As more established businesses raise with us here at Crowdcube, it has become increasingly common for the company’s existing and new investors to have different classes of shares. These shares can have different terms and protections to Ordinary Shares.
For instance, some institutional investors like venture capital firms may receive Preference Shares when making a large equity investment into a high-growth business. It’s important to note that Preference Shares are not unique to Crowdcube or equity crowdfunding. These shares have been around for decades and are very common in the venture capital and private equity sectors. However, as a result of the later-stage businesses we work with who are more likely to have secured institutional investment, we are seeing these more often on Crowdcube.
What are Preference Shares?
Typically, Preference Shares seek to protect a shareholder’s position in the event that the business is sold for less than the valuation at which they invested. Preference Shares are essentially ranked ahead of Ordinary Shares, which is the most common share class for other shareholders, including the company’s founders. In real terms, this means they’ll be paid first if a business is sold for a valuation that’s under a certain predefined level or a dividend is paid. This reduces the risk for shareholders with preference shares.
Why do businesses agree to Preference Shares?
Preference Shares act as a reward for the risk an institutional investor takes by putting in a significant investment. In very general terms this tends to be an investment of £1m or more. These institutional investors can also bring additional strategic support and advice to the business in the long term. Such support might take the form of:
- Attending regular board meetings
- Advising on strategy and planning
- Utilising their extensive networks
- Helping develop large strategic relationships
- Hiring and attracting the best talent
- Providing advice and guidance during an M&A/IPO process
- On-going corporate governance
This type of ongoing advice can be invaluable for an ambitious business seeking to grow rapidly and can potentially be beneficial to all shareholders. Typically, venture capital firms don’t get the same generous EIS income tax and capital gains relief and loss relief that individual UK investors benefit from. Therefore, additional protections gained from Preference Share are sometimes seen as a way of compensating these investors.
How might they affect other shareholders?
In certain liquidity scenarios, typically triggered when a company sells for a lower valuation, holders of Preference Shares will get their initial investment back before other shareholders. This includes the founders, other venture capital firms, angel investors, friends and family and crowd investors with Ordinary Shares.
An institutional investor puts in £5m and receives preference shares which equate to 20% of the Company. If the Company doesn’t increase its value and is eventually sold or wound up with £5m or less available to shareholders, that institutional investor will receive all of those proceeds. That’s pretty tough for other shareholders, but that is the risk/reward that we’ve mentioned above.
However, as long as Company is sold for more than £5m the other shareholders will receive a return. The institutional investor receives the first £5m and the other shareholders share the rest pro-rata to their percentage shareholdings.
Once the Company is sold at a value which means that the institutional shareholder would receive their investment back even if the funds were distributed pro-rata amongst shareholders, then all shareholders receive the funds pro-rata: i.e. in this case if the Company was sold and proceeds available for shareholders was £25m or more.
What is anti-dilution protection?
Sometimes, as well as a liquidation preference, institutional investors insist on another form of protection known as anti-dilution. This operates to “top-up” the investor’s shares in the event the company raises funds at a lower valuation than the valuation at which the investor invested. The reason for this is, again, to protect the investor’s position.