Understanding Preference Shares

A term sheet sets out the basic terms and conditions of new investment in the form of preference shares. It contains all the essential points relating to the investment and offers details on, for example, the percentage being acquired, conversion rights, and liquidation preferences. 

If you are going through an equity funding round it’s important that you familiarise yourself with the general terms and conditions pertaining to preference shares.

Equity financing rounds traditionally use the naming convention “Series ___”, where the blank is a letter of the alphabet. Series A is generally the first preference share round, followed by Series B, Series C, and so on. The rights pertaining to each round may be similar or could diverge on points such as seniority.

The following list highlights some of the different rights and privileges that may be attached to your preference shares:

Pre-Money valuation: This is the value of the company prior to an equity investment and determines the price per share that the new equity investors will pay.

Post-Money valuation: This figure is calculated by adding the investment received to the pre-money valuation.

Conversion Ratio: This is the ratio at which preference shares will convert to common shares. Preference shares can be convertible or non-convertible.

Seniority: This determines the payout order in a liquidation event, with ‘1’ being the highest and the first class of share to pay out. The higher the number, the less senior the share class. Multiple stock classes can have the same level of seniority. This is referred to as Pari Passu Seniority.

Liquidation Preference: If a company liquidates and the holders of preference shares do not choose to convert their shares to common shares, then a liquidation preference gives them a right to receive a multiple of the capital committed ahead of payouts to common stockholders. The multiple is captured in what’s known as the liquidation multiplier and is usually expressed as 1* original purchase price or 2* original purchase price.

Participation Rights: In a liquidation event, instead of choosing between receiving a liquidation preference and a pro rata portion of converted common stock, shareholders holding participating preferred shares will receive the liquidation preference, and also a pro rata share of the remaining proceeds, on an “as converted to common stock” basis.

Participation Cap Multiple: This is where preferred proceeds are capped at a multiple of initial investment when also participating in common stock where participation rights are in place.

Dividends: A dividend is a payment from the company to its shareholders. Holders of preferred stock are entitled to dividends ahead of any paid to common stock. Dividends can be paid in cash or stock and will be expressed as a percentage of original purchase price, while a term sheet will specify the frequency of payments, whether, for example quarterly or yearly.  

Cumulative vs Noncumulative dividends: With a noncumulative dividend, if the board of directors does not declare a dividend in a particular fiscal year then the right to receive a dividend for that year becomes void; that is, it does not carry forward and does not accumulate. By contrast, a cumulative dividend must be paid to those entitled to it by their shareholding, irrespective of the company’s profitability or the wishes of the board.