Preference shares - overview, risks and alternatives

Preference shares are a class of shares within a company that give holders certain advantages or different rights over ordinary shareholders.

Uses and examples

• Raising capital - companies can issue preference shares to attract a specific type of investor who prioritises fixed income over capital growth.

• Controlling corporate structure - by issuing different classes of shares with varying voting rights, companies can impact control and protect specific interests.

• Employee incentives - offering employees preference shares can act as a retention tool and reward their loyalty.

• Acquisitions and financing - preference shares can be used in complex finance structures or as part of acquisition deals.

Common differences between preference and ordinary shares

There are no set rules. However, in almost all circumstances investors who will agree to accept preference shares want additional rights which ordinary shareholders will not have. Typically examples include :-

• Fixed dividend rates, payable before any dividends can be made available for ordinary shareholders.

• Priority over ordinary shareholders if the company goes into liquidation.

On the face of it, ordinary shareholders will be disadvantaged. However, ordinary shareholders commonly will try to obtain the comfort of insisting that preference shares do not have voting rights.

Risks for existing shareholders

• Dilution of voting power - issuing preference shares can dilute the voting power of existing ordinary shareholders.

• Dividend payments - preference dividends must be paid before ordinary dividends, impacting the amount available for distribution to ordinary shareholders.

• Change in control - issuing preference shares with voting rights can alter the company's control structure, impacting existing shareholders' influence.

Types of preference shares

There are various types of preference shares, each with unique characteristics. Some common types include cumulative preference shares, which allow shareholders to receive unpaid dividends at a later date, and convertible preference shares, which provide the option to convert preferred shares into ordinary shares.

• Cumulative preference shares - if a dividend payment is missed, it carries forward to the next payment cycle. When dividends are eventually paid, shareholders receive both the current and any previously unpaid amounts. If dividends remain unpaid for multiple cycles, they continue accumulating until payment is made.

• Non-cumulative Preference shares - if the company decides to skip a dividend payment, the shareholder forfeits that payment permanently and cannot claim it in the future.

• Convertible Preference shares - these shares allow holders to convert their preference shares into ordinary shares at specific intervals based on agreed terms. After conversion, shareholders gain voting rights.

• Participatory preference shares - holders receive a fixed annual dividend and may also benefit from additional payouts when the company surpasses certain performance benchmarks.

• Redeemable preference shares - issued with a predetermined redemption period, after which the company repurchases them from shareholders based on the share value at redemption.

Process of issuing and company law issues

• Drafting Class Rights - the specific rights and limitations attached to each share class need to be considered and defined, such as voting rights (full, limited, none), dividend rights (priority, fixed dividend, participation in residual profits), liquidation preferences (priority in repayment of capital), conversion rights (option to convert to another class of shares) and redemption rights (company's right to buy back the shares)

• Board approval - the board of directors must approve the creation and issue of preference shares.

• Shareholder and/or articles of association approval - depending on the company's articles of association, shareholder approval may be required. If the articles require approval, a general meeting must be convened, and a special resolution passed by a majority of shareholders present and voting in person or by proxy.

• Filing with Companies House - the company must file the necessary documents with Companies House to formalise the issue of preference shares.

• Redemption and conversion - Some preference shares may have redemption or conversion rights, adding further layers of legal complexity.

Alternatives to preference shares for UK private companies

While preference shares offer certain advantages, they also come with limitations and considerations. Depending on your specific needs and goals, several alternative options exist for raising capital or structuring ownership in a UK company:

• Issuing more ordinary shares to investors or existing shareholders

• Convertible Loan Notes

• Employee Stock Option Plans (ESOPs)

• Debt Financing whether bank loans or overdrafts or mezzanine finance - debt with some equity features, providing more flexibility for borrowers than traditional bank loans with potential higher returns for lenders.

• Joint Ventures or Strategic Partnerships - partnering with another company can provide access to resources, capital, and market reach.

Get in contact

Raising finance and attracting inward investment are very important for growth companies, often at a critical stage of their development. Navigating the different alternative ways to quickly grow your company is complex. You can rely on our experience to help you understand the options, make the right choices and streamline the legal process. Please do get in contact.