Preferred Shares

Written by Narda Ben Zvi, Adv., Partner and Head of High tech and IP department at Yaacov Salomon, Lipschutz & Co.

Founders and angels, as well as employees and consultants who receive shares of a startup company, typically own ordinary shares, and pre-seed startups usually have a uniform equity structure consisting solely of ordinary shares.

Sophisticated investors who invest in a startup generally require preferred shares in return for their investment. The preferred shares have certain rights attached to them in addition to those of ordinary shares, as settled upon during the negotiations for the investment.

When negotiating with investors, it is in the founders' best interests to retain a simple and uniform equity structure consisting solely of ordinary shares, since the rights and advantages of preferred shares generally come at their account, diluting or reducing the founders' take from an exit. A significant portion of the negotiations for investment is frequently devoted to the existence and precise definition of the rights of preferred shares.

Of course, it is recommended that investors receive ordinary shares in early stages, with the right to convert such shares to the type of shares granted in later rounds being substituted for the grant of preferred shares. However, many times, investors insist on receiving preferred shares and therefore, it is of vital importance for the founders and shareholders of a startup company to understand the advantages preferred shares possess over the ordinary shares of the founders, early investors and employees, and the ramifications of each particular right.

When preferred shares are granted to investors, they will be converted to ordinary shares upon certain events. The number of ordinary shares issued in return for each preferred share will be determined based on the anti-dilution protection granted to the investor, along with other agreed-upon conversion modifiers.

There are several rights which are generally attached to preferred shares. Among the most important rights are anti-dilution rights, which serve to protect an investor from dilution when shares of the company are sold at a price per share lower than the price paid by the investor, and the liquidation preference, which provide the investor with preference on the first returns in the case of an exit.

Liquidation Preference means that in the event of sale or liquidation of the company, holders of preferred shares with a liquidation preference would receive an amount of the proceeds before the holders of ordinary shares are entitled to receive anything.

Liquidation preference, contrary to its name, does not trigger merely in the case of liquidation or dissolution of the company, but, most importantly, also in the event of a "deemed liquidation", which is usually broadly defined to include any type of exit. The exact definition of this right is of great importance, with significant monetary ramifications.

A non-participating liquidation preference grants the investor the right to receive, in case of an exit, the greater of either the amount of the investment, possibly with an increased multiplier or interest, or their share of the proceeds of the exit as an ordinary shareholder. Non-participating liquidation preference is the most equitable choice for ordinary shareholders.

A participating liquidation preference grants the investor the right to receive their invested amount in case of an exit, possibly with an increased multiplier or interest, and on top of that, share in the remaining proceeds with the ordinary shareholders on a pro-rata basis. This is essentially double dipping, and is obviously more favorable for investors.

There are hybrid liquidation preferences which consist of a combination of the above.

Liquidation preference is primarily meant to secure the investment, at the cost of the other shareholders. If the company is sold at a low valuation, liquidation preferences grants the investor the right to get their money back first. Under such circumstances, there is frequently little left to share among the ordinary shareholders. In addition, an investor with a participating liquidation preference will obtain a significant reward in the event of a successful sale or merger of the company.

Note that excessive liquidation preference may actually prove harmful for an early-stage startup, as later investors would receive senior preference rights, and successive rounds would result in the early investor (and the ordinary shareholders) being last in line and remaining empty-handed.

The second right intrinsic to preferred shares we will elaborate on is anti-dilution rights. Although an investor is diluted in any investment, in the sense that it owns a smaller percentage of the company following any new issue of shares, the value of the portion of the company owned by such investor has theoretically increased due to the increase in the total company valuation due to the higher price per share paid by the new investor.

Anti-dilution protection refers to protection from dilution when shares of the company are sold at a price per share lower than the price paid by the investor, and typically involve increasing the number of ordinary shares into which each share of the preferred shares is convertible. There are several mechanisms for calculating the increase, with the primary difference between them being the magnitude of the adjustment, and the most commonly used is the named the “broad-based weighted average" mechanism.

Rarely, absolute anti-dilution protection is requested by an investor against any dilution arising as a result of the subsequent sale of shares, which basically guarantees a certain percentage ownership of the company for a specified time period or until the occurrence of a certain event, such as an initial public offering or a second round of financing. However, these provisions may impair the company’s ability to raise financing. In any event, anti-dilution protection should be granted for a predefined period of time and only following a carefully defined events.

In summary, the rights of preferred shares may heavily impact the value and attractiveness of a company to future investments, its fund-raising potential, and the reward founders, employees and early investors receive from their investment in the company. Accordingly, it is vitally important for a company's future that you work together with the company's lawyer to craft a package that offers sufficient reward to an investor and does not risk both the company's future and your personal benefits.

Written by Narda Ben Zvi, Adv., Partner and Head of High tech and IP department at Yaacov Salomon, Lipschutz & Co.

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