Seed Capital Funding: What’s the difference between a preference share and an ordinary share?
“I want to set up a private company for my business and have an investor that is interested in providing some seed capital but asked for preference shares in return. I’m not quite sure though what the difference between a preference share and an ordinary share is. Can I lose control over the company if I give him preference shares?”
As a point of departure, it is important to understand what exactly is denoted by the concept of a “share”. Simply put, a share represents the measure of a shareholder’s (the owner of the shares) interest in a company and consists of a collection of personal rights and obligations which the shareholder may transfer and dispose of.
The Companies Act 71 of 2008 (“the Act”) provides for the authorisation and issue of various classes of shares by a company. Although shares can hold many different descriptions, shares can be basically divided into two categories, namely ordinary shares and preference shares. Various different rights and obligations are attached to these catergories of shares, ranging from voting rights, preferential status in relation to the payment of dividends and the return of capital as well as an obligation to comply with the provisions of a company’s memorandum of incorporation or “MOI”. The class of shares to be employed and preferred by shareholders will depend on the particular circumstances at hand and may be tailored to fit the situation, as well as to address the specific concerns and needs of each shareholder. There is no ‘one size fits all’ approach when it comes to a company’s shares.
The Act makes provision for a company’s founding document, the MOI, to regulate the number and different classes of shares that may be authorised and issued by a company, with extensive leeway as to the manner and form in which rights and limitations may be attached to different classes of shares in an MOI, including determining that different classes of shares have distinct voting rights.
Preference shares typically entitle the holder thereof to preference over any other class of shares in relation to the payment of dividends and the return of capital upon the winding-up of the company. The rights attached to these shares are primarily determined by a company’s MOI and usually entail that these shareholders are paid their dividends before ordinary shareholders. A company cannot, however, only have preference shares and must have another class of shares as well. Preference shares generally enjoy no voting rights although voting rights may be authorised by the MOI usually for specific circumstances such as arrear dividend payments.
Ordinary shares are therefore the residual (or primary) class of shares. The dividends paid to the shareholders who hold ordinary shares is not a secured amount and fluctuates in accordance with the profits of the company. However, the holders of ordinary shares are generally entitled to vote at general meetings of shareholders.
The selection of the different classes of shares for a particular company will accordingly depend on the nature and needs of the company, the shareholders and the purpose for which the shares are to be distributed. Ordinary shares will be preferable if the intention is to extend or control voting power, since preference shares usually carry none of these rights. Preference shares on the other hand tend to be a useful mechanism for providing a return on investment without handing over control of the company.
In your case, a well structured preference share class may accordingly address both your needs and that of your investor and we would recommend that you seek the assistance of a commercial attorney to help with the correct structuring of your company’s share classes.