Rights attached to classes of shares are outlined in a company’s articles of association. These rights can provide more control over the running of the company, financial protections, or priority in receiving pay-outs when the company is sold ('Exit').
This guide outlines the key types of shares used in venture capital transactions ('VC'), their effects, and what founders should consider before issuing them.
Ordinary vs. Preference Shares
The two main types of shares in VC transactions are ordinary and preference shares. Although there is no legal requirement as to the rights attached to these shares, they usually tend to provide the following rights:
- Ordinary Shares: offer standard voting rights but no financial protections in an Exit.
- Ordinary shareholders are usually last in line to receive a pay-out in an Exit.
- Founders, employees, and early investors usually hold this class of shares.
- Preference Shares: offer special rights protecting shareholders' investments.
- These may include priority in receiving returns, fixed pay-outs, or influence over company decisions.
- VC investors will normally only subscribe to preference shares.
While preference shares help attract funding, they also dilute founder control and potential financial upside.
Types of Preference Shares
Investors can negotiate different types of preference shares, attaching different rights, to ensure certain financial protections.
- Convertible preference shares allow investors, at their discretion, to convert these into ordinary shares when a company is sold or goes public (when it is financially beneficial to do so).
- Participating preference shares provide investors with a two-stage pay-out: they first recover their original investment, then they share the remaining profits alongside ordinary shareholders. This structure is highly favourable to investors but can leave little for founders and employees.
- Non-participating preference shares allow investors to choose to reclaim their original investment or convert their shares into ordinary shares. This is generally more balanced and founder-friendly.
- Redeemable preference shares allow investors to require the company to buy-back their shares after a set period. If the company is not generating enough cash, this can put significant financial pressure on the business.
Voting Rights and Control
Investors often negotiate for voting rights that provide them with influence over key decisions.
- Ordinary shares typically carry one vote per share.
- Super-voting shares grant multiple votes per share, allowing founders to retain control of a company even with a minority stake.
- Protective provisions give investors veto rights over critical business decisions (e.g. raising more funding, selling the company, or appointing directors).
For founders, giving up too much control early can make it harder to steer the company in the long term.
Liquidation Preferences: Who Gets Paid First?
Liquidation preferences determine the order of payment in an Exit of liquidation.
- 1x Liquidation Preference (most common): investors recover their original investment before founders are paid.
- 2x or 3x Liquidation Preference (less common, more aggressive): investors take double or triple their initial investment before founders are paid.
Higher liquidation preferences can significantly reduce returns for founders and employees, even in a successful Exit.
Anti-Dilution Protections
Start-ups may raise additional funding at a lower valuation than previous rounds. To protect the value of their stake in the company if this occurs, Investors often negotiate anti-dilution protections . The two main types of protection are:
- Full Ratchet Anti-Dilution: If new shares are issued at a lower price, early investors’ shares are adjusted as if they had originally bought at the lower price. This heavily dilutes founders.
- Weighted Average Anti-Dilution: A more moderate approach that adjusts the investor’s price based on the number of new shares issued, softening the impact on founders.
Strict anti-dilution protections can make it harder for startups to raise future funding, as new investors may be wary of earlier investors holding overly protective terms.
Key Takeaways for Founders
- Consider the long-term impact of share structures: What seems like a small concession today could drastically affect payouts and control in the future.
- Pay attention to liquidation preferences: Higher multiples can leave founders with little or nothing in an Exit.
- Negotiate fair investor protections: Some investor rights are reasonable but overly protective terms can make future fundraising difficult.
By structuring share classes carefully, startups can attract investment while ensuring a fair outcome for all stakeholders.
