Corporate life used to be simple in that a company would have one class of shares: Common Shares. Every shareholder had the same entitlements regarding voting, and participating in dividends and exits.
However, as the investment landscape changed with the increased participation of various types of investors, so have corporate structures evolved.
There have always been two main types of shares: Common and Preferred. Companies nearly always issue Common Shares to founders and investors but may also issue Preferred shares – especially to investors – to provide them with preferences, i.e. special rights, over the Common Shares.
All shares have three main attributes:
a) Voting or Non-Voting: can the holders of the shares attend and vote at meetings of shareholders, e.g. to elect the Board of Directors?
b) Dividends – are the holders entitled (or not) to dividends that the Board may, from time to time, declare?
c) Dissolution – when the company is would up, e.g. sold, can, and if so, how do the holders participate in the proceeds received on an exit event in comparison to other share classes?
Companies can create as any classes of common and as many classes of preferred shares as they wish. This results in a defined pecking order mainly in the event of dissolution as well as conveying certain on-going rights. For example, when a company has an exit, each share class has specific rights with respect to dividing up the proceeds from a sale.This could mean that those with Class B Preferred shares get paid out before Class A Preferred Shares get paid out and the Class A Preferred Shares get paid out before the Common Shares get paid out. Moreover, the Class B Preferred shares may have a special participation right, for example, a 2X liquidation preference which means that those shareholders get back two times their investment before the other classes get paid out and then they also participate pro-rata with other shareholders in dividing up the remaining funds. It’s not inconceivable that the Class C Preferred shareholders have a 3X liquidation preference that has priority over all other classes.
If the exit is substantial, every shareholder may get paid out even though the preferred shareholders may receive much more on a per-share basis than other shareholders. You may hear the term, “exit waterfall“. This involves a calculation that determines how much the shares in each class are worth when an exit occurs. Obviously, if the exit is small, some shareholders – often those with common shares, will get nothing. If the exit is huge, everyone will get something.
As companies grow, they may require multiple investment rounds. Each round may result in a new class or a new series within a class. Upon founding, it is typical for a company to issue voting Common Shares to the founders. When a seed investment round takes place, the investors may be OK with receiving Common Shares. This puts all shareholders – founders and investors – on an equal footing. This works well when the company is young and the valuation is reasonable in the investors’ eyes. However, investors may demand preferred shares especially when the round is large and the valuation is high. In its simplest form, they may ask for Preferred shares with a simple conversion or participation feature. For example, in the event of an exit, they could either a) get only their money back (perhaps with some premium or unpaid dividends) and no more or b) convert their shares to Common shares and divide the liquidation proceeds ratably among all shareholders. If the exit value is very low, this ensures that the investors get their capital back before the founders – ostensibly with penny stock – get anything. Since the prospect of just getting their money back is not appealing to many investors, they may ask for a participating liquidation preference (see above) in which case they first get their money back and then they also participate (i.e. share) the remaining funds ratably with other shareholders.
Each time an investment round is contemplated, it is not necessary that a new share class be defined. There could be several Series of shares issued within a share class.
What’s Par Value all about?
When shares are issued they may have a Par Value or No Par Value. This can add a little more complexity. If shares have a par value the accounting treatment is different. Instead of recording the amount received under common shares on the balance sheet, only the par value is recorded under common shares and the excess is recorded as Contributed Surplus. Also, if shares are issued at a high par value and the price drops below the par value, the company may be liable to shareholders for the difference but if the par value is very low, like a penny, it really doesn’t matter. Having a par value may be useful in that it sets a minimum price for redemption purposes. Suffice it to say that issuing NPV (No Par Value) shares is the common practice. Shares can be issued at whatever price is negotiated.
Preferred shares may have Redemption Rights. The company may, upon giving notice to the shareholders in a specific class of shares, redeem some or all of the preferred shares on payment of a redemption price for each such share to be redeemed. All shareholders in the class have to be treated equally in that a company can’t make selective redemptions.
A holder of a class of preferred shares may require the Company to redeem the shares held by such holder in accordance with a prescribed procedure.
All of the classes of shares that a company issues must be defined in the company’s Articles. The articles are like bylaws that clearly spell out the rights of each class of shares. If the investors on a given investment round are issued a new class of shares, it behooves them to confirm that the Articles have been amended to include the definition of that new class. There was a case where investors were given a liquidation preference that was not spelled out in the Articles. On exit, the company did not honour that preference (although it was in the Shareholders’ Agreement) resulting in a legal battle that could have been avoided.