetermined returns, but will not receive any portion of the remaining proceeds.

FACTS: 

Startup- ABC Private Limited

Investor-XYZ Ventures,

Investment amount: USD 5 million for 20 percent of the equity in the Startup with a predetermined liquidation preference of 1x of the Investment Amount. (this typically ranges from 1x to 1.5x depending on the deal size)

Liquidation Event Proceeds = USD 100 million

1. As per Non-participating Liquidation Preference, XYZ Ventures will have the option to take the greater of USD 5 million or 20 percent of USD 100 million.  Here, XYZ Ventures will opt for the latter and take away USD 20 million;
2. As per the Participating Liquidation Preference, XYZ Ventures will have the right to take USD 5 million first and then partake 20% in the remaining USD 95 million as well. This totals the aggregate amount of return to XYZ Ventures to USD 24 million (USD 5 million + 20% of USD 95 million).

In practice, an event of liquidation is not limited to “winding up”, under the Companies Act, 2013. It usually includes any merger or consolidation of the company in which its shareholders do not retain a majority of the voting power in the surviving entity, the sale of all or substantially all of the company’s assets, and any other transaction constituting a change of control or even an initial public offer.

If the company has to be wound up, then to ensure the protection of their money, an investor would prefer to have preferential rights at the time capital is repaid. Here, preference shareholders have an edge over equity shareholders. The priority of repayment in the course of winding up is statutorily prescribed, such that shareholders may be repaid only after all outstanding liabilities of the company have been discharged. The Companies Act, 2013  provides that, with regard to capital, Preference Shares carry or will carry on winding up or repayment of capital a preferential right to be repaid the amount of the capital paid up or deemed to have been paid up, whether or not there is a preferential right to the payment of either or both of the following amount: (i) any dividend remaining unpaid up to the date of winding up or repayment of capital; and (ii) any fixed premium or premium on any fixed scale, specified in the company’s charter documents.

An investment agreement usually includes provisions that provide an assured exit to the investors at a fixed return post a specified period. However, the need for liquidation preference protection arises in scenarios where a liquidation event takes place prior to the investor being provided an exit. In such a case it is essential that the investor receives a return on its investment and such a clause is included in an investment agreement.

Anti-dilution –

Another practical benefit of preference shares is that they provide ‘down round’ protection to the investor. In India, the two commonly used forms of anti-dilution protection are: (a) Full Ratchet and (b) Broad-Based Weighted Average.

A Preference Shareholder has the option to require the company to protect its interest in the event the company issues shares in the subsequent rounds at a price lower than the price of the investor’s share. This is achieved by conversion of the existing Preference Shares of the investor into such number of equity shares, or by issuing a further number of Preference Shares to the company at a lower value, such that the shareholding percentage of the investor does not take a hit.

Dividends –

“The first rule in investing: don’t lose any money. The second rule: don’t forget the first rule!” as quoted by Warren Buffet on an occasion.

Since the prime reason for all investments is returns, it is only prudent to investigate the nature of the instrument in respect of returns. While most investments are done looking at the returns being received via the enhanced value of the shares at the time of exit, it is also prudent to also look at dividends.

A Preference Share gives a preferential right in regard to dividends under the Companies Act, of 2013. An interesting fact is that the provision relating to Preference Shares under the Companies Act only contemplates the payment of a fixed amount or an amount calculated at a fixed rate, in preference to the equity shareholders of a company. The provision does not mention the time period within which a dividend has to be paid. Therefore, the investor is free to contractually require the company to pay not only a dividend in preference to other shareholders but also to require the company to pay a dividend on a year-on-year basis, rather than as and when declared.

Conclusion

The characteristics and the understanding of how Preference Shares are beneficial to the investors lead us to conclude that Preference Shares are a perfect mechanism to protect the interest of the investors who are making an investment in startups and taking on the risk associated with such investments.

We can conclude that the liquidation preference that these Preference Shares provide to the investors (which is incorporated in the investment agreements in the language acceptable to the investor) becomes one of the prime reasons for them asking for Preference Shares.

However, dividends and anti-dilution are also equally important factors. Dividends are primarily important because investors are majorly interested in protecting cash flows through dividends than returns.

Based on the above discussion we can conclude a Preference Share can be customized to the needs of the investor, making Preference Shares a more attractive solution for investments than equity or debt. However, it is always advisable for investors to invest in a few equity shares as well in order to maintain their voting rights.