What is the deal with preference shares? Part 1: liquidation and dividend preference

What is the deal with preference shares? Part 1: liquidation and dividend preference

(This post is the first in a series, giving practical information to start-up founders to gain a better understanding of the mechanics of preference shares. This post will focus on liquidation and dividend preferences.)

Venture capital investors are almost always aiming to invest in start-ups through “preferred” equity, typically referred to as preference shares. Preference shares trump ordinary shares, as the holders of preference shares normally receive preferential treatment in the event of a liquidation of the business. (For these purposes, a liquidation event can be the insolvency, a dissolution or a sale of the company.)

When start-ups enter funding stages, the good and/or lucky ones may end up with a few term sheets from an array of interested investors. These term sheets often come with an abundance of terms regarding the structure of the preference shares. As an inexperienced founder, this can be an overwhelming experience and it can be a daunting task to understand which terms are “standard” and which are particularly important. Venture capital investors have the upper hand due to their experience in this area – this is where professional advisors, such as start-up lawyers, come in handy in assisting the start-up and its founders.

The purpose of this series of articles is not to cover all aspects of term sheets, but to give you, a start-up founder, a better understanding of what preference shares really are, what to look out for and how they are typically structured during a series seed or series A investment.

What are preference shares?

When early-stage start-ups issue shares, there are generally two classes of people receiving shares: founders and investors. Founders typically receive ordinary shares and investors generally receive preference shares in return for their investment and risk taken.

The main characteristic of preference shares is that they provide for the preferential treatment of their holders and rank above ordinary shares in the event of a liquidation event. This means that if a company is unable to pay its debts or its business is sold, the investor will have a first claim on the company’s assets or sale proceeds over ordinary shareholders i.e. the founders. This is a protection mechanism given to the investor in return for the risk incurred when investing in the company.

Preference shares may further entitle the holder to preferential dividends, based on the profits of the company. Preference dividends are normally fixed at a certain annual percentage. As a preference shareholder, the investor will receive dividends ahead of ordinary shareholders when dividends are declared by the board of the company.

Liquidation preference

The liquidation preference determines how the pie is shared on a liquidation event. Preference shares almost always come with a liquidation preference, but the amount of the liquidation preference can differ. For example, the investor’s preference shares may come with a multiple of 1x purchase price. This means that upon a liquidation event, the investor will be paid 1x the issue price of his shares before the ordinary shareholders get anything. (For example, if the investor invested R1 million into the company, the investor wants R1 million paid back to him before the founders receive anything.) Similarly, if the investor’s liquidation preference is 2x purchase price, the investor will receive a multiple of 2x the issue price of his shares before the ordinary shareholders get anything.

As a start-up founder, you need to know what you are promising the investor. You might realise a few months down the line, when it’s too late, that you have given the investor a preference of 10x return on liquidation, leaving you and your co-founders with nothing. How a liquidation preference is structured can make a significant difference when the proceeds from a sale are split between the shareholders. Start-up founders should pay particular attention to this term.

Participating and non-participating

Generally, as seen above, the preference shareholders receive preferential returns. This means that they are paid back their initial investment plus some preferential payment (the liquidation preference multiple) before any other proceeds are disbursed. The extent to which additional funds, beyond this preference, are disbursed to investors depends on whether the equity is participating or non-participating preference shares. Participating preference shares take a share of the additional proceeds, along with ordinary shareholders, after receiving their preferential returns. For example, the preference shareholder participates in the equity apportionment in addition to receiving his liquidation preference. Holders of non-participating preference shares, however, only receive the preference plus any accrued dividends.

For example, an investor invests R2 million into a company at a 2x liquidation preference and at a post money valuation of R10 million (giving the investor a 20% stake in the company). The company is sold for a net sale price of R20 million. Therefore, the investor receives his 2x R2 million liquidation preference (receiving R4 million) and a R16 million surplus remains. If the preference shares are participating preference shares, the investor will receive an additional 20% of the surplus amount (a further R3.2 million). Alternatively, if the shares are non-participating preference shares, the other shareholders, i.e. the founders, will distribute the surplus among themselves according to their shareholding percentages.

An important point to note is that “participation” in venture capital deals generally refers to capital, however, it may also refer to a participation in pro rata dividends beyond the fixed preference dividend. As a founder, you must have clarity on this from the start.

Dividend preference: cumulative and non-cumulative

Preference shares often provide for a preferential dividend as well – investors with preference shares are entitled to receive dividends before ordinary shareholders.

Dividends increase the total return for the investors and decrease the total return for ordinary shareholders. Dividends are often stated as a percentage of the share issue price for the preference shares (for example, 8% of the total share issue price). There are at least three general ways dividends are structured in venture capital deals: (i) cumulative dividends; (ii) non-cumulative dividends; and (iii) dividends on preference shares only when paid on the ordinary shares.

Dividend structures (i) and (ii): If a company does not declare a dividend in respect of a particular year, then preference shareholders with a right to non-cumulative dividends would lose the right to receive a dividend for that year. However, preference shareholders with a right to cumulative dividends would be able to carry over their right to receive a dividend for that year, entitling them to receive that dividend in the future, together with the dividend declared in that next year (before any dividends are payable to ordinary shareholders). Clearly, cumulative dividends are the most beneficial to the investor and the most burdensome on the founders (being ordinary shareholders).

Dividend structure (iii): Where dividends are paid on the preference shares only if paid on the ordinary shares, the preference shares are treated as if they had been converted into ordinary shares at the time the dividend is declared. This is the least beneficial to the investor and the most beneficial to the founders.

If not clearly understood, agreeing to a cumulative dividend can lead to significant and unexpected monetary burdens on the available and distributable profits for you and your co-founders. As a start-up founder, you must understand the different ways in which dividends can be structured. You need to consider the company’s projected cashflow from now until the expected exit and the impact the dividend preference has on shareholders.

Concluding remarks

We trust that the issues highlighted above will give you some insight and guidance as to why it is so important to have a good understanding of the preference share terms you are likely to find in a term sheet. If you would like to discuss any of these topics in more detail, please feel free to contact our Start-up Law team and we’ll gladly assist.

Software-as-a-Service (SaaS) – understanding some of the aspects of this technology model

Software-as-a-Service (SaaS) – understanding some of the aspects of this technology model

As commercial law attorneys, much of our work is helping tech start-ups negotiate and draft software agreements. There is no doubt that the emergence of Software-as-a-Service (SaaS) – often referred to as “cloud computing” – has been one of the most profound technological developments in the commercial software industry.  It is shaking up traditional software vendors and it is expected to continue disrupting traditional businesses. Think “Slack”, “Trello”, “Salesforce”, “Stripe” and “Dropbox” – these are all SaaS enterprise applications delivered over the internet.

This article will provide a basic overview of SaaS and some of the legal aspects tech start-up founders need to understand when negotiating and preparing their SaaS agreements.

What is “SaaS” and SaaS Agreements?

Software-as-Service is a software distribution model with which a business hosts software applications and makes them available to customers over the internet.  The agreement or contract that governs the access and use of the software service and describes the rights and obligations of the parties is referred to as a SaaS agreement. The SaaS agreement differs from your typical software license agreement because SaaS is not a license to use the software, but rather is a subscription to software services and allows remote software access.

Benefits of SaaS

Low set-up cost: SaaS removes the need for organizations to install and run expensive software applications on their computers and data servers. It eliminates the expenses associated with hardware acquisition and maintenance, as well as software licensing, installation and support costs.

Payment flexibility: rather than purchasing software to install, or additional hardware to support it, customers subscribe to a SaaS offering. Typically, customers pay for this service on a monthly subscription or utility basis i.e. the number of users who has access or the number of online transactions.

Highly scalable: cloud services like SaaS offer high scalability. Upgrades, additional storage or services can be accessed on demand without needing to install new software and hardware.

Automatic updates:  customers can rely on a SaaS provider to automatically perform updates and software improvements and modifications, which are generally free of charge.

Accessibility:  customers aren’t restricted to one location and can access the service from any internet-enabled device and location.

Software Licencing Model vs SaaS Model

Software license agreements are used when a proprietary software is being licensed by the licensor to a licensee.  The licensee purchases the software and receives a right to install, download and use the software. The licensor owns all the intellectual property rights in the software and related documentation.  A license is a limited grant of use those rights.

With SaaS agreements, the customer does not download or install copies of the software, but remotely accesses and uses the software by logging into the software provider’s system.  The software provider hosts the software either on its server or in the cloud and provides a service to the customer which consists of hosting its software, performing services to support the hosted software and granting access to the hosted software.

Important legal aspects to consider in your SaaS Agreement

SaaS agreements can touch upon nearly every area of the law, but broadly, a SaaS agreement should include clauses regarding: the services provided; the parties who will have access to the service; user obligations and prohibited use; payment terms; data collection and personal information; termination; service levels; maintenance and support services; disclaimers and liability; and intellectual property rights.

We discuss a few of these below:

Limitation of liability

The most important provision of any SaaS agreement is the liability clause as liability presents itself in many forms. What if the SaaS service is hacked or the subject of a cyber-attack and the customer’s sensitive confidential data (including banking details) is stolen? Are you going to indemnify and hold the customer harmless for all the damages suffered as a result of the data breach? Limitation of liability explains the extent of damages your customer can seek against you and how much they can sue you for. A well-drafted limitation of liability cannot be overstated!

Service levels

An important consideration is whether the SaaS service is going to be up and running and functioning for a guaranteed minimum amount of time. Service level agreement or commitments are very common in any SaaS agreement. Generally, the SaaS provider guarantees that the service will be up and running for 365 days a year 99% of the time, for example. Your company will need to consider what type of service guarantees and commitments it will be making in terms of its service “uptime” and “downtime”.

Maintenance and support

What types of maintenance and support services will your company be providing? Will you be guaranteeing bug fixes in a timely manner, providing customer support via email and telephone or periodic software upgrades and maintenance? These are issues that need to be considered and which will affect your agreements with your customers. To this end, the contact details, extent of support and troubleshooting methods offered by the provider should be recorded in your agreement.

Upselling and upgrading

You should consider including language in your agreement that allows for future orders or “up-sales” from the customer. By specifying that “up-sales” or upgraded orders from the customer will be governed by the agreement, you avoid having the customer sign or click through another agreement if they purchase additional services, upgrades or expand their usage.

Conclusion

A SaaS agreement is designed to be a comprehensive document and as such, companies should pay careful attention to the multiple aspects of the agreement that set out their liability, responsibilities and obligations. Failing to include or properly define a crucial clause can have serious legal implications on a business’ risk, reputation and commercial relationships.

If you require any assistance in preparing any SaaS, software development or any other software related agreements don’t hesitate to contact us.