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Introduction
Preference shares are a common financing tool used by Australian companies, particularly startups, growth businesses and venture-backed enterprises. They allow companies to raise capital while providing investors with enhanced economic rights and protections that are not typically available to holders of ordinary shares.
Preference share structures have become increasingly prevalent in venture capital and private equity transactions because they provide flexibility in allocating economic and governance rights between founders, investors and other stakeholders.
This article outlines the legal framework governing preference shares in Australia, the rights commonly attached to them, and why companies use multiple classes of preference shares as part of their capital-raising strategy.
The Legal Framework for Preference Shares
Under the Corporations Act 2001 (Cth), Australian companies may issue different classes of shares carrying different rights and obligations. Preference shares commonly provide rights relating to:
- priority dividends;
- priority repayment of capital;
- conversion into ordinary shares;
- redemption rights; and
- modified or limited voting rights.
Section 254A of the Corporations Act empowers a company to issue bonus, partly paid, preference or redeemable preference shares. However, a company can only issue preference shares, if the rights attached to the preference shares with respect to the following matters are set out in the company’s constitution (if any), or have been otherwise approved by special resolution of the company:
- the repayment of capital;
- participation in profits or surplus assets;
- dividend entitlements (whether cumulative or non-cumulative);
- voting rights; and
- priority of payment of capital and dividends relative to other classes of shares.
As the company is entitled to determine the terms on which its shares are issued and the rights and restrictions attaching to those shares, careful drafting is essential to ensure that shareholder rights are clear and enforceable.
Common Types of Preference Share Rights
Preference shares can be tailored to meet the commercial objectives of both investors and companies. A few of the more typical features of the rights contained in the preference share terms are discussed below.
Dividend Rights
Preference shareholders may receive dividends ahead of ordinary shareholders; These dividends may be cumulative or non-cumulative depending on the terms of issue. The right to receive a dividend will give the holders of that particular class more certainty in relation to the return of capital and encourage investors to provide funding to the company.
Liquidation Preferences
Preference shares often provide priority access to capital proceeds on a liquidation, sale or other exit event before ordinary shareholders participate. Each new class of preference shares issued will generally afford the holder a higher priority in the liquidation preference in comparison to earlier classes.
Conversion Rights
Investors frequently negotiate the ability to convert preference shares into ordinary shares, particularly before an IPO or major liquidity event, as this would provide the holder with a level of liquidity in the shares that they otherwise would not ordinarily enjoy.
Redemption Rights
Companies can issue redeemable preference shares, which are issued on the terms that they are liable to be redeemed. They may be redeemable at a fixed time or on the happening of a particular event, at the company’s option or at the option of the shareholder.
Voting Rights
Preference shares may carry full voting rights, limited voting rights, or voting rights only in specific circumstances. Typically, the voting rights attached to the preference shares will only entitle the holder of the preference shares to vote on matters affecting the particular class of preference shares which they hold.
Multiple Classes of Preference Shares
As companies undertake successive funding rounds, it is common for new classes of preference shares to be created. For example, some of the typical preference share class features could include:
- series A preference shares could be shares that do not participate in the liquidation preference but offer different rights and protections to the holders;
- series B preference shares could offer enhanced anti-dilution protections that the other classes do not offer; and
- series C preference shares could offer additional liquidation or participation rights.
The terms of each class may contain different rights and obligations for each class of preference share, including different:
- dividend rights;
- liquidation preferences;
- conversion mechanics;
- redemption rights;
- participation rights; and
- anti-dilution protections.
These structures enable companies to accommodate different investor requirements while continuing to attract capital as the business grows.
Why Companies Use Preference Share Structures
Preference shares offer several commercial advantages. The main reasons why company will choose a preference share structure, is that they allow companies to:
- raise capital across multiple funding rounds (allowing for various classes of preference shares in each funding round);
- attract institutional and strategic investors;
- tailor economic rights to specific investors;
- preserve founder control through ordinary share ownership; and
- provide downside protection to investors without transferring day-to-day management control.
For investors, preference shares can reduce investment risk by providing preferential economic rights while preserving upside participation in future growth.
Examples of when Preference Share Structures are used
A company may choose to make use of a preference share structure for a number of reasons. A few practical examples of when a company may choose to make use of the structure and the practicalities of that structure.
Preference share structures are commonly used in private equity transactions, for example, a private equity fund purchases 60% of the issued share capital in a company, while management retains the balance of the issued shares. The private equity fund may be issued preference shares (in addition to the shares which they have purchased) which entitle them to receive dividends in priority to the other shareholders, which have a liquidation preference, and which may convert to ordinary shares on an exit.
The benefit is that the private equity fund receives preferential returns on their investment while management continues to participate in the growth of the business.
In the second example, in a joint venture with unequal contributions from the two parties, where party A contributes the intellectual property and party B contributes funds. Party B would require priority in the return of capital. In this instance, Party A will receive ordinary shares in the joint venture, while Party B will receive ordinary shares and preference shares. The preference shares, in this structure, may entitle Party B to dividends in priority as well as a priority in relation to the repayment of the invested capital.
This structure reflects the different risk profiles and contributions of the two parties.
Another example would be a family business seeking capital without losing control of their business. In this instance, the family retains their ordinary shares and issues preference shares to the investor. The preference shares might entitle the investor to an 8% cumulative (providing a dividend yield of 8% per annum – which requires the company to prioritise paying this fixed amount before any other dividends are declared), and priority repayment of the capital if the company is sold.
The investor receives some downside protection and income, while the family avoids losing control of the company by diluting their shareholding.
Looking Ahead
While preference shares are a powerful financing tool, complexity increases as additional classes of preference shares are introduced over time. Differences in ranking, liquidation rights, participation rights and conversion mechanics can significantly affect the distribution of value among stakeholders.
Part 2 of this series examines the key legal, commercial and exit risks associated with multiple classes of preference shares and explains why careful structuring is critical to avoiding disputes and unintended outcomes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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