Bagging a backer will mean doling out preference shares
Hunting for investors is never easy. And even when a start-up or developing company bags a backer, an understanding of different share classes and where founders and newcomers slot in to the hierarchy is not just useful, but essential.
The basic unit of ownership of a company is an ordinary share. Shares that have rights over and above ordinary shares, are called 'preference' or 'preferred' shares.
People who invest in companies for a profit will, far more often than not, invest for preference shares. That's frequently the manner in which Enterprise Ireland invests, for instance.
The most basic preference right is the entitlement to be paid before other shareholders when a company is sold.
Let's say our backer paid €100,000 for preference shares with a "1X preference", the most common preference right.
When the company is sold, the investor has the choice to receive her original €100,000 investment back, or to take her percentage, in this case 10pc of the proceeds.
If the company is sold for more than €1m, 10pc of that amount will be greater than €100,000 and the investor should take her percentage of the proceeds.
But if the company hasn't lived up to expectations and is sold for less than €1m, let's say €400,000, it makes sense for the investor to take their €100,000. In this case, instead of receiving 90pc of the money, the entrepreneur gets €300,000, or just 75pc.
The simple preference results in an investor receiving their money back first, with the rest of the money being divided among the other shareholders.
If the preference shares are 'participating', it means that after the investor recoups their money they also receive a portion of the remaining cash.
If our second startup is sold for €1bn, first the investor takes €100m from the proceeds, leaving €900m to be divided.
If the investor holds a participating preference share, they also receive their percentage (10pc) of what's left, or an additional €90m.
The end result is that the investor receives €190m, or 19pc of the value, not the 10pc we originally understood from the headline.
Entrepreneurs should resist the participating preference share at early stages.
Company valuation increases with progress, customers and revenue, so a focus on the basics and "doing more with less" is one of the most reliable ways to build mutual confidence in the value of the company.
Having layers of preference rights means company founders will receive less and less money if a company is sold for other than a much higher price relative to the valuation at the last round of investment.
A complex investment at a high valuation is not necessarily better than a simple investment at a lower valuation.
Síofra Flood is general counsel and executive adviser at nearForm, and author of the 'Frontline Startup Manual'.
She is running an interactive workshop on investment deals for entrepreneurs at Airfield Estate, Dundrum, Dublin, on Wednesday, March 7 as part of Local Enterprise Week. More information at www.enterpriseweekdlr.ie