What are Cumulative Preference Shares?

As a startup investor, you’re about to embark on an exciting journey with the potential to generate significant returns. One of the key aspects of startup investing is understanding the various types of shares you may encounter during a fundraise. In this blog, we’ll explore cumulative preference shares, though they are not common, at least in earlier stages of financing.

What Are Cumulative Preference Shares?

Cumulative preference shares are a type of preference share that offer investors additional perks compared to ordinary (common) shares. They are particularly attractive to investors who prioritize a stable income and downside protection. Here’s a quick breakdown of cumulative preference shares:

1. Dividends: Cumulative preference shares come with a fixed or predetermined dividend rate. Unlike ordinary shares, where dividends are discretionary, cumulative preference shares guarantee a regular income stream to their holders.
2. Accumulated dividends: One key feature of cumulative preference shares is the accumulation of unpaid dividends. If the company is unable to pay dividends in a given period, those dividends accumulate and must be paid out in full before any dividends can be distributed to ordinary shareholders. This ensures that investors receive their promised returns, even if there are temporary financial setbacks.
3. Liquidation preference: In the event of a company’s liquidation, exit, or acquisition, cumulative preference shareholders have priority over ordinary shareholders in the distribution of assets. This provides investors with an additional layer of protection for their investment.
4. Limited voting rights: Cumulative preference shareholders typically have limited or no voting rights on key corporate matters. However, they may have special powers to block certain significant decisions, like issuing new shares or altering the company’s bylaws.

Preference shares explained to a teenager

Cumulative preference shares are a special kind of shares that a company, like a startup you work at, can issue to investors. These shares come with some cool benefits for investors. First, they receive a fixed amount of money, called dividends, every year based on a percentage of their investment. If the startup can’t pay that dividend one year because it doesn’t have enough money, no worries! The unpaid dividends will pile up and be paid later when the startup has enough money. Second, if the startup is sold or goes out of business, the people who own these cumulative preference shares get their money back (plus any unpaid dividends) before the regular shareholders. So, it’s kind of like having a VIP pass in the world of shares. Remember, cumulative preference shares are mostly for investors, not for employees like you. But understanding them can give you a better idea of how the startup world works!

How do Cumulative Preference Shares actually impact founders?

Preference shares as broadly defined do not impact you if you have a big exit. Since these preference shares come with a term of paying a dividend which keeps adding up, they only matter if you agree to pay dividends at all, which is rarely the case since most startups are loss-making. This type of preference share is typically big-boy stuff and is not typical.

Why do founders and staff get common shares and not Cumulative Preference Shares?

Investors almost always have preference shares, or if they are investing in a convertible note, will convert their debt note into preference shares at the next qualified financing round. Cumulative Preference Shares are not common though. Read the blog on preference shares for a more detailed answer.

Do investors always want to have Cumulative Preference Shares?

Venture capital investors do not always want or request cumulative preference shares when investing in a startup. The specific terms of a venture capital investment, including the type of shares issued, are subject to negotiation and depend on various factors, such as the startup’s stage, valuation, market conditions, investor preferences, and the founder’s negotiating position. In some cases, investors may prefer non-cumulative preference shares or other types of shares with different rights and provisions, depending on the risk profile and potential returns associated with the investment. It is crucial for founders to understand the implications of the shares they issue and negotiate terms that align with their long-term goals and the interests of all stakeholders involved.

Should founders be worried about giving investors Cumulative Preference Shares?

These are not normal. If an investor asks for them you should explain that you intend to raise more money and that future investors want the same deal (or better) than previous investors got. So by asking for crazy terms, they have limited your ability to raise, and also put them lower on the stack where future investors will be paid out first. Smart investors know not to ask for too much.

What is the difference between cumulative and non-cumulative preference shares?

Cumulative and non-cumulative preference shares are two types of preference shares that differ primarily in how they handle unpaid dividends. Here’s a comparison of the main differences between cumulative and non-cumulative preference shares:

Dividend accumulation

Cumulative preference shares:

• If the company cannot pay dividends in a given period, the unpaid dividends accumulate.
• Accumulated dividends must be paid out in full before any dividends can be distributed to common shareholders.
• Investors are eventually compensated for any missed dividend payments once the company has sufficient profits or experiences a liquidity event.

Non-cumulative preference shares:

1. If the company cannot pay dividends in a given period, the unpaid dividends do not accumulate.
2. Investors are not compensated for missed dividend payments, and these unpaid dividends are effectively lost.
3. Non-cumulative preference shareholders still have priority over common shareholders when it comes to dividend payments, but there is no obligation for the company to make up for missed dividends in the future.

Risk and return

Cumulative preference shares:

• These shares are generally considered less risky compared to non-cumulative preference shares, as investors are eventually compensated for any missed dividend payments.
• The accumulation feature provides a safety net for investors, ensuring they receive their promised returns even if the company experiences temporary financial setbacks.

Non-cumulative preference shares:

• These shares carry a higher risk, as investors do not receive compensation for missed dividend payments.
• The returns for non-cumulative preference shareholders can be less predictable due to the lack of accumulation feature, making them less attractive to risk-averse investors.

Other features, such as dividend rate, liquidation preference, voting rights, and protective provisions, can be similar for both cumulative and non-cumulative preference shares. The specific terms and conditions of these shares can vary depending on the negotiation and the startup’s unique situation.

How are preference shares different to Cumulative Preference Shares?

I have explained this in a table here:

Preference Shares	Cumulative Preference Shares
Definition	A type of shares with preferential rights, such as fixed dividend rates and liquidation preferences.	A specific type of preference shares where unpaid dividends accumulate over time and must be paid before any dividends are distributed to common shareholders.
Dividends	Fixed dividend rates that may or may not be paid depending on the company’s financial situation.	Fixed dividend rates that must be paid, with any unpaid dividends accumulating and to be paid out before any dividends are distributed to common shareholders.
Accumulation of unpaid dividends	Unpaid dividends may be lost if the company is unable to pay them.	Unpaid dividends accumulate, and the company is obligated to pay them when it has sufficient profits.
Liquidation preference	Priority over common shareholders when the company is liquidated, acquired, or exits.	Priority over common shareholders when the company is liquidated, acquired, or exits, plus any unpaid accumulated dividends.
Voting rights	Typically have limited voting rights, with a say in only specific matters or decisions.	Typically have limited voting rights, with a say in only specific matters or decisions.

How are Cumulative Preference Shares valued differently to common shares in the USA with a 409a?

See my blog on preference shares.

Why do investors want Cumulative Preference Shares?

Venture capital investors may want cumulative preference shares when investing in a startup for several reasons:

1. Dividend accumulation: Cumulative preference shares come with the advantage of accumulated dividends. If a startup is unable to pay the agreed-upon dividends in a given year, the unpaid dividends accumulate and must be paid out before any dividends are distributed to common shareholders. This provides a safety net for investors, ensuring they receive their due returns when the company generates sufficient profits.
2. Liquidation preference: Cumulative preference shareholders typically have priority over common shareholders during a liquidation, acquisition, or exit event. This priority includes receiving the original investment amount and any unpaid accumulated dividends before any proceeds are distributed to common shareholders. This feature protects investors by giving them a higher chance of recouping their investment in case the company is sold or goes bankrupt.
3. Reduced risk: Cumulative preference shares help reduce the risk associated with a startup investment. Since startups are known for their high-risk, high-reward nature, investors may prefer cumulative preference shares to provide some downside protection and improve their overall investment returns.
4. Negotiating leverage: Requesting cumulative preference shares can be part of an investor’s negotiating strategy to secure better terms in the investment deal. By including such provisions, investors can ensure they receive favourable treatment compared to other shareholders.

What happens if investors own Cumulative Preference Shares in a startup that goes bankrupt?

See my blog on preference shares.

Why Cumulative Preference Shares Matter in Startup Fundraising

For investors participating in their first startup fundraise, cumulative preference shares offer several benefits:

1. Reduced risk: The guaranteed dividends and liquidation preference provide a level of downside protection, reducing the overall risk associated with startup investing.
2. Predictable income: The fixed dividend rate of cumulative preference shares ensures a steady income stream, making them an attractive option for investors seeking regular returns.
3. Investment leverage: By accumulating unpaid dividends, cumulative preference shares offer investors the possibility of receiving substantial payouts once the startup becomes profitable or experiences a liquidity event, like an acquisition or IPO.

Key Considerations for First-Time Startup Investors

Before investing in cumulative preference shares, there are several factors to consider:

1. Valuation: As an investor, it’s essential to understand the startup’s valuation and how the cumulative preference shares fit into the overall capital structure.
2. Dividend rate: Analyze the dividend rate and evaluate whether it aligns with your investment goals and risk tolerance.
3. Company performance: Assess the startup’s financial health and growth prospects to gauge the likelihood of it generating sufficient profits to pay out dividends.
4. Exit strategy: Consider the company’s exit strategy and the potential for liquidity events, which may impact the return on your investment.

Are cumulative shares debt or equity?`

Cumulative preference shares are a form of equity financing in startup investment, not debt. Although they have certain features that resemble debt instruments, such as fixed or predetermined dividends and priority during liquidation, they still represent ownership interests in the company. Here’s a quick comparison between debt and equity in a startup investment: Debt:

• Investors lend money to the company, and the company is legally obligated to repay the principal amount along with interest.
• Debt holders do not have ownership interests or voting rights in the company.
• Debt instruments have a maturity date when the principal must be repaid.
• Interest payments on debt are tax-deductible for the company.

Equity (including cumulative preference shares):

• Investors purchase shares in the company, obtaining ownership interests and potentially voting rights.
• Unlike debt, equity does not have a maturity date, and the company is not obligated to repay the invested amount.
• Dividends on equity (including those on cumulative preference shares) are paid out of the company’s profits and are usually not tax-deductible.
• Cumulative preference shares, as a type of equity, provide certain preferential rights like fixed dividends and liquidation preference, making them more attractive to investors compared to common shares.

In summary, cumulative preference shares are considered equity financing in a startup investment, despite having some debt-like characteristics.

What is an example of Cumulative Preference Shares in startup investments?

It’s important to note that the terms and conditions of cumulative preference shares can vary depending on the negotiation and the startup’s unique situation. Here’s a hypothetical example to illustrate how cumulative preference shares might work in a startup investment: Suppose a startup, called “TechVenture,” is raising funds through a Series A round. An investor, “Investor A,” decides to invest $1 million in the company. TechVenture issues cumulative preference shares with the following terms:

1. Dividend rate: 8% per annum, payable annually.
2. Liquidation preference: 1x (equal to the original investment).
3. Voting rights: Limited voting rights, with special powers to block certain significant decisions.

In this example, Investor A would receive $80,000 per year in dividends (8% of the $1 million investment). If TechVenture is unable to pay the dividends in any given year, the unpaid dividends would accumulate and must be paid out before any dividends are distributed to common shareholders. If TechVenture were to be acquired or liquidated, Investor A would receive their original $1 million investment (plus any accumulated unpaid dividends) before any proceeds are distributed to common shareholders. This liquidation preference provides Investor A with downside protection on their investment. Although this example provides a general overview of how cumulative preference shares might work in a startup investment, it’s essential to remember that the specific terms and conditions can vary based on the negotiation and the particular circumstances of the startup.

How common are Cumulative Preference Shares in startup investments?

Cumulative preference shares are not as common in startup investments as non-cumulative preference shares, especially in venture capital deals. Most venture capital investors prefer non-cumulative preference shares because they are generally more focused on capital appreciation and the long-term success of the company rather than regular dividend payments. Cumulative preference shares, with their accumulating unpaid dividends, can impose an additional financial burden on early-stage startups, which often need to prioritize growth and cash flow management. That being said, cumulative preference shares may still be used in certain situations, such as when investors want additional downside protection, or when the startup has a track record of paying dividends. They may also be requested by risk-averse investors, family offices, or strategic investors who prioritize regular income streams. While cumulative preference shares are less common in startup investments, it’s crucial to remember that the specific terms and conditions of each deal can vary. Ultimately, the prevalence of cumulative preference shares in startup investments will depend on the negotiation between the startup and its investors, as well as the unique circumstances of the business.

Conclusion

Cumulative preference shares offer several advantages for first-time startup investors, including reduced risk and predictable income. By understanding the key features of these shares and carefully evaluating the investment opportunity, you can make more informed decisions during your first startup fundraise.