Basic Rights
A common share will generally, in the absence of special provisions in the company’s Articles of Association, grant voting rights in the company, residual profit rights, and the right to receive dividends.
Preference Rights
A Preference Right is a right attached to Preferred Shares, which are shares granting superior rights over other shareholders. Typically, founders do not hold Preferred Shares (unless they invest as investors in a round). The holders of Preferred Shares are usually investors who, through these shares, receive priority—particularly when an exit event occurs, which is generally defined as the sale of the company’s entire or majority of assets, or the sale of the company itself.
The nature of Preference Rights has evolved over time, but one fundamental principle remains unchanged—the later-stage investor is the first to "touch the money." This is why, when attorneys and accountants discuss fund distribution in an exit event, they refer to it as a waterfall. It is metaphorically likened to a cascading waterfall, where those at the bottom are the founders, followed by the early investors who "stand on their shoulders," and then the later-stage investors who stand on the shoulders of the earlier ones.
Imagine a scenario where each participant in the waterfall brings a bucket. Once the water begins to flow, the last investor in line (the latest-stage investor) will fill their bucket first and step aside (thus exercising their Preference Right). The investor before them will fill their bucket next and then move aside, and so on—until reaching the investors and founders who hold common shares.
At this stage, there are two types of Preference Rights: Participating Preference and Non-Participating Preference.
The key difference is that in a scenario where Preferred Shareholders have a Participating Preference, instead of the remaining funds being distributed solely among common shareholders, the Preferred Shareholders will also participate in the distribution. The division will then be made according to the proportional ownership of shares.
Participating Preference
In a Participating Preference scenario, each Preferred Shareholder will receive their preference amount, and after the full distribution of all preference amounts to investors holding Preferred Shares, they will also have the right to participate in the distribution of the remaining funds with the other shareholders according to their shareholding percentage in the company.
Below is an example of a Participating Preference clause:
*"Distribution Preference. In any Liquidation Event (as defined below), funds, assets, or proceeds (whether cash, capital, surplus, earnings, funds, shares, securities, or assets of any kind) legally available for distribution to Shareholders or payable to Shareholders in connection with such Liquidation Event, as the case may be ("Distributable Assets"), shall be distributed to the Shareholders in the following order and preference:
First, the holders of the Preferred A Shares shall be entitled to receive on a pro rata pari passu basis among themselves, prior to and in preference to any distribution of any Distributable Assets to the holders of any other existing classes of shares by reason of their ownership thereof, in respect of each Preferred A Share, an amount per Preferred Share equal to one point two (2) times the respective Original Issue Price for such series of Preferred Shares (as adjusted for any Recapitalization Event with respect to such shares) plus any declared but unpaid dividends thereon less any amount actually paid pursuant to this Article (the "Series A Preference Amount").
If the assets and funds thus distributed among the holders of the Preferred A Shares shall be insufficient to permit the payment to such holders of the full aforesaid Series A Preference Amount, then the entire amount of such assets and funds legally available for distribution shall be distributed ratably among the holders of the Preferred A Shares in proportion to the Series A Preference Amount that each such holder is otherwise entitled to receive, and
Second, after payment to the holders of the Preferred A Shares of the Series A Preference Amount, the entire amount of the assets and funds legally available for distribution, if any, shall be distributed ratably to all of the Shareholders on a pro rata pari passu basis."*
Essentially, the clause above describes the allocation of proceeds during a distribution event.
First, holders of Preferred A Shares will receive their preference amount (a 2x multiple of their investment, minus any dividends they have already received—also referred to as 2x Preference).
Then, after the Preferred A Shareholders have received their preference, they will participate in the remaining distribution alongside all other shareholders according to their proportional holdings.
This means that investors benefit twice:
First, they receive double their initial investment as Preference, and
Then, after preference distributions, they share in the remaining proceeds with all other shareholders.
This type of Preference is also referred to as a Double Dip.
Although preference multiples (such as the 2x Preference mentioned above) still exist, they have become less common in recent years, according to what I and other practitioners have observed.
Non-Participating Preference
In a Non-Participating Preference scenario, each Preferred Shareholder can choose:
Either to convert their Preferred Shares into Common Shares and participate proportionally with all other shareholders,
Or to receive only their preference amount (usually their original investment plus a certain premium) and exit the distribution process entirely.
This type of Preference is sometimes referred to as Downside Protection.
Below is an example of a Non-Participating Preference clause:
*"In the event of (i) a Liquidation Event, (ii) a Distribution or (iii) the consummation of a Deemed Liquidation Event, then in each such event, the assets, proceeds, or dividends available for distribution or payment to the Shareholders (the "Distributable Assets"), shall be distributed to the Shareholders of the Company in the following order and preference:
First, each holder of Preferred A Shares shall be entitled to receive, prior and in preference to the distribution of any Distributable Assets to the holders of all other equity securities of the Company, an amount per each Preferred A Share then held by such holder equal to the Original Issue Price (as adjusted for any recapitalization, share combinations, share dividends, share splits, and the like with respect to such shares) plus an amount equal to declared but unpaid dividends on each Preferred A Share, less any dividends actually paid with respect to such Preferred A Share (the "Liquidation Preference").
If the assets and funds thus distributed to the holders of Preferred A Shares shall be insufficient to permit the payment in full of the Liquidation Preference to all the Preferred A Shareholders, then the Distributable Assets shall be distributed among them on a pro-rata basis in proportion to the number of Preferred A Shares held by each on an As Converted basis;
Second, after payment of the full Liquidation Preference pursuant to the Article above, any remaining Distributable Assets, if any, shall be distributed to all holders of Ordinary Shares of the Company (excluding the holders of Preferred A Shares), on a pro-rata basis among themselves."*
In this distribution structure, Preferred A Shareholders first receive their preference amount (their initial investment minus any dividends paid).
Then, the remaining common shareholders divide the remaining proceeds without additional participation from the Preferred A Shareholders.
Thus, Preferred A Shareholders in this case only receive Downside Protection, which ensures they recover their investment (plus a premium) in the event of company liquidation or a low-exit scenario.
If Preferred A Shareholders wish to participate in the remaining distribution, they must convert their shares into common shares, in which case they will share equally with all other shareholders according to their proportional holdings. This option is beneficial in high-exit scenarios.
As we can see, Preference Rights are perhaps the most crucial and economically significant rights that impact investor terms and their returns in a company sale or liquidation.
In the next discussion, we will explore additional rights that also play a significant role in shaping investment transactions.
