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

In this brief blog lets study the prime reasons why the investors ask the companies to issue preference shares during their funding rounds. In order to understand the reasons why investors seek preference shares let us study what preference shares mean, what are the 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 which 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 are 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.

Features of Preference Shares

I. Dividend payouts –

Preference shares uniquely allow holders to receive dividend payouts in situations where other stockholders may not be receiving any dividends or may receive dividends later. The payouts can be fixed or floating, which is based on the interest rate benchmark.

ii. Preference in assets -

Upon liquidation/winding up of the company, one sees Preference Shares getting priority over non preferential shareholders when it comes to claiming the company’s assets. 

iii. Voting rights –

In general Preference Shares do not carry any voting rights. However, some preference shareholders may be allowed to vote on in case of some extraordinary events such as events that directly affect the rights attached to their Preference Shares, resolution for the winding up of the company, repayment or reduction of its equity or Preference Share capital.

iv. Convertibility -

Preference Shares can be converted into common equity shares. They are typically converted into a predetermined number of non-preference shares after certain trigger events. Some Preference Shares inform investors that they can be converted beyond a specific date, while others may require permission and approval from the company’s board of directors to be converted. 

Types of Preference Shares

Preference Shares can be classified into a number of types based of certain distinctive features they all carry –

i. Convertible Preference Shares: Convertible Preference Shares are the type of shares that enable the shareholders to convert their Preference Shares into equity shares at a fixed rate, after the expiry of a specified period.

ii. Non-convertible Preference Shares: These type of Preference Shares cannot be converted into equity shares. These shares will only get fixed dividend payout and also enjoy preferential dividend payout during the liquidation/dissolution of a company.

iii. Redeemable Preference Shares: Redeemable Preference Shares are shares that can be repurchased or redeemed by the company at a fixed rate and date. These types of shares help the company by providing a cushion during times of inflation. The maximum number of years allowed for redemption under the Companies Act, 2013 is twenty years.

iv. Irredeemable Preference Shares: Irredeemable Preference Shares are those shares that cannot be redeemed during the entire lifetime of the company. Irredeemable Preference Shares are prohibited under the Companies Act, 2013.

v. Participating preference shares: These types of shares allow the shareholders to demand a part in the surplus profit of the company at the event of liquidation of the company after the dividends have been paid to the other shareholders. In other words, these shareholders enjoy fixed dividends and also share a part of the surplus profit of the company along with equity shareholders.

vi. Non-participating preference shares: These shares do not yield the shareholders the additional option of earning dividends from the surplus profits earned by the company. In this case, the shareholders receive only the fixed dividend.

Reasons for choosing Preference Shares

Keeping an eye out for when the ship might sink is an important aspect of investment for any investor. Hence, the prime reason why investors ask for Preference Shares is the security it offers them, especially when it comes to investing in early stage startups.

Liquidation Preference –

Most investors include 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 be entitled to receive its predetermined returns, but shall not be entitled to receive any portion of the surplus proceeds to be distributed to the equity shareholders. Preference Shares are always deemed to be non-participating, unless stated otherwise.

To explain in brief what participating and non-participating liquidation preference is let's take a small example –

FACTS: 

Startup- ABC Private Limited

Investor-XYZ Ventures, 

Investment amount: USD 5 million for 20 percent of equity in the Startup with 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 later 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).

The other forms of liquidation preference a company can have are –

a. Standard Seniority Liquidation Preference: This is a structure followed by most early-stage companies. Here, the liquidation preferences are honored in reverse order from the latest investment round to the earliest. Thus, the Series B investors would receive their liquidation preference amount in priority to that of the Series A investors, who, in turn, would receive their liquidation preference amount in priority to that of the Series Seed investors, etc.

b. Pari-Passu Seniority: This practise gives all preferred investors equal seniority status, meaning that all investors would share in at least some part of the proceeds. If the proceeds from a sale cannot cover every investors’ liquidation preference, the payouts are made in proportion to the amount of money invested (which does not necessarily correlate to ownership).

c. Tiered Seniority: This can be thought of as a hybrid between standard and pari-passu seniority. With tiered seniority, investors from different funding rounds are grouped into distinct seniority levels that follow the standard seniority format. However, within each tier the payouts follow the pari-passu format.

In practice, an event of liquidation is not limited to "winding up", under the Companies Act, 2013. It usually includes any merger, consolidation of the company in which its shareholders do not retain a majority of the voting power in the surviving entity, 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 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 the 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 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 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 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, 2013. 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 which 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 the 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 customised 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.

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Disclaimer

The content of this article is for information purpose only and does not constitute advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer to relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc. before acting on the basis of the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that the Author / Treelife is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof.