What are preference shares and why should I care?
As your journey as an angel investor progresses and you start investing into later rounds, especially if VCs start investing, you will start seeing terms crop up like ‘preference shares’ or in general different classes of shares and share stack waterfall.
In reality it is nearlly impossible to raise money from VCs without issuing them ‘preference shares’.
Preference shares were introduced as a term to differentiate between shareholders who should be paid out first. So in the NON startup world you may have pref shares that give you priority receipt of dividends. Or if the company goes bust, you get first ‘dibs’ on the cash and assets to recoup your investment over the ‘ordinary’ shareholders.
In startup world ‘preference’ shares are generally used to give their owners one or many of the following, which ‘ordinary’ shareholders don’t get:
Liquidation preferences. If the company undergoes a liquidation event. This could be selling a large stake, being totally acquired or an IPO, owners of ‘pref shares’ may have a minimum guaranteed return. i.e. 2x pref shares.
Example.
You are an angel investor invest in the first funding round of honkytonk.io which has been bootstrapped for 2 years:
In an overall £1m round
pre-money valuation of £10m and post-money valution of £11m.
So, 11,000 shares in total with a share price of £1,000
You as an Angel have invested £110,000 for 110 shares and 1% of the company
Other angels invested £890,000, for 890 shares and 8.9% of the company
The 3 founders own 10,000 shares and 90% of the company
2 years later honkytonk.io raises a Series A from 1 individual VC fund:
£8m growth round to capitalise on early success
At a pre-money valuation of £24m and post-money valuation of £32m.
This is 25% dilution for all existing investors. (so 1/3 dilution)
3,667 new shares are issued to the VC fund and there are 14,667 shares now in total
Share price is now £2,182.82 - Angel is up 2.18x
Angel’s 110 shares are now 0.75% of equity
Other angel’s own 890 shares which are 6.07% of equity
The 3 founders still own 10,000 shares, so 68.18%
VC fund owners 3,667 shares, so 25%
BUT this is the sticky point. VC fund’s shares are all ‘preference’ shares with a 3x liquidiation preference
Finally, 1 year later the market has crashed, growth has stalled and honkytonk.io is bought by a large US competitor for a slight up round valuation of £35m.
On paper this sounds like a win overall and as no new shares are issued, so there are still 14,667 shares and theoritically the share price is now £2,386.36 a 2.386x return for all the angels. So a cash return of £262,500 and a £152,500 profit in 3 years.
In this example the reality is very different.
This is as the VC Fund gets their liquidity before any other investor (including the founders) and they are guaranteed a 3x return on their £8m investment. So:
Company is sold, all cash, for £35m
VC gets 3x £8m = a £24m. Giving the VC a £16m profit in 1 year. This removes their 3,667 shares from the calculation.
This leaves £11m for the remaining investors.
The 3 founders own 10,000 of the remaining 11,000 shares (91%) so get £10m between them. That’s £3,333,333 each, for 5 years of graft or £666k for each year of graft!
You as an angel own 110 shares of the remaining 11,000 (1%), so only get the initial £110k investmetn back. 0 return after 3 years of investment and an exit 3.5x the valuation you invested at.
The remaining investors own 890 shares of the remaining 11,000 (8%), so also only get the initial £890k investment back.
Now you could absolutely argue that this is an extreme scenario and would never happen. However the reality is that it has happened (a lot more back in 2020 / 2021) and is more likely to happen the less education you are about investing.
Also, please note that the liquidiation preferences don’t always have to be as a X multiple to be punitive to angels. I have also seen them as annual % interest on the VCs investment that compounds over time. In this scenario a slow burning startup burns all the angel’s investment…
On a final note, this also explains why the SEIS tax rules are so important. In the scenario where the investor got no return over the 3 years, they would have got half their initial investment back after filing their taxes that year…
Anti-dilution protection. In this scenario instead of asking for a guaranteed return, the VC protects their investment by preventing dilution of their % holding. Dilution is always a risk for angels and we have described this elsewhere. Also please note that some VCs may ask for both of these provisions.
The dilution the VC is protecting themselves from could be in the form of a “down” round, where the valuation of the company has fallen. Or dilution could be from a “up round” subsequent fundraise. In the former instance, mechanisms that adjust the price at which preferred shares convert into common shares can be put in place. To prevent the latter source of dilution, pro-rata rights—which give the investor the right to invest in future rounds to maintain their shareholding percentage—are common.
It could be argued that this post is a little extreme and scare-mongering but the whole point of these posts is to educate and protect angel investors who provide essential earliest stage liquidity to founders.
Note: Image generated using DeepAI with the text “preference shares”
