Overview
When dealing with investors in startups, you’ll often hear the term “preferred shares”. These are the type or class of shares such investors typically expect to receive when investing in a startup’s equity funding round. This means that the shares investors hold have special rights compared to the other shares in the startup held by non-investors, primarily the founders and team members), which are usually called common shares or ordinary shares (we will be using ordinary shares for the purposes of this article). Investors ask for these special rights as a way to protect and monitor their investment.
Key features of preferred shares
Liquidation preference. This is probably the most important right that preferred shares have and is the primary reason for their name – that they get preferred treatment over the ordinary shares when it comes to “liquidation”. This refers to when a company has cash that it can distribute to its shareholders, either from net profit from operating the business or as a result of a sale of all or some of its business. When this happens, the usual rule would be to distribute this cash equally to all shareholders. When you have preferred shares that have a liquidation preference, those shares have the right to receive a portion of that cash before (i.e. in preference to) other classes of shares (like the ordinary shares). What portion is open to negotiation.
A typical liquidation preference is what is called a 1x preference. This means that the investors have the right to receive an amount equal to one-time their initial investment amount before any other shareholders can receive their portion of the cash. Practically, this means that if you have an exit and the value of your startup is equal to or higher than its value when your investors invested, everyone will just receive their normal portion of the cash in accordance with their shareholding and regardless of class of shares. However, if you sell at a lower value than the valuation of your investors, the investors will receive a higher portion than their shareholding. For example. Note that liquidation preferences can be “stacked”, meaning that each time you do an equity funding round.
Anti-dilution rights. Along with the liquidation preference, antidilution rights are the most important economic rights preferred shares carry. These rights protect investors from any excessive dilution of their shareholding in a startup as a result of the startup raising funds in the future at a valuation that is lower than the valuation used when they invested. If this happens, antidilution rights would grant the investors additional shares for free to put them in the same position they would have been in had the fundraising happened at the same valuation as the one used when they invested. This can happen through a bonus share issuance or an adjustment to the amount of proceeds they have a right to upon an exit (sometimes referred to as a “conversion price”). Anti-dilution rights can be on the basis of either narrow or broad-based weighted averages. The difference between the two is quite technical and its detail is beyond the scope of this article, so please make sure to consult your lawyer when negotiation these rights. In a nutshell, the broad-based weighted average is more market standard at the moment and fairer on the startup / founders, because its impact reduces the amount of additional shares given to holders of preferred shares when compared to a narrow-based weighted average.
Board appointment rights. Investors may ask for the right to appoint one or more directors to your board of directors. This right can be linked to the class of preferred shares or held by one or more specific investors. It’s more typical for your “lead” investors (i.e. your largest or most actively involved investors) to have this right.
Reserved matters. These are veto rights that investors have over key decisions of a startup’s business (e.g. making senior hires, doing future rounds, exits, spending beyond a certain limit, litigation, changes to share capital, selling assets and many others). The rights are typically given to the preferred shares and require that a certain percentage of all preferred shares vote to approve the taking of any of these matters. Some reserved matters can also be granted at board level, meaning that one or more of the directors appointed by the investors / preferred shares must approve.
Share transfer restrictions. Various share transfer restrictions typically apply to a startup once it has carried out an equity funding round, such as preemption rights, rights of first refusal, tag along and drag along rights. Sometimes, some of these restrictions are granted exclusively in favour of the preferred shares. Other times, the holders of the preferred shares might be exempted from these restrictions.
TL;DR
Your investors will likely ask for preferred shares when investing in your equity funding round.
This will give them some special rights over your founder ordinary shares (and any shares of your team members).
The most important economic rights are the liquidation preference and antidilution rights. These can give your investors extra cash or extra shares if you exit or fundraise at a valuation lower than the one they were given when they invested in your startup.
Investors may also get the right to appoint one or more directors to your board and to have veto rights over certain material decisions related to your business.
Keep an eye out for any carve-outs the preferred shares may have from share transfer restrictions (such as preemption rights, rights of first refusal, tag along and drag along rights).