When issuing shares to investors, companies often grapple with the decision to issue ordinary shares or preference shares. While issuing ordinary shares may be simpler, sophisticated investors such as venture capitalists (VCs) and private equity firms often expect to receive preference shares in exchange for their capital. These shares offer additional rights and protections compared to ordinary shares. This article explores the key differences between ordinary shares and preference shares and some of the key terms typically attached to preference shares in the Australian market.

Ordinary Shares vs Preference Shares

An ordinary share represents a unit of ownership in a company and generally entitles the holder to certain basic rights, such as the right to vote, receive dividends (if declared by the company), and participate in the distribution of the remaining assets of the company when it is wound up or when an exit occurs. However, if a liquidation or exit event occurs, ordinary shares generally rank last in priority, meaning creditors and other shareholders (such as preference shareholders) get paid first in such scenarios.

A preference share is also a unit of ownership in a company, but as the name suggests, it provides preferential or more favourable rights over ordinary shares. For example, preference shares often include anti-dilution protection and receive priority treatment in an exit or liquidation event. We explore these rights, along with others, in further detail below.

Liquidation Preference

A liquidation preference determines how money is distributed in a liquidation or exit event (such as the winding up of the company, the sale of all the company’s shares or assets, or an initial public offering (IPO)).

In Australia, preference shares typically have a 1x non-participating liquidation preference. This means that when a liquidation or exit event occurs, the holder of preference shares receives the greater of:

1. 1x the amount paid for their preference shares (i.e., the original issue price of those shares); or
2. Their pro-rata proportion of the proceeds available for distribution to shareholders, calculated as if the preference shares were converted into ordinary shares.

Once calculated, the above amount (known as the ‘Preference Amount’) is payable to the holder of preference shares before holders of ordinary shares (or lower-ranking preference shares) receive any money.

However, the non-participating feature of the liquidation preference means that once the Preference Amount is paid, the remaining proceeds are distributed solely among the other shareholders. In other words, the holder of preference shares cannot ‘double-dip’ by receiving both their Preference Amount and a share of the remaining funds.

For investors, a liquidation preference is an important protection as it provides greater comfort (but not absolute certainty) that they will recover their initial investment in the future.

Alternative: In other markets, such as the US and certain European countries, participating liquidation preferences are more common. Under this structure, preference shareholders receive their initial investment back and then share in the remaining proceeds alongside ordinary shareholders. In some cases, investors also receive a liquidation preference greater than 1x their initial investment (e.g. 2x, 3x, or 4x, and so on). This can significantly disadvantage founders, employees, and other shareholders, which is why it is not standard practice in Australia.

Ranking

It is important to understand that a company can issue more than one class or type of shares (including multiple classes of preference shares). Each class of shares may carry different rights, which are typically set out in the company’s Constitution.

As an example, a company may have:

1. Ordinary Shares (which rank lowest of all share classes on issue);
2. Series A Preference Shares (which rank ahead of Ordinary Shares);
3. Series B Preference Shares (which rank ahead of Ordinary Shares and Series A Preference Shares);
4. Series C Preference Shares (which rank ahead of Ordinary Shares, Series A, and Series B Preference Shares); and
5. Creditors, who are owed money for goods, services, or loans (who rank ahead of all shareholders).

In an exit or liquidation event, funds are generally distributed first to creditors and then to the various classes of shareholders in order of priority. This process is known as the ‘waterfall’ distribution. This is because distributions flow down from creditors to the highest-ranking preference shareholders before reaching ordinary shareholders.

It is entirely possible that lower-ranking shareholders will not receive any funds in a liquidation or exit event. The extent to which certain shareholders receive proceeds depends on the value of the exit event and the liquidation preferences negotiated by investors. For this reason, companies must carefully consider the impact of granting liquidation preferences, particularly when offering investors multiples greater than 1x their original investment.

Dividends

Some companies may distribute profits to their shareholders in the form of dividends. These payments are usually made on a quarterly, biannual, or annual basis. However, dividend payments are more common in profitable, mature companies than in early-stage startups, which typically reinvest profits into business growth and working capital.

If a company declares dividends, preference shareholders may be entitled to receive dividends before ordinary shareholders. However, in many cases, preference shares and ordinary shares have identical dividend rights.

Conversion Rights

Preference shares typically include conversion rights, allowing holders to convert their shares into ordinary shares. Generally, holders can convert their preference shares at any time, and in some cases, conversion happens automatically upon a specific event, such as an IPO.

This feature is critical in the context of liquidation preferences because it enables preference shareholders to choose the most financially advantageous option. For example, if the company is sold or liquidated and the shareholder has a 1x non-participating liquidation preference, they can either claim their fixed payout (typically equal to the price paid for their shares) or convert into ordinary shares and share in the available proceeds.

This flexibility is particularly valuable in high-growth scenarios where the company’s valuation exceeds the liquidation preference, allowing preference shareholders to maximise their returns by participating in the upside rather than being capped at a fixed amount.

Generally, preference shares convert into ordinary shares on a 1:1 basis. That is, each preference share converts into one ordinary share. However, this ratio may be adjusted in certain circumstances, as explained below.

Anti-Dilution Rights

If a company issues shares at a lower price than what earlier investors paid (known as a ‘down round’), existing investors may experience significant dilution. To mitigate this, preference shareholders often receive anti-dilution protection.

Anti-dilution rights result in an adjustment to the number of ordinary shares preference shareholders receive upon conversion. As noted above, preference shares usually convert into ordinary shares on a 1:1 basis. However, if anti-dilution protections apply, the conversion rate adjusts to grant investors more ordinary shares.

In Australia, the most common method is the ‘broad-based weighted average’ method. This calculation considers both the lower fundraising price and the original price paid by investors, resulting in a weighted average price that softens the dilution impact.

For example, if anti-dilution protections result in a revised conversion ratio of 1:1.5, an investor holding 400 preference shares would receive 600 ordinary shares upon conversion. This increases their ownership percentage and enhances their potential return in a liquidity or exit event.

Alternative: A more aggressive anti-dilution adjustment method is full-ratchet anti-dilution, where the conversion price is fully reset to match the lower price of new shares. While this provides stronger protection for investors, it is rarely seen in Australia as it significantly dilutes founders and employees.

Voting Rights

Preference shares usually have the same voting rights as ordinary shares, typically:

1. One vote per shareholder, if the vote is conducted by a show of hands; and
2. One vote per share held, if the vote is conducted by a poll.

Where voting is conducted by poll, the number of votes cast by preference shareholders is typically calculated on an as-converted basis (i.e. reflecting any anti-dilution adjustments).

Contact Us

Whether you are issuing preference shares or ordinary shares, our experienced corporate transactional lawyers can help. Contact us at 03 9481 2000 or info@tauruslawyers.com.au.