Explaining investment terms: types of share
A venture capital investor will normally only subscribe to a preferred class of shares in the company in which they invest. These are shares to which certain rights attach, that are not shared by ordinary shares held by the founders and others. Venture capital investors require these additional rights because in most cases they are investing much larger sums than the founders (whose investment usually takes the form of good ideas, time and a small amount of seed money) and at a much higher valuation. The venture capital investors will also have less control over the company’s day-to-day operations than the founders, who typically remain closely involved in management.
If a preferred share class already exists at the time of an investment round, the new round of investors will typically create a new series of preferred shares to distinguish the rights (voting, financial, etc.) that attach to their preferred series from those that attach to all prior series of shares. Distinguishing the rights enjoyed by different series is common practice because the investments made at the time of the creation of each series are usually based on different company valuations and circumstances and, consequently, have different risk profiles.
In some Continental European jurisdictions, there are restrictions on the types of different shares classes permissible. This can be compensated for to an extent by creating special rights for certain shareholders in the investment documentation.
The following are typical types of share in a company:
Cumulative preferred shares
A form of preferred shares which provides that if one or more dividends are omitted, those dividends accumulate and must be paid in full before other dividends may be paid on the company's ordinary shares (see Dividend rights).
Convertible preferred shares
Preferred shares convertible into ordinary shares.
Founder shares
Founders and senior management are usually central to the decision of venture capital investors to put money into a company. Having decided to put money behind a management team they have confidence in, investors are usually keen to ensure that they remain in place to deliver their business plan. Therefore, it is often the case that founders and key managers (and sometimes all shareholders/employees who leave the company within a certain period of time) are required to offer to sell their shares back to the company or to other shareholders. The price paid for the shares may depend upon circumstances of departure – it may be at market value if the founder/manager is deemed to be a good leaver, or it might be considerably less in the case of a bad leaver. A bad leaver may be someone who has breached his contract of employment, or someone who resigns from the company within a particular period. The Board often retains the right to determine whether to implement the bad leaver provisions.
In addition or as an alternative to good leaver/bad leaver provisions, investors may require that shares held by founders who are employees or consultants be subject to a vesting schedule in order to incentivise the founders not to leave employment with the company in the short term. The effect of this is that anyone holding such shares must be employed or engaged as a consultant by the company for a certain period of time if that person is to obtain unrestricted ownership of all of their shares. Within that period shares may vest on a straight-line basis or on whatever basis is negotiated. Sometimes founders have different vesting schedules in recognition of their different levels of contribution to the company.
If a founder leaves within the requisite period, he will keep only that proportion of his shares that are deemed to be vested. The remaining shares that are unvested lose their value, either by being bought back by the company for a nominal amount or converted into deferred shares which have no rights attaching to them. It may be decided that on certain events such as death or incapacity or where a founder's employment may terminate through no fault of their own, the vesting schedule is accelerated either partially or fully. The Board may retain the right to determine such issues at the time, in the light of circumstances.
(See Sweat equity)
Fully participating
This term is sometimes used to describe a liquidation preference which entitles beneficiaries to receive a priority initial fixed payment and share pro rata with other share classes in any remaining proceeds (see Liquidation preference and deemed liquidation).
Ordinary shares
These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied.
Participating preferred shares
Preferred shares which entitle the holder not only to its stated dividend and liquidation preference, but also allows the holder to participate in dividends and liquidating distributions declared on ordinary shares.
Preferred ordinary shares
These may be known as A ordinary shares, cumulative convertible participating preferred ordinary shares or cumulative preferred ordinary shares. These are equity shares with preferred rights. Typically they will rank ahead of ordinary shares for income and capital. Once the preferred ordinary share capital has been repaid, the two classes may then rank pari passu in sharing any surplus capital. Their income rights may be defined; they may be entitled to a fixed dividend (a percentage linked to the subscription price) and/or they may have a right to a defined share of the company profits – known as a participating dividend.
Redeemable shares
Shares which the company can be made to repurchase or which the company has the right to repurchase at a predetermined value (see Redemption).
Sweat equity
Equity (shares in a company) which is given to the founder of the company in recognition of the effort (sweat) which he or she has expended in getting the company started up (see Founder shares).
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