Ordinary vs preference shares – what’s best for founders?

In the world of venture capital, the type of shares issued to investors can have significant implications for both founders and investors. While most early-stage businesses begin with ordinary shares, VC investments almost always involve the issuance of preference shares, a class of shares designed to provide investors with additional rights and protections.

This article explores the differences between ordinary and preference shares, the rationale behind these structures, and the implications for both founders and investors. As part of our "Anatomy of a term sheet" series, this insight article will help demystify these structures and explain why they are a cornerstone of venture capital deals.

What are ordinary shares?

Ordinary shares are the basic building blocks of a company’s share capital. Holders of ordinary shares typically have:

• Equal voting rights: one share, one vote
• Residual rights to profits: dividends are distributed to ordinary shareholders after all obligations (including those to preference shareholders) have been met.
• Pro-rata claim on company assets: in a liquidation, ordinary shareholders are last in line, receiving what remains after creditors and preference shareholders have been paid.

Most founders and employees in early-stage businesses hold ordinary shares, as they represent the equity and control at the heart of the business.

Ordinary shares and SEIS/EIS eligibility

Ordinary shares often play a critical role in securing investment under the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS). These schemes offer significant tax reliefs to investors in qualifying UK companies, including income tax relief and exemption from capital gains tax on profits.

To qualify for SEIS and EIS, the shares issued must be ordinary shares with no preferential rights. This means that investors looking to benefit from SEIS or EIS will need to hold ordinary shares, making these schemes particularly attractive for early-stage companies where the focus is on growth rather than complex share structures. Founders and advisors should consider this when planning their funding strategy.

What are preference shares?

Preference shares are a special class of shares that offer investors protections and economic benefits not available to ordinary shareholders. Key features of preference shares include:

• Liquidation preference: preference shareholders receive a defined payout before ordinary shareholders in the event of a sale, liquidation, or winding up. (read more about liquidation preferences here)
• Dividend rights: preference shares may carry a fixed or cumulative dividend, providing investors with a return even if the company does not exit.
• Conversion rights: preference shares can typically be converted into ordinary shares, particularly in scenarios such as an IPO.
• Anti-dilution protection: preference shareholders often receive protection against dilution in future funding rounds. (read more about anti-dilution protections here) 

These features are designed to de-risk the investment for VCs while still allowing them to benefit from the company’s upside potential.

Participating vs non-participating preference shares

Non-participating preference shares

Non-participating preference shares provide the investor with either their liquidation preference or their pro-rata share of the proceeds as if the shares had converted to ordinary shares—whichever is higher. This structure balances downside protection with fair upside sharing at higher exit values.

Non-participating shares are considered more founder-friendly, as they avoid giving investors a disproportionate return at higher valuations.

Participating preference shares

Participating preference shares allow the investor to receive both their liquidation preference and their pro-rata share of the remaining proceeds. This structure, sometimes referred to as the "double-dip," significantly enhances investor returns, especially at lower-to-mid-level exits.

Participating preference shares can sometimes include a cap (e.g., 2x the original investment), which limits the total amount an investor can receive under this structure. This makes it less punitive for founders at high exit valuations.

Key differences between ordinary and preference shares

Why do investors prefer preference shares?

Investors seek preference shares because they align risk and reward in their favour. These shares reduce downside risk while preserving upside potential. For example:

• Downside protection: if the company is sold at a lower-than-expected valuation, liquidation preferences ensure the investor recoups their initial investment (and potentially a multiple of it) before ordinary shareholders receive anything.
• Upside participation: conversion rights allow preference shareholders to convert into ordinary shares and participate in the residual value once their liquidation preference has been satisfied.

For investors, this structure provides a balanced approach to managing the high-risk nature of venture capital.

Examples of preference share mechanics

Liquidation preference

A company raises £5 million in a Series A round, issuing preference shares with a 1x non-participating liquidation preference. If the company sells for £10 million:

• Preference Shareholders: Receive their £5 million investment back first.
• Ordinary Shareholders: Share the remaining £5 million.

In a participating liquidation preference, preference shareholders would also share in the remaining £5 million, increasing their total payout.

Conversion rights

In the same scenario, if the company sells for £50 million, the preference shareholders may convert their shares to ordinary shares, receiving their pro-rata share (e.g., 25% ownership) of the total proceeds.

Negotiation points for founders

While preference shares are a standard requirement in venture capital deals, founders can negotiate terms to ensure fairness and alignment. Common areas of negotiation include:

• Capping liquidation preferences: a cap (e.g., 2x the original investment) ensures investors’ returns are not disproportionately high.
• Structuring dividends: avoiding cumulative dividends that accrue over time and add to liquidation preferences.
• Anti-dilution protections: favouring "broad-based weighted average" protection over more punitive "full ratchet" terms.

Analysis: founders’ perspective vs investors’ perspective 

In summary

The choice between ordinary and preference shares is a fundamental aspect of venture capital deals. For founders, understanding the mechanics and implications of preference shares is crucial to structuring a fair and sustainable investment. For investors, these structures provide the protections and upside they need to make high-risk investments.

Read the next article in our ‘Anatomy of a term sheet’ series, exploring liquidation preferences in greater detail, examining how they influence payout scenarios and exit dynamics.

If you're navigating the complexities of venture capital term sheets or preparing your business for investment, our experienced team is here to help. Get in touch today to discuss how we can support you in securing the right deal for your business.