Investing in Preference Shares: Key legal considerations
A company in its initial stages i.e. (startup) would typically not have a demonstrated record of its business model and thus it may encounter challenges in securing a loan from a bank.
Conversely, if the company decides to raise funds through equity, it could result in a reduction in the founders' or current shareholders' ownership stakes, which may ultimately diminish their control over the company.
Hence, the company may choose a hybrid approach, such as issuing preference shares that combine characteristics of both equity and debt, to secure funding.
As an investor, should you be investing in these preference shares?
What are Preference Shares? Section 2 of the Companies Act 2016 defines a preference share as a share, by whatever name called, which does not entitle the holder to the right to vote on a resolution or to any right to participate beyond a specific amount in any distribution whether by way of dividend, or on redemption, in a winding-up, or otherwise.
Essentially, preference shares allow founders to access capital without surrendering their hold on the company, while also guaranteeing investors priority in receiving returns on their investment through dividend payments and, in the event of liquidation, priority in receiving distributions.
Key legal considerations Control over the Company: The issuance of preference shares allow the founders or current shareholders to maintain their authority over the company because (i) the issuance of preference shares does not dilute their voting rights, and (ii) preference shareholders are typically not authorized to vote except in specific situations that concern them. However, preference shares that are offered as Redeemable Convertible Preference Shares (RCPS) can provide investors with the opportunity to participate in the company's growth and the potential to control the company upon the conversion of such shares into ordinary shares. A set of properly structured RCPS terms and conditions can detail out the mechanics of such a conversion.
Dividend traits: Preference shareholders are entitled to receive dividend payments before ordinary shareholders, and cumulative preference shares allow the deferral and accumulation of unpaid dividends when the company is not profitable. When the company becomes profitable, any accumulated unpaid dividends must be paid to preference shareholders before any dividends are distributed to ordinary shareholders.
No security needed to be offered: When a company obtains financing through a loan, it is common for collateral or security to be necessary, which could come in the form of a debenture, charge, or mortgage over the company's assets. Whereas, preference shares are typically issued without such security requirements, allowing a company to obtain funds without having to pledge or create any security over its or its shareholders' assets. Consequentially, this reduces the risk of the company facing the risk of insolvency, liquidation or closure due to its inability to finance such a loan.
Priority upon winding-up/liquidation of Company: Preference shareholders have a priority claim over ordinary shareholders (but not over creditors) on the repayment of capital in the event of liquidation or winding-up of the company;
Issuance of the Preference Shares Before investing, it is prudent to conduct some form of due diligence for the purpose of ensuring the preference shares have in fact been validly issued by the company. This can be done by checking whether the following measures/actions have been taken by the Company:
The company has in fact catered provisions in its consitution in relation to the issuance of preference shares;
Resolutions have been passed by the members and directors of the company for the purpose of amending the company’s constitution to incorporate the features of the preference shares;
A resolution has been passed by the members in a general meeting authorising the board of directors to issue the preference shares;
A resolution has been passed by the board of directors for the allotment and issue of the preference shares.
If you’re interested in more legal insights on investing in preference shares or investing in general, feel free to drop us an email or schedule a complementary call with us.