Information on legal and business topics from Canadian business lawyer Shane McLean

What are Preferred Shares?

Posted by Shane McLean on July 2, 2009

I recently put up a post about financing term sheet basics.  In that post I mentioned that one of the key elements to any financing is determining “what” is being sold to/bought by the investor.  Very often with private companies that “what” is a preferred share.  So, what is a preferred share and how is it different from any other share?

First, it may help if I explain what a common share is.  Generally speaking, a common share is the term used to describe the most basic class of shares that a company has.  Typically common shares have a right to vote at shareholder meetings, have a right to receive dividends if and when declared by the company’s board of directors and have a right to share in the proceeds of liquidation if the company was ever to be wound up and liquidated.

Preferred shares can differ from common shares in any number of ways but the key concept is that they enjoy  some “preference” — i.e. some right that is perceived as being better than or coming before the common shares.  With  startup companies receiving venture capital financing, for example, the preferences enjoyed by the holders of preferred shares often include:

(i) some liquidation preference — if the company is ever liquited or even sold the holders of preferred shares will receive  some portion of the proceeds ahead of the common shareholders.  Depending on the circumstances, this could even result in the common shareholders receiving no proceeds.

(ii) some voting or veto rights — sometimes the holders of preferred shares will have an approval or veto right over the company taking certain fundamental actions.

(iii) redemption — the holders of preferred shares may have the right to demand that the company repurchase their shares, often at a defined price  and on or following some predefined time or event.

(iv) dividend rights — preferred shares may come with a fixed dividend right and/or may come with a right to receive dividends in preference to the holders of common shares

(v) conversion —  holders of preferred shares may have a right to convert those shares into common shares (or some other class of shares).  This would be used in any situation where  the holder was better off  to hold common shares instead of preferred shares. For example, if a company goes public and its common shares become publicly tradeable on a stock market but its preferred shares do not, an investor may want to convert preferred shares to common shares in order to sell.

There are other terms that come with preferred shares and if you are a company reviewing a term sheet received from an investor interested in buying preferred shares, you would be well advised to consult with experienced legal counsel who review term sheets regularly.  They will be able to tell you whether the terms proposed are the current standard  “market” terms or something different.

In addition to the preferred share terms, the investor is likely to ask for a number of other rights/concessions that will appear in the various contracts governing the investment such as the shareholder agreement.  Those will be the subject of future posts.


2 Responses to “What are Preferred Shares?”

  1. Excellent overview of a fundamental business component that is far too frequently not adequately discussed or explained.

  2. […]    What are Preferred Shares? (July 2, […]

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