What are Preference Shares?
Preference shares are a class of shares that have preferential rights over equity (ordinary) shares. These preferences typically relate to dividend payments and return of capital in case of winding up. Under the Companies Act, 2013, preference shares are defined under Section 43.
For startups, preference shares are the standard instrument used by venture capital and private equity investors. They provide investors with downside protection through preferential rights while still allowing participation in the upside through conversion to equity.
Key Characteristics of Preference Shares
- • Preferential Dividend: Right to receive dividend before equity shareholders
- • Fixed Dividend: Usually specified as percentage of face value
- • Priority in Winding Up: Repayment of capital before equity shareholders
- • Limited Voting: Generally no voting rights except on matters affecting their class
- • Convertible or Non-Convertible: May convert to equity shares
- • Redeemable or Irredeemable: May be bought back by company
Types of Preference Shares
Preference shares can be classified based on various features. Understanding these types helps in structuring investment deals appropriately.
Based on Dividend
- Cumulative: Unpaid dividends accumulate and must be paid before any equity dividend
- Non-Cumulative: Dividend lapses if not declared in a year
Based on Conversion
- Convertible: Can be converted to equity shares
- Non-Convertible: Remain as preference shares permanently
Based on Redemption
- Redeemable: Company can buy back after specified period
- Irredeemable: Permanently outstanding (rare in India)
Based on Participation
- Participating: Get preference amount PLUS share in remaining profits
- Non-Participating: Get only preference amount (or convert to participate)
Startup Standard: Cumulative Convertible Preference Shares (CCPS)
For startup funding in India, the standard is CCPS - Cumulative Convertible Preference Shares. This combines:
- • Cumulative: Dividends accumulate if not paid
- • Convertible: Converts to equity shares (usually 1:1 ratio)
- • Non-Participating: Typically non-participating in India (investor chooses between preference or conversion)
CCPS Explained
Compulsorily Convertible Preference Shares (CCPS) are the regulatory-compliant instrument for foreign investment in Indian startups. They must convert to equity shares within a specified timeframe.
Key Features of CCPS
- Conversion Obligation: Must convert to equity, cannot remain as preference indefinitely
- 10-Year Limit: FEMA requires conversion within 10 years for foreign investment
- Conversion Ratio: Typically 1:1 (one equity share per CCPS)
- Dividend Rights: May have preferential dividend right (often not exercised)
- Liquidation Preference: Priority over equity in winding up before conversion
- Voting Rights: Vote only on matters affecting CCPS class rights
Why CCPS for Startup Investment?
Investor Benefits
- • Liquidation preference protection
- • Fixed return option in downside
- • Equity upside participation
- • Downside protection until conversion
Founder Benefits
- • No immediate dividend obligation
- • Voting control retained longer
- • Flexible capital structure
- • Standard market practice
Rights of Preference Shareholders
Preference shareholders enjoy specific rights that protect their investment and provide preferential treatment.
Economic Rights
- Dividend Preference: Right to receive dividend before any dividend to equity shareholders
- Fixed Dividend Rate: Dividend typically specified as percentage of face value
- Cumulative Rights: Unpaid dividends accumulate for future payment (for cumulative shares)
- Capital Protection: Priority in return of capital during winding up
- Liquidation Preference: Specified amount (usually investment amount) paid first
Conversion Rights
- Conversion Ratio: Number of equity shares per preference share
- Conversion Price: Effectively the price paid for equity upon conversion
- Conversion Events: IPO, next financing round, or time-based trigger
- Optional vs Mandatory: Some CCPS allow optional conversion; FEMA CCPS is mandatory
Protective Provisions
Preference shareholders typically have veto rights (through SHA) over:
- • Amendment of rights attached to their class of shares
- • Winding up of the company
- • Repayment of capital
- • Reduction of capital
- • Creation of new class of shares with superior rights
Dividend Preferences
Dividend preference is one of the key features that distinguishes preference shares from equity shares.
Cumulative vs Non-Cumulative Dividend
Cumulative Dividend
- • Unpaid dividends accumulate as arrears
- • Must be paid before any equity dividend
- • Arrears carry forward indefinitely
- • Investor-favorable term
- • Standard for startup investments
Non-Cumulative Dividend
- • Dividend lapses if not declared
- • No accumulation of unpaid dividends
- • Each year's dividend stands alone
- • More founder-favorable
- • Rare in startup investments
Dividend Calculation Example
CCPS Terms:
- • Face Value: ₹10 per share
- • Dividend Rate: 8% per annum
- • Type: Cumulative
- • Shares held: 1,00,000
Annual dividend entitlement: 1,00,000 × ₹10 × 8% = ₹80,000
If no dividend paid for 3 years, arrears = ₹2,40,000
Before any equity dividend, company must pay ₹2,40,000 to CCPS holders
Startup Reality Check
In practice, high-growth startups rarely pay dividends. The cumulative feature protects investors if the company becomes profitable but decides not to distribute profits. Most investors are focused on capital appreciation through equity conversion, not dividend income.
Liquidation Preference
Liquidation preference determines the order and amount of distributions to shareholders when the company is wound up, sold, or merged.
How Liquidation Preference Works
In a liquidation event:
- 1. Creditors are paid first
- 2. Preference shareholders receive their liquidation preference
- 3. Remaining amount distributed to equity shareholders
Types of Liquidation Preference
Non-Participating (Standard)
Preference holder receives liquidation preference OR converts to equity and participates pro-rata, whichever is higher. Standard in India.
Participating (Aggressive)
Preference holder receives liquidation preference AND participates pro-rata in remaining distributions. Less common in India.
Voting Rights of Preference Shareholders
Under the Companies Act, 2013, preference shareholders generally do not have voting rights except in specific circumstances.
When Preference Shareholders Can Vote
Section 47(2) of the Companies Act provides voting rights when:
- • Resolutions directly affecting rights attached to their shares
- • Any resolution for winding up of the company
- • Any resolution for repayment or reduction of share capital
- • Dividend on preference shares has not been paid for 2+ years (for cumulative)
Voting Rights Through Shareholders Agreement
While statutory voting rights are limited, investors typically negotiate additional rights through the Shareholders Agreement:
- • Board representation (board seat or observer)
- • Protective provisions (veto rights on specific matters)
- • Information rights
- • Pre-emptive rights
Conversion Terms
Conversion terms determine when and how preference shares convert to equity shares.
Conversion Triggers
- Qualified Financing: Next institutional funding round
- Time-Based: Specific date or period (e.g., 5 years from issuance)
- IPO: Company going public
- Change of Control: Sale or merger of company
- Investor Option: Investor elects to convert
FEMA Conversion Requirements
For foreign investment in CCPS:
- • Must convert within 10 years of issuance
- • Conversion at fair value determined by CA/Merchant Banker
- • FC-GPR filing after conversion
- • No conversion at a value less than fair value
Issuance Process in India
Issuing CCPS involves several steps under the Companies Act and FEMA (if foreign investment).
Step 1: Board Resolution
Board approves issuance of CCPS, determines terms (face value, premium, conversion ratio), and authorizes directors to execute.
Step 2: Shareholder Approval
Ordinary resolution (special resolution if altering articles). Pass resolution for allotment and amendment to authorized capital if needed.
Step 3: Share Purchase Agreement
Execute SPA and Shareholders Agreement defining rights, preferences, and obligations.
Step 4: Subscription and Allotment
Investor subscribes, company allots shares, issues share certificates.
Step 5: Regulatory Filings
File PAS-3 with ROC within 30 days. If foreign investment, comply with FEMA reporting (FC-GPR).