Preference shares - reasons for issuing, risks and alternatives

Preference shares are a class of shares within a company that give holders certain advantages or different right over ordinary shareholders.

Uses and Examples

• Raising capital - companies can issue preference shares to attract a specific type of investor who prioritises fixed income over capital growth.

• Controlling corporate structure - by issuing different classes of shares with varying voting rights, companies can influence control and protect specific interests.

• Employee incentives - offering employees preference shares can act as a retention tool and reward their loyalty.

• Acquisitions and financing - preference shares can be used in complex finance structures or as part of acquisition deals.

Risks for Existing Shareholders

• Dilution of voting power - issuing preference shares can dilute the voting power of existing ordinary shareholders.

• Dividend payments - preference dividends must be paid before ordinary dividends, impacting the amount available for distribution to ordinary shareholders.

• Change in control - issuing preference shares with voting rights can alter the company's control structure, impacting existing shareholders' influence.

Process of Issuing and company law issues

• Drafting Class Rights - the specific rights and limitations attached to each share class must be defined such as voting rights (full, limited, none), dividend rights (priority, fixed dividend, participation in residual profits), liquidation preferences (priority in repayment of capital), conversion rights (option to convert to another class of shares) and redemption rights (company's right to buy back the shares)

• Board approval - the board of directors must approve the creation and issuance of preference shares.

• Shareholder and/or articles of association approval - depending on the company's articles of association, shareholder approval may be required. If the articles require approval, a general meeting must be convened, and a special resolution passed by a majority of shareholders present and voting in person or by proxy.

• Filing with Companies House - the company must file the necessary documents with Companies House to formalise the share issuance.

• Redemption and conversion - Some preference shares may have redemption or conversion rights, adding further layers of legal complexity.

Alternatives to preference shares for UK private companies

While preference shares offer certain advantages, they also come with limitations and considerations. Depending on your specific needs and goals, several alternative options exist for raising capital or structuring ownership in a UK company:

Equity Financing:

• Ordinary Shares - the most common type, offering ownership rights and potential for capital growth but no priority payments or guaranteed income.

• Convertible Loan Notes - a loan that converts into shares at a future date, providing initial debt financing with an equity conversion option.

• Employee Stock Option Plans (ESOPs) - grants employees the right to purchase shares at a predetermined price, incentivizing them and aligning their interests with the company's success.

Debt Financing:

• Bank Loans and Overdrafts - traditional borrowing options offering flexibility and potential lower cost of capital, but requiring interest payments and collateralization.

• Bonds - debt instruments issued to investors with defined interest payments and maturity dates, offering a fixed income stream for investors.

• Peer-to-Peer Lending - online platforms connecting businesses with individual lenders, offering alternative access to capital without traditional bank requirements.

Other Options:

• Mezzanine Finance - debt with some equity features, providing more flexibility for borrowers than traditional bank loans with potential higher returns for lenders.

• Convertible Preference Shares - preference shares with the ability to convert into ordinary shares at a predetermined price, combining fixed income with potential for capital growth.

• Joint Ventures or Strategic Partnerships - partnering with another company can provide access to resources, capital, and market reach.

Choosing the Right Option

The best alternative to preference shares depends on your specific needs, financial situation, risk tolerance, and future plans. Consider factors such as:

• Funding requirements - how much capital do you need to raise?

• Desired ownership structure - do you want to dilute ownership or maintain control?

• Investor preferences - what type of return are investors looking for?

• Risk tolerance - can you handle the potential downside of debt financing?

• Future plans - do you anticipate future exits or changes in ownership structure?

• Preference shares can create a two-tiered shareholder structure, potentially leading to dissatisfaction among different shareholder groups.

• Preference shares may not be as attractive to some investors who prioritise capital growth over fixed income.