Preference shares are shares that carry rights on top of those of ordinary shares, usually the right to be paid first: first for dividends, first for money when the business is sold or wound up, or both. Ordinary shares are the standard shares every company has. They carry a vote and an equal share of whatever is left once everyone ranking ahead of them has been paid.
When an investor asks for preference shares, they’re asking the company to create a new share class, and a share class is a set of rights written into the company’s articles of association, its rulebook. Two investments at the same valuation can leave the founder with very different amounts on a sale, depending on the rights attached to the investor’s shares.
I’ve funded more than 750 businesses with over £1bn and raised £250m+ for my own companies, so I’ve seen share classes as an investor, as a lender and as the founder issuing them.
Preference Shares vs Ordinary Shares at a Glance
| Ordinary shares | Preference shares | |
|---|---|---|
| Dividends | A share of any dividend the directors declare, after any preference dividend | A dividend paid before ordinary shareholders get anything, often a fixed percentage, sometimes cumulative |
| Voting | Usually one vote per share | Whatever the articles say: no vote, a limited vote, or a vote alongside the ordinary shares |
| On a sale or winding up | Paid last, and share whatever is left | Paid their preference amount before the ordinary shares |
| Upside | No limit | Limited to the preference, unless the shares are participating or convert into ordinary shares |
| Redemption | Not usually redeemable | Can be redeemable on a set date or when the holder asks |
| SEIS and EIS | Qualify | Lose the relief if they carry the rights the schemes bar |
Ordinary Shares: the Baseline
Most UK private companies start with one class of ordinary shares. Under the model articles many companies are formed with, each share carries one vote, an equal right to any dividend the directors declare and an equal share of whatever is left for shareholders on a sale or winding up.
A founder holding 60% of the ordinary shares gets 60% of each dividend and 60% of the sale proceeds left for shareholders. Ordinary shareholders take the most risk because they’re paid last, and they get all of the upside once anyone ranking ahead of them has been paid.
Ordinary shares can be split into classes, such as A and B ordinary shares, with different votes or dividends. They stay ordinary shares as long as neither class is paid ahead of the other.
What Preference Shares Add
An investor putting a large sum into a business for a minority stake has very little control over what happens to that money. Preference shares give them protection if things go badly: if the business is sold for less than hoped, or fails, they get their money back before the ordinary shareholders get anything. In venture deals the shares usually convert into ordinary shares too, so the investor keeps the upside if the business does well.
There’s no standard preference share. The rights are whatever the articles say, so each right has to be understood on its own terms, alongside the valuation. The share class on offer is set out in the investment memorandum where there is one. The investor pitch deck says how much is being raised, but the rights usually aren’t settled until the term sheet.
The Rights a Preference Share Can Carry
Dividend Preference
A preference dividend is paid before anything goes to the ordinary shareholders. It’s usually a fixed percentage of what the investor paid for the shares.
If the dividend is cumulative, any year it isn’t paid rolls forward. Say an investor puts £500,000 into shares carrying an 8% cumulative dividend. That’s £40,000 a year. If the company pays nothing for 3 years, £120,000 has built up, and all of it has to be paid before the ordinary shareholders receive a dividend. Some articles also add unpaid cumulative dividends to what the investor gets back on a sale.
A non-cumulative dividend lapses if it isn’t declared that year. Many early-stage companies pay no dividends, so the dividend right usually matters less than what the shares get on a sale.
Liquidation Preference
The liquidation preference is the amount the investor gets back first when the business is sold or wound up. It’s set as a multiple of what they put in: a 1x preference returns the investment, and a 2x preference returns double it.
With a non-participating preference, the investor takes either the preference or their percentage of the proceeds, whichever is higher. With a participating preference, they take the preference and then their percentage of what’s left as well.
Say an investor puts in £1m for 20% of the company, on a 1x non-participating preference.
| Sale price | Investor’s 20% | Investor takes | Left for ordinary shareholders |
|---|---|---|---|
| £3m | £600,000 | £1m preference | £2m |
| £10m | £2m | £2m as ordinary shares | £8m |
The full sums for participating preferences and bigger multiples are worked through in liquidation preference.
Conversion Rights
Preference shares in venture deals can usually be converted into ordinary shares, at the holder’s choice and automatically if the company lists on a stock market. Conversion is what lets an investor give up the preference and take their percentage when the percentage is worth more. The conversion rate normally starts at one ordinary share for each preference share. Anti-dilution terms can change that rate if the company later issues shares at a lower price than the investor paid.
Voting Rights
Traditional preference shares often carry no vote unless their dividend is unpaid. In venture deals, preference shares usually vote alongside the ordinary shares as if they had converted, and the investor gets class consent rights on top: a list of things the company can’t do without the agreement of a set majority of that class, things like issuing shares that rank ahead of them or changing their rights.
The Companies Act protects class rights as well. Unless the articles set their own procedure, the rights attached to a class can only be changed with the written consent of holders of three-quarters of that class by nominal value, or a special resolution at a separate meeting of that class, under section 630 of the Companies Act 2006.
Redemption Rights
Redeemable preference shares can be bought back by the company on a set date, or when the holder asks. They give the investor a way to get their money out without a sale of the business, so they work more like a loan than an equity stake.
Share Classes and SEIS/EIS Rules
If a company is raising under the Seed Enterprise Investment Scheme or the Enterprise Investment Scheme, the investors’ shares can’t carry most preference rights.
HMRC’s SEIS guidance says the shares must be full-risk ordinary shares, not redeemable and with no special rights to the company’s assets. They can have a limited preferential right to dividends, as long as the dividend can’t build up or be varied. HMRC’s EIS shares requirement sets out the same tests for shares issued since 6 April 2012, for 3 years after issue.
In practice, that rules out a liquidation preference, a redemption right and a cumulative dividend on the shares SEIS and EIS investors receive. If their shares carry any of these, the investors lose the relief.
When a round mixes SEIS or EIS investors with an investor who wants a preference, the scheme investors’ shares are set up without those rights, and the preference sits on a separate class held by the other investor. HMRC’s advance assurance service will look at the share structure before the shares are issued.
When Preference Shares Are Reasonable
A preference is a normal request when an investor is putting a large amount into a business for a minority stake, at a valuation the founder has set. An angel putting in a smaller sum often takes ordinary shares, especially where SEIS or EIS relief is involved.
A 1x non-participating preference only changes who gets what if the business sells for less than the post-money valuation the investor came in at, which is the valuation including their money. In the example above, the investor’s 20% is worth more than their £1m on any sale above £5m, so above that figure everybody is paid by percentage.
The terms that move much more money away from the ordinary shareholders are:
- a participating preference
- a multiple above 1x
- cumulative dividends added to the preference
- new preference shares ranking ahead of preference shares issued earlier
Each of these is set in the term sheet, and each can change what the founder receives on a sale by more than a small move in the valuation would.
Setting Up a New Share Class
- Agree the rights. The term sheet sets out the dividend, the liquidation preference and its multiple, conversion, voting, consent rights and any redemption.
- Adopt new articles. Class rights live in the articles, so the company adopts new articles by special resolution, which needs 75% of the votes cast. A copy goes to Companies House within 15 days.
- Get class consent if existing rights change. If an existing class’s rights are affected, its holders consent under the articles or under section 630.
- Authorise the allotment. The directors need the shareholders’ authority to issue shares of the new class, and existing shareholders’ pre-emption rights usually have to be waived or disapplied.
- Issue the shares and file. The company files a return of allotment, form SH01, within one month, with a statement of capital that sets out the rights of each class, under section 555 of the Companies Act. Naming a new class needs form SH08 and changing an existing class’s rights needs form SH10, each within one month. The register of members and the cap table are updated to show the new class.
Preference Shares Outside the UK
The rights work the same way in most countries, because a preference is a term in the company’s own constitution. SEIS and EIS are UK schemes, so the share restrictions above apply only to UK raises using them.
In the US, venture rounds are usually sales of preferred stock, such as Series Seed or Series A preferred, with the rights set out in the company’s certificate of incorporation. Many US deals start from the NVCA model documents, which include a model certificate of incorporation and stock purchase agreement. In Australia, Singapore and the UAE, the company’s constitution or articles set out the rights of each share class in the same way.
FAQs
Are preference shares better than ordinary shares?
Neither is better in itself. Preference shares protect the holder’s money if the business sells for less than hoped or fails, while ordinary shares get all of the upside once anyone ranking ahead has been paid. Which suits an investor depends on how much they’re putting in, the stake they get and whether they need SEIS or EIS relief.
Do preference shares have voting rights?
Only if the articles give them a vote. Traditional preference shares often carry no vote, while preference shares in venture deals usually vote alongside the ordinary shares as if they had converted, with class consent rights on top.
Can preference shares qualify for SEIS or EIS?
Only if they carry none of the rights the schemes bar. They can have a limited preferential dividend that can’t build up or be varied, but no preferential right to the company’s assets on a winding up and no right to be redeemed.
What happens to preference shares when a company is sold?
They’re paid their liquidation preference before the ordinary shareholders, or they convert into ordinary shares if their percentage is worth more. What they receive depends on the multiple and whether the preference is participating.
Next read
The rights attached to an investor’s shares are agreed in a negotiation, and how to prepare for a negotiation like this and run it is what I teach in the Negotiation Masterclass. If you’re raising and want it run properly, from making the business investable to getting in front of the right investors, that’s what Capital Raiser does. If you’re earlier than that, join Capital Catalyst for free and learn how every type of funding works before you take any of it.
This explains how share classes generally work for UK companies. It isn’t legal or tax advice, and a solicitor and accountant should review the articles and any SEIS or EIS position before the shares are issued.
