Ordinary Shares vs Preference Shares for Startups
Synopsis
What Are Ordinary Shares and Preference Shares? It’s not unusual for startups to issue various categories of shares while raising funds, the most common being ordinary and preference shares. Ordinary shares are usually distributed…
What Are Ordinary Shares and Preference Shares?
It’s not unusual for startups to issue various categories of shares while raising funds, the most common being ordinary and preference shares.
Ordinary shares are usually distributed among a company's founders, employees, and early backers. They grant certain ownership rights and allow their holders to vote at shareholders' meetings.
The value of ordinary shares is directly linked with the success of the company.
Preference shares are usually sold to venture capitalists, business angels, and institutional investors to provide investors with additional rights, protections and benefits that are not available to the holders of ordinary shares.
This difference is particularly important when it comes to funding rounds, sales, mergers, acquisitions, or liquidation of the company in the future. By understanding the basic differences, the founders will be able to understand the conditions of their investments and figure out how ownership and returns are going to change in different situations.
Ordinary Shares vs Preference Shares: Key Differences
| Feature | Ordinary Shares | Preference Shares |
| Typical holders | Founders, employees, early team members | Investors, VCs, angel investors |
| Voting rights | Usually full voting rights | May have limited or special voting rights |
| Dividends | Paid after preference shareholders | Often receive priority dividends |
| Liquidation priority | Paid last | Paid before ordinary shareholders |
| Conversion rights | Not applicable | Often convertible into ordinary shares |
| Investor protection | Limited | Includes negotiated protections |
| Economic rights | Participate in company growth and value creation | May include negotiated protections such as liquidation preference and dividend priority |
| Upside potential | Unlimited growth participation | Often includes downside protection with upside participation |
This difference explains why investors often request preference shares when investing significant capital into a startup.
Who Typically Holds Each Share Class?
In most venture-backed startups, founders receive ordinary shares when the company is formed. Besides founders, people taking part in ESOP programs may also get ordinary equity or options convertible into ordinary equity.
Preference shares are usually made available during the financing rounds held externally. Investors like these because they provide them with extra safeguards from downside risks and let them participate in the growth of the company.
Here is what a standard cap table might look like:
- Founders: Ordinary shares
- Employee option pool: Ordinary shares/options
- Initial funding round investors: preference shares
- A Series A funding round investors: preference shares
- A Series B funding round investors: preference shares
As the company keeps raising funds, different types of preference shares will be issued with slightly different rights.
Voting Rights: How They Differ
Ordinary shareholders generally have voting rights on key company matters. However, investor agreements may give preference shareholders approval rights over specific major decisions, particularly those that could affect their investment.
The most common examples of decisions that may require investor approval include the following:
- Issuing additional shares;
- Selling the company;
- Borrowing money over certain limits;
- Changing the rights of ordinary shareholders;
- Altering the company constitution.
Depending on the investment terms, preference shareholders may have approval rights over specific corporate actions even if they hold a minority ownership stake.
Liquidation Preference: The Biggest Difference
One of the most important distinctions between ordinary shares and preference shares is liquidation preference.
Liquidation preference determines how proceeds are distributed if a company is sold, merged, or wound up. It gives preference shareholders the right to receive certain payments before ordinary shareholders receive any proceeds.
For example:
- An investor invests $2 million in a startup and receives preference shares.
- Several years later, the company is sold for $5 million.
- If the investor holds a 1x non-participating liquidation preference, they will typically choose the option that delivers the higher return.
- They may either receive their original $2 million investment back under the liquidation preference, or convert their preference shares into ordinary shares and receive their proportionate share of the sale proceeds.
- The outcome depends on the company's ownership structure and the specific rights attached to the preference shares.
Other preference-share arrangements, such as participating preferences or multiple liquidation preferences, can produce different outcomes. For this reason, founders should carefully review the terms attached to any preference shares issued during a funding round.
Liquidation preferences are designed to provide investors with additional downside protection, which is one reason preference shares are commonly used in venture capital and startup financing.
Conversion Rights and Exit Scenarios
Many venture capital preference shares include conversion rights that allow investors to convert their shares into ordinary shares under specified circumstances. The exact rights depend on the terms negotiated in the investment documents.
An investor chooses the option that will yield the best profit.
In particular, one can either stay with the preference shares and obtain the payment according to the liquidation preference or convert the preference shares into ordinary shares and obtain the proportional profit share.
In a successful exit, investors may choose to convert their preference shares into ordinary shares if doing so results in a higher return than exercising their liquidation preference rights.
The investors are able to take advantage of the benefits provided by preference shares, which include downside protection, as well as possible upside from investing in ordinary shares.
How Preference Shares Affect Founders
Many beginner entrepreneurs are concerned about their valuation and ownership share. At the same time, the classes of shares matter too.
For instance, a founder might hold a majority of ordinary shares but get much less money upon his exit than preferred shareholders.
Take an example:
- Imagine a startup that is funded in multiple rounds.
- The investors own shares with specific liquidation preferences.
- The startup gets sold for less than initially estimated.
- In this case, investors may receive proceeds ahead of ordinary shareholders, depending on the liquidation preferences attached to their shares.
Thus, a founder needs to study all provisions concerning preference shares before accepting the funding.
When Are Preference Shares Used?
Preference shares are commonly used during:
- Seed funding rounds
- Angel investment rounds
- Venture capital funding
- Series A, B, and later rounds
- Growth equity investments
They are less common in bootstrapped businesses where founders retain full ownership and control.
As startups scale and attract professional investors, preference shares are commonly used in venture financing.
Which Share Class Is Better?
No class of shares is better than another. Each has a different purpose.
Ordinary shares exist to reward founders and employees for their contributions to the growth of the business. Ordinary shares offer ownership of the business and voting rights as well as unlimited profit potential.
Preference shares exist to protect investors who provide external financing. Preference shares provide financial security, priority rights, and negotiated advantages that decrease risk.
For founders, preference shares should not necessarily be avoided, but the rights to be granted to investors must be understood.
Conclusion
Ordinary shares and preference shares serve different purposes within a startup's capital structure. Ordinary shares are typically held by founders and employees and provide ownership and voting rights. Preference shares are commonly issued to investors and may include additional rights such as liquidation preferences, dividend priority, conversion rights, and investor protections.
Before raising capital, founders should understand not only how much equity they are giving away, but also the rights attached to each share class. These terms can have a significant impact on future fundraising, governance, and exit outcomes.
At Inspirepreneurs Magazine, covering entrepreneurship, business failures, and the human stories behind the world's most ambitious founders. She writes at the intersection of strategy and storytelling.
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