Shares 101: Understanding shares ownership and investment

Shares are legal rights that represent a shareholder’s stake in a company. In addition to shares subscription, a company may also issue warrants (i.e. an investment instrument which grants an option to the holder to convert the warrants into shares), but we won’t cover it in this post.

It is common for a company to issue different types of shares, as each type of shares provides different rights to its shareholders. The type of shares that can be issued by companies are usually governed by the company law depending on where your startup is domiciled.

Considering that traditional bank loans are out of the question, for most startups, the usual way for founders to raise funds in their company is to sell the equity stake in the company in exchange for cash. In exchange for the new capital, the company will issue new shares, either ordinary shares or preference shares, to the investor, who will be a new shareholder in the company.

Consequently, deciding on the investment shares is crucial for making informed capital-raising decisions.

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This table summarises the key differences between ordinary and preference shares.

What are ordinary shares?

Ordinary shares (or ‘common stock’) represent the equity stake in a company. As a founder, founders’ shares are typically issued when a startup is formed before any equity is purchased by future investors or VCs. Ordinary shares confer voting rights, allowing the ordinary shareholder to influence the company’s direction.

However, in terms of financial returns, company law ranks ordinary shareholders at the absolute bottom of the order of priority. Dividends, if any, are paid out only after all other obligations, including those to creditors and preference shareholders, are met before any distribution may be made to the ordinary shareholders.

Prior to a capital raising exercise, a company’s shares capital may initially consist of ordinary shares held by the founders and angels.

What are preference shares?

A preference share (also called ‘preferred stock’) is a class of shares which offers its holders a more secure position. These preference shares usually come with preferential rights, such as priority in receiving dividends and asset distribution in the event of a liquidation.

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In our experience acting as the law firm for VCs at Izwan & Partners, VCs usually insist on “watertight” agreements that seek to mitigate the risks they take with their investment (as VCs are expected to finance unproven companies).

For instance, although company law states that preference shareholders by default may not have any voting rights, most or all holders of preference shares expect to have voting rights. Additionally, preference shareholders may yield influence through clauses like reserved matters, anti-dilution protection, and board representation.

When negotiating a preference share issuance, founders should consider the following matters:

• Investor category: Generally, if the investor is a financial investor (i.e. a professional investor that deploys capital on a professional basis) like VCs and corporates, you may expect preference shares to be the default investment instrument.
• Valuation: The company’s valuation will affect the conversion price of preference shares into ordinary shares. The conversion ratio formula is usually agreed upon at the time of the investment and is based on factors such as the preference share’s issue price, conversion price, or a predetermined formula. For instance, if the conversion ratio is set at 1:1, each preference share is converted into one ordinary share.
• Liquidation preference: As a VC, liquidation preferences allow for some form of capital protection for its capital investment. In the financial context, liquidation preferences are usually expressed as a multiple of the original investment. The “1x” means a VC will get a dollar back for every dollar invested, a full recouping of their money (in practice, the entire scenario only works on the basis that there’s enough cash to cover this, while ordinary shareholders will receive what’s left — if there is money left over of course).
• Exit strategy: A VC usually investment holding period in an investee is between two to five years. Therefore, the founders’ exit plans (IPO, acquisition) would need to be aligned with the preference share structure.
• Control: The level of control founders wish to retain will impact voting rights and other governance provisions, such as negotiating a set of reserved matters (i.e. actions that the company must not do without the approval of the investor) that will not stifle the daily operations of the business.

A startup lawyer can help you go through the term sheet to ensure that all the investment terms are industry standard terms, and help you negotiate (as you are usually at the highest negotiating point during the term sheet in contrast to subsequent rounds when the definitive documents are being prepared usually by the investor’s lawyer).

Final thoughts

Ordinary shares, while carrying voting rights, offer limited financial protection to the holders. As an investor, preference shares offer a range of benefits, including dividend preferences, liquidation preferences, in addition to the existing contractual rights such as anti-dilution protection and reserved matters. While preference shares offer greater flexibility when it comes to structuring the shares issuance, it can also be complex and confusing to structure due to the wide range of features available.

As a founder, engaging a startup and venture lawyer as early as possible prior to your capital raising exercise can help you ensure that you’re aligned in terms of your investment expectations when dealing with investors while complying with the applicable securities laws.

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