In Simple Term Sheets: How Do Preference Shares Work?

When talking about Funding Rounds, pre-money valuation is certainly the figure that makes the headlines. Founders often spend hours of meetings with investors trying to negotiate a favourable valuation, which without a doubt is important to ensure that the company’s achievements are reflected in financial terms, but that figure alone does not tell the whole story.

Preference shares are one of the key tools with which investors protect themselves from downside risk. As such, they have significant impact into how the proceeds of a sale or liquidation are distributed among shareholders, including the Founders. This is why it’s important to understand how they work and what the market standards are when it comes to liquidation preference, liquidation multiples and participation clauses.

HSBC Innovation Banking has put together a VC Term Sheet guide, harnessing data from over 400 anonymised term sheets supplied by some of the most prominent corporate law firms in the UK to try and understand how investment terms have shifted in the past three years, especially in light of a less founder-friendly fundraising environment and a generalised funding shortage.

How Do Preference Shares Work?

Preference shares are a class of stock that investors tend to opt for starting at the Seed stage—where 65% of the term sheets audited involved preference shares—and do so increasingly often at subsequent investment stage—up to 97% of Series B and Series C term sheets.

“Preference” means that in a liquidation or sale event, the investor has a right to receive proceeds amounting to a set multiple of their original investment. This is called liquidation multiple and is set by default at 1x.

Liquidation multiples higher than 1x are not as common, but they do exist in situation of higher perceived downside risk such as a down-round or a fundraising at an exceptionally high valuation.

Example:

ACME Ventures invests £1m into Abstract Business Company (ABC) at a £9m pre-money valuation. ACME now owns 10% of non-participating shares of ABC. The Founders own the remaining 90% as ordinary shares.
ABC later winds down their operations and sell their assets and operational units for a total of £7m.

Scenario A: 1x liquidation multiple
ACME excercises their preference shares and collects the original £1m.
The Founders split the remaining £6m.

Scenario B: 2x liquidation multiple
ACME excercises their preference shares and collects the original £1m times 2, for a total of £2m.
The Founders split the remaining £5m.

In most cases (<90% of the Term Sheets analysed by HSBC) , preference shares are non-participating. This means that if the investor takes advantage of their liquidation preference, they will not take part in the share of remaining proceedings once their liquidation multiple has been paid.

Sometimes—again, mostly to offset a higher downside risk—participating preference shares are required by the investor so that on top of their original investment (times the agreed liquidation multiple) they also receive a share of the remaining proceeds equal to their holding in the company.

This is sometimes capped at a multiple of their initial investment, known as a participation cap.

Example:

ACME Ventures invests £1m into Abstract Business Company (ABC) at a £9m pre-money valuation. ACME now owns 10% of participating shares of ABC. The Founders own the remaining 90% as ordinary shares.
ABC later winds down their operations and sell their assets and operational units for a total of £7m.

Scenario C: 2x liquidation multiple, no participation cap
ACME excercises their preference shares and collects the original £1m times 2, for a total of £2m.
ACME also collects 10% of the remaining £6m, totalling £2.6m.
Founders split the remaining £4.4m.

Scenario D: 2x liquidation multiple, capped at 2.5x
ACME excercises their preference shares and collects the original £1m times 2, for a total of £2m.
ACME also collects 10% of the remaining £6m, which would bring them to £2.6m.
However that is capped at 2.5x their initial investment so they eventually collect £2.5m
The Founders split the remaining £4.5m.

It’s easy to understand from these scenarios that a 1x liquidation multiple with non-participating preference shares is the most founder-friendly option among those available, but when the investors do require participating shares a participation cap may help ensure that there is something left for the Founders after the proceeds of a sale are distributed.

How Are Preference Shares Being Used In 2024 Term Sheets

The prevalence of preference shares in term sheets has remained largely unchanged over the past three years, according to HSBC IVB, with the main negotiating point remaining valuations rather than share class. Preference shares were present in 84% of Term Sheets in 2021, 76% in 2022 and 83% in 2023.

However, within term sheets that involved preference shares, there has been an increase in the percentage of participating shares: 7% in 2021, up to 14% in 2022 and down to 11% in 2023. It’s easy to see how the figures go hand in hand with the general availability of funding, with investors being more keen on putting additional risk protection in place when funding is scarce.

According to the report, however, non-participating preference shares with 1x liquidation multiples have remained the market standard for most funding rounds.

How To Negotiate The Ideal Share Structure

The main thing to keep in mind when negotiating a Term Sheet is that these clauses are not just there to mitigate investor risk, but more importantly to make sure that investors and Founders are aligned with their goals. A funding round is a partnership, and all parties should be aiming towards the same objective.

With that logic, it’s easy to see how high liquidation multiples and participating shares can cause a misalignment of goals, as investors have an assurance that they’re going to make more than their investment back even if the company goes into liquidation. Founders should keep this in mind when considering whether to introduce these clauses in favour of a higher valuation.

Antoine Moyroud, Partner at Lightspeed Venture Partners told HSBC IVB: “Participating structures of more than 1x liquidation multiples should only be considered as a last resort option when the company hasn’t been able to show strong enough results to catalyze enough “traditional” investor interest. At early stage, it should be a big no-no as it reflects a misalignment of incentives with investors who are heavily optimizing for downside protection. That being said, any funding enabling founders to successfully take their company towards their next milestones and granting them “another shot at goal” should be considered. Founders should clearly understand the implications of these non-market terms as they will heavily affect the founder’s outcomes in the event of an acquisition or exit.”