Preference shares - overview, risks and alternatives

Preference shares are a class of shares 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.

• Employee incentives - offering employees preference shares can be 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.

• Family Succession Planning - balancing inheritance while maintaining voting control

• Restructuring - converting debt to equity without diluting management control

Common differences between preference and ordinary shares

Preference shares are flexible. However, in almost all circumstances shareholders who agree to hold preference shares want additional rights which ordinary shareholders will not have. Typical rights attaching to preference shares include :-

• Fixed dividend rates, payable before any dividends can be made available for ordinary shareholders or other shareholders. The dividend could be paid on a monthly basis.

• Priority over ordinary shareholders if the company goes into liquidation or the company is wound up.

• No voting rights

This typical structure for preference shares means that they will receive a dividend on a regular basis but will have limited involvement in the company.

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

• Class Rights - the specific rights and limitations attached to each class of shares 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.

Practical considerations if you have preference shares

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:

• Shareholders Agreement - if your company has 2 or more shareholders then we strongly recommend that you have a Shareholders Agreement. This will regulate the relationship between the shareholders and the company and govern such issues as the issue of a dividend, transferring shares, issue of new shares ect. Discuss your Shareholders Agreement with us.

• “Tag and drag” - what happens if you have preference shareholders and you want to sell the company? The buyer of your company will probably want to buy all the preference shares as well, so you need a mechanism to provide for this and to work out the price.

• Option Agreement - an alternative mechanism to deal with preference shares is that the company or another shareholder can buy the preference shares if the company is being bought.

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.

How we can help and next steps

Our firm provides expert guidance on implementing preference shares tailored to your specific needs, handling all required documentation and ensuring full compliance with Companies Act requirements while supporting your business objectives. our experience and services include, as necessary :-

• Assessment of whether preference shares suit your company structure and objectives, short, medium and long term.

• Advising on the best type of preference shares and attached rights and commercial and legal pros and cons

• Articles of Association -  amendments to include basic preference share rights

• Shareholder Resolutions - special resolutions authorising creation and issuance

• Directors' Minutes - documenting board approval

• For Family Business Succession Planning - family charter amendments and integrating preference shares into succession planning and voting trust agreements if preference shares are part of voting control arrangements

• For Management Incentives - management rights documentation if preference shares form part of executive compensation and performance criteria documentation for performance-linked preference shares

• For Corporate Restructuring - debt-to-equity conversion agreements when replacing debt with preference shares and/or creditor consent documents if restructuring involves existing creditors

• Company law compliance - with Companies Act 2006 requirements

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.