Understanding Preference Shares and the possible sting in the tail for founders
Preference shares are a type of share or equity that gives holders preferential rights over ordinary shareholders. The preference could in relation to dividends and priority in liquidation.
Whilst preference or priority in dividends is generally understood, one possible sting in the tail for founders is preference or priority in an exit or liquidation event.
If the preference shareholders have preference or priority in an exit or liquidation event, this may impact the amount of money left to distribute to other shareholders such as founders.
The easiest way to understand this is by looking at some examples.
In example 1 below, the preference shareholders invest $20m for a 25% share of the business and there is 1x preference.
If the business ultimate sells for $30m, the preference shareholder get $20m, and the other 75% shareholders get $10m or just 33% of the sale value. If it sells for $50m, preference shareholders still get their $20m, but the 75% other shareholders now get $30m, or 60% of the sale value. It is only when the sale value exceeds $80m do the other shareholders get their 75% of the sale value.
In the next example we look where the preference shareholders invest $20m for a 25% share of the business with 2x preference.
In this case, with a $20m investment by the preference shareholders, the other shareholders will not get any return until the sale value exceeds $40m (being $20m investment x 2), whereas in the 1x preference, other shareholders will start to get some money back if the business is sold for in excess of $20m.
And if you are a founder and your business is widely successful, this preference on an exit event may not be a problem, as everyone is likely to be rewarded financially on the exit event.
But if your business is not a widely successful, you could find your equity is worthless. Hence the sting in the tail from the issue of preference shares.
And we have not considered preference stacking in the above example. This is where there are multiple preference shares with some ranking ahead of others. Which complicates this and may make the outcome for the founder even financially worse.
Contact Wayne on wayne@arealcfo.com.au or 0412 227 052.
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