Ordinary shares: The foundation of the capital structure
Ordinary shares form the core equity held by the investor and any reinvesting managers. They typically carry voting rights in line with economic ownership, giving holders meaningful influence at shareholder level. Key features typically include:
- Full voting rights on shareholder decisions.
- Economic participation through dividends and exit proceeds.
Typically, the investor's ordinary shares will also afford the investor certain control rights that operate in tandem with the investment agreement (e.g. reserved matters, enhanced voting rights, etc.). In spite of this, ordinary shares are normally treated as one class of share for the purposes of the “equity waterfall”, crystallising value after any preferred return.
Preferred instruments: Enhancing investor economics
Private equity investors use preferred ordinary shares or loan notes to shape their return profile. These preferred instruments allow investors to mitigate downside risk while preserving equity‑linked upside. Common forms include:
- Preferred ordinary shares with a fixed or compounding preferred return (e.g., 8% per annum).
- Loan notes, often subordinated to senior debt but ahead of equity on insolvency or any other return of capital.
- Convertible or redeemable instruments, depending on the deal’s tax and commercial design.
Preferred instruments typically provide:
- A priority return, meaning investors recover capital and a coupon (by way of interest or dividend) before other shareholders.
- Structural seniority ovr management equity.
- Flexibility in tailoring the investor’s internal rate of return (IRR).
These preferred instruments are especially common in minority deals or situations requiring enhanced downside protection.
Sweet equity: Aligning management with value growth
Sweet equity is a staple of UK private equity deals. It incentivises management by giving them a meaningful equity stake at a low entry price, typically sitting behind any preferred instruments. Key characteristics include:
- Small percentage of the total equity, (often 5–20%).
- Low acquisition cost, reflecting its junior position in the structure.
- High potential upside/enhanced rate of return, sweet equity becomes disproportionately valuable once investors have achieved their preferred return.
To maintain alignment, sweet equity is usually subject to:
- Leaver provisions, which determine the price at which management must sell if they leave the business.
- Economic vesting, being the process by which the shares gain economic value (often over 3–5 years) depending on a manger's continued employment.
- Drag and compulsory transfer provisions, ensuring management cannot block or complicate an exit.
Sweet equity is effective because it directly aligns management’s incentives with the growth of the company’s equity value. Once investors have achieved their preferred return, any additional value created in the business disproportionately benefits management, giving them a meaningful share of the upside.
Bringing the structure together
A private equity capital structure will therefore typically include:
- Preferred instruments
– providing a priority return and downside protection. - Ordinary shares
– capturing the bulk of the upside once the preferred return is met. - Management sweet equity
– heavily leveraged to performance and exit value.
This layered structure balances three competing needs:
- investors want risk‑adjusted returns and governance control;
- management want meaningful participation in the upside; and
- the company needs a stable, clearly defined capital base to support funding and growth.
Conclusion
UK private equity deals rely on carefully designed share capital structures. By using a mix of ordinary shares, preferred instruments and sweet equity, investors can balance risk and reward while keeping management aligned with growing the company’s value. Although each deal is different, the core aims are the same: protect investor downside, motivate management and create a clear structure that supports a smooth and profitable exit.
DWF has one of the largest dedicated private equity groups in the UK, advising investors, management teams and portfolio companies across a wide range of sectors including financial services, technology, media and telecommunications, life sciences and healthcare, and real estate and infrastructure.
With our standing and presence in the market, DWF can rely on an extensive network of skilled lawyers in various jurisdictions to provide our clients a seamless and co-ordinated approach to private equity transactions. If you have any queries on the issues covered in this article, please contact one of our private equity specialists: Frank Shephard, Jonathan Robinson, Alasdair Outhwaite, Darren Ormsby, Will Munday, Vicky Ross, Matthew Judge, Francesca Kinsella, Mark Gibson, Alistair Hogarth, Paul Pignatelli, Gemma Gallagher, James Morrison, Laurence Applegate, James Bryce, Scott Kennedy and Dhruv Chhatralia.
