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Companies can raise capital by issuing different types of shares. Company shares are capable of having different rights attached to them. Most commonly, these fall into two categories: ordinary shares or preference shares. Usually, early-stage investors will seek preference shares in exchange for their cash, whereas founding shareholders will hold ordinary shares in the company. This article will examine the difference between ordinary shares and preference shares.
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Shares: An Overview
Holders of company shares obtain a bundle of rights in the company. Shares with the same rights attached to them as another set of shares are of the same class. Shares with different rights compared to another set are of a different class.
The three most important rights attached to shares relate to:
- voting rights;
- the right to dividends; and
- the right to a return of capital.
Therefore, when you hear people refer to ordinary versus preference shares, they are referring to shares of different classes.
What Are Ordinary Shares?
If your company has only one class of shares, in most cases, the shares will be ordinary shares. Companies with more than one class of shares usually have ordinary shares in addition to the other class(es), though there is no obligation to call them ordinary shares.
Ordinary shares typically have the following rights attached to them:
- the right to vote;
- the right to dividends; and
- return of capital.
Right to Vote
An ordinary share entitles the shareholder to vote at shareholder meetings. Typically, upon a poll vote, one share equals one vote. However, there is some degree of flexibility. Your company could create another class of shares identical to ordinary shares in all other respects except voting rights, which may be weighted differently.
These “dual share structure” companies are common in large family-owned businesses or certain publicly traded companies. In such cases, the company may have “A Shares” and “B Shares,” where, for instance, A shares have twice the voting power compared to B shares.
Right to Dividends
An ordinary share entitles the shareholder to a proportionate share of any declared dividends.
Suppose Craig holds 25% of the company’s ordinary share capital, and the company declares a $10,000 dividend. Here, Craig is entitled to $2,500.
Return of Capital
The usual rule is that the company cannot release its capital to shareholders except through specific means like dividends. That is, once Hannah invests $10,000 in the company, she has no general right to demand its return.
However, companies may cease to trade for a variety of reasons, including:
- the predetermined end of a business venture;
- a shareholder dispute; or
- insolvency, where the company’s liabilities exceed its assets.
For instance, suppose that following the end of the business venture, a company has $50,000 in assets after all creditors are repaid. If the only shareholders are ordinary shareholders, Craig would get $12,500.
If a company is insolvent, there are typically no assets left after repaying creditors in a windup. In this case, Craig gets nothing.Continue reading this article below the form
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What Are Preference Shares?
Preference shares entitle the holders to some form of preference compared to other shareholders (typically ordinary shareholders). Preference shares are commonly issued to early-stage investors to compensate them for the risk of investing in a startup.
Right to Vote
Preference shares may or may not have voting rights attached to them. Your company is under no obligation either way. However, the general rule is that where preference shares give the shareholders more favourable rights to dividends and return of capital, they are less likely to have voting rights. This reflects the fact that preference shareholders are often early-stage investors looking to cash in on their investment after a fixed period.
Preference shares usually entitle the shareholder to dividends paid in advance of other non-preference shareholders. You would typically express these rights in terms of a fixed amount based on a percentage of the paid up value. For instance, if the company issues preference shares at $1 per share, the rights may specify that the holder is entitled to 5% of the paid amount. If Hannah owns 10,000 shares and a dividend is declared, she is entitled to $500 before any non-preference shareholders are paid.
To illustrate, if the company declares a $10,000 dividend:
- if Hannah’s preference shares are capped, the company must pay her $500 before the ordinary shareholders are paid, but she has no right to any more than this; or
- if uncapped, the company must pay her $500, following which she also gets a portion of the remaining dividends.
Return of Capital
Preference shares also typically grant the holders priority over ordinary shareholders on a return of capital in a windup. You may hear this called a liquidation preference.
Like dividend rights, the preferred right is usually expressed in terms of the paid up value of the share and is usually equal to this amount. In Hannah’s case, this would mean she is entitled to $10,000 of any remaining assets after repaying creditors and before ordinary shareholders.
Similarly, the return of capital for preference shares is either capped or uncapped. Where capped, Hannah gets priority to her paid up amount only. Where uncapped, her capital is returned, plus she is entitled to a portion of any remaining value to share along with ordinary shareholders.
Notably, the law does not provide a fixed definition of preference shares. Your company has some flexibility about the extent of the rights attached to shares. This is why, in practice, a company can describe preference shares in different ways. For instance, non-participating preference shares refer to shares whose rights to dividends and return of capital are limited to a certain amount. That is, the holder has no rights to surplus profit.
Likewise, preference shares may be cumulative or non-cumulative. Where a company does not declare a dividend in a certain period, cumulative preference shares mean the company must backpay the holder for each period it did not declare a dividend.
Recording Rights in Shares
The law generally requires companies to specify the nature of the rights attached to different classes of shares in the company constitution. The constitution can provide for other conditions to be attached to shares. For example:
- a class of preference shares with non-voting rights;
- redeemable preference shares; or
- fixed preference shares.
You should also ensure the company’s share register and cap table are current. This will aid future investors when determining how to structure their investments.
Company shareholders will obtain a bundle of rights by virtue of their shareholding in a company. Ordinary and preference shares are two different classes of shares. Depending on the terms of these shares, preference shares usually give shareholders more favourable rights compared to ordinary shares.
Typically, company founders will hold ordinary shares, whereas they will offer preference shares to investors to attract their investment. A company wishing to record the difference in these two classes of shares must document it in their company constitution. Further, it is best practice to record this distinction in the company’s share register and cap table.
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