Investing in an early-stage startup is inherently high risk. One way investors seek to reduce investment risk is by opting for ‘preference shares’ in place of ordinary shares. So, what is a preference share? The clue is in the name. Preference shares give the holder a ‘preference’ over other shareholders. There are many kinds of preference shares that can exist, some more common than others and often, the type of preference depends on the type of investment. In the start-up world, preference shares typically mean a liquidation preference. A liquidation preference gives an investor a ‘preferential’ or ‘priority’ right to a return on a liquidity event (whether positive, such as a sale of the start-up business, or negative such as a liquidation).
How Preference Shares Work in Startups
The widely used Angel Association New Zealand template documents outline the following approach to a liquidation preference:
- Separate Class of Shares: Investor shares will be described in the company’s constitution and shareholders’ agreement as “preference shares”. This is a separate class of shares from the ordinary shares on issue. Preference shares rank equally with a company’s ordinary shares in all respects (voting, right to dividend) except that they outline a ‘preferential return’ right on the occurrence of a specified liquidity event.
- Liquidation Preference Clause: The company’s constitution will typically include a clause that sets out how an investor’s liquidation preference works. Broadly, an investor who holds preference shares is attributed a “Preference Amount”. This is the issue price of those preference shares multiplied by the number of preference shares held by that investor, this is the investor’s investment amount.
In simple terms, if there is a liquidity event, the investor has ‘first right’ to the proceeds for a return up to that investor’s stated liquidation preference (ie. their investment amount).
Possible Scenarios for Investors
Here are some potential outcomes for an investor holding preference shares in the event of a liquidity event:
| Scenario | Outcome |
| The liquidity event creates funds available equal to the Preference Amount. | The investor gets their investment back and there are no returns available for any ordinary shareholders (ie. a total loss). |
| A negative liquidity event where there are insufficient funds to return investors their Preference Amount. | The investor gets a share of their investment back proportionate to their holding of preference shares against all preference shares on issue (ie. a partial loss) and there are no returns available for any ordinary shareholders (ie. a total loss). |
| The liquidity event creates funds available that are greater than the Preference Amount, but the investor’s Preference Amount is a higher number than the investor’s pro rata distribution (treating the investor like an ordinary shareholder). | The investor gets their investment amount and ordinary shareholders share the surplus funds leftover (ie. a partial return for ordinary shareholders). |
| A positive liquidity event, where the liquidity event creates funds available greater than the Preference Amount and the investor’s Preference Amount is lower than the investor’s pro rata distribution (treating the investor like an ordinary shareholder). | The preference shares effectively act like ordinary shares and the investor gets a pro rata share of the return. |
Additional Considerations
As you can see from the table above, the ‘standard’ approach to liquidation preferences in New Zealand provides an investor with downside protection in anything other than a positive liquidity event and penalises ordinary shareholders. In theory, this position incentivises founders to maximise returns and compensates investors for providing ‘risk capital’ to enable Founders to be aggressive and prioritise growth and long term value creation over short term profit and survival.
However, some investors will seek more beneficial preference terms than what we have outlined above. This can include:
- Participation Multiples: While the standard position in New Zealand (reflected in the Angel Association documents) is a 1x liquidation preference (ie the investor gets their money back), it is not unheard of for investors to ask for higher multiples (ie a 10x preference means 10 times the amount of money invested), particularly in later stage or distressed financings. A multiple higher than 1x goes further than a ‘safeguard’ and creates a preferential return. For example, a company with $10m in preference shares on issue with a 2x liquidation preference needs to obtain at least a $20m exit before the founders see any return on their ordinary shares.
- Participating vs. Non-Participating: It is also standard in New Zealand for preference shares to be “non-participating”. This means that holders of Preference Shares are entitled to the greater of the Preference Amount or their pro rata share of available funds. However, it is also possible for investors to negotiate “participating” preference shares. This ‘double dip’ mechanism supercharges an investor’s preferential return on a positive exit, giving the holders of preferences shares both their Preference Amount and a share of the available funds leftover once the Preference Amount has been paid, proportionate to their total shareholding in the company. For example, consider the split of returns for a company that achieves what is, on the surface, a great exit. Assume a company raised $2m in preference shares on a post-money valuation of $10m. a $20m exit with $2m in ‘participating preferred’ shares on issue with a 2x liquidation preference and where the preference shares constitute 20% of all shares on issue (the other 80% being simple ordinary shares), look like this:
| Class of share | Simple share of company equity | Investment return | Share of proceeds |
| Preference shares ($2m invested) | 20% | $5.2m | 52% |
| Ordinary shares | 80% | $4.8m | 48% |
Our View
A sensible liquidation preference regime provides investors with some degree of comfort in terms of a negative exit event. The Angel Association of New Zealand standard approach reflects this.
As with any structuring of a capitalisation table, preference shares are not ‘free’. They create a mismatch in rights and interests as between investors and founders, particularly when times get tough. We are aware of anecdotal instances of conflict between investors and founders in relation to this very issue.
Often, the ‘comfort’ obtained from preference shares will prove illusory. Many outcomes for a failed start-up involve zero returns to equity at all. No amount of preference can protect an investor’s capital when a start-up fails and no buyer is willing to pay more for the failed business than it owes to staff and other trade creditors. Sometimes, when times are tough, founders will use their natural leverage (no company without me) to renegotiate.
There is some appeal to a simple capitalisation table where all shareholders have identical risk and reward.
Finally, as a practice point, we are aware of technical issues where a company raises multiple rounds of preference shares and past horror stories of confused directors and liquidators and preference terms not working as intended. All these issues are fixable with good legal documents, but both founders and investors need to be alive to this issue and ensure their lawyers check the terms of their documents before raising a second or multiple preference rounds.
How We Can Help
Whether you’re a founder looking to raise capital or an investor seeking to invest in a startup, we have the expertise to guide you through the process. We can help you implement the terms you want and provide clear advice on the benefits and drawbacks of different equity structures.
Get in touch with our Start-up team.
This article was authored by Ryan McMaster and Richard Hoare.