As a first-time startup investor, it’s essential to grasp the various types of shares that companies can issue during a fundraise. One such share type is non-cumulative preference shares. In this blog, we will discuss the basics of non-cumulative preference shares, their advantages and disadvantages, and how they differ from other types of shares, particularly cumulative preference shares.
What are Non-Cumulative Preference Shares?
Non-cumulative preference shares are a type of preference shares that provide investors with certain preferential rights, such as fixed dividend rates and liquidation preference. However, unlike cumulative preference shares, if the company is unable to pay the dividend in a given period, the unpaid dividends do not accumulate and are effectively lost. 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.
Non-Cumulative Preference Shares explained to a teenager
Non-cumulative preference shares are another type of shares that companies, including the startup you work at, can offer to investors. They come with some nice perks for the investors, but they’re a bit different from cumulative preference shares.
First, investors who own non-cumulative preference shares get a fixed amount of money, called dividends, every year based on a percentage of their investment. But here’s the catch: if the startup can’t pay the dividend one year because it doesn’t have enough money, the unpaid dividends don’t pile up like with cumulative preference shares. Instead, the investors just miss out on the dividends for that year.
Second, just like cumulative preference shares, if the startup is sold or goes out of business, the people who own non-cumulative preference shares get their money back before the regular shareholders. It’s like having a VIP pass, too!
As an employee, you may not directly deal with non-cumulative preference shares, but understanding them can help you learn more about how startups and investments work!
How do Non-Cumulative Preference Shares actually impact you?
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, 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 Non-Cumulative Preference Shares?
See my blog on preference shares.
Do investors always want to have Cumulative Preference Shares?
Venture capital investors do not always want or request non-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 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:
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:
- If the company cannot pay dividends in a given period, the unpaid dividends do not accumulate.
- Investors are not compensated for missed dividend payments, and these unpaid dividends are effectively lost.
- 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 Non-Cumulative Preference Shares?
I have explained this in a table here:
|Preference Shares||Non-Cumulative Preference Shares|
|Definition||A type of shares with preferential rights, such as fixed dividend rates and liquidation preferences. Can be cumulative or non-cumulative.||A specific type of preference shares where unpaid dividends do not accumulate and are effectively lost if the company is unable to pay them.|
|Dividends||Fixed dividend rates that may or may not be paid depending on the company’s financial situation. May be cumulative or non-cumulative based on the terms.||Fixed dividend rates that do not accumulate if unpaid. Unpaid dividends are effectively lost if the company is unable to pay them.|
|Accumulation of unpaid dividends||Depends on the terms of the preference shares. Cumulative preference shares accumulate unpaid dividends, while non-cumulative preference shares do not.||Unpaid dividends do not accumulate and are lost if the company is unable to pay them.|
|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, but without the accumulation of unpaid 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.
Advantages of Non-Cumulative Preference Shares
- Lower financial burden on startups: Since non-cumulative preference shares do not require companies to pay any missed dividends in the future, they impose a lesser financial burden on startups compared to cumulative preference shares. This can be beneficial for early-stage startups that need to prioritize growth and cash flow management.
- Dividend priority: Non-cumulative preference shareholders enjoy priority over common shareholders when it comes to dividend payments. This means that, as an investor, you will receive your share of dividends before they are distributed to common shareholders, provided the company has sufficient profits.
- Liquidation preference: Like other preference shares, non-cumulative preference shares often come with a liquidation preference. This gives investors priority in the distribution of assets in the event of a company’s liquidation, exit, or acquisition.
Disadvantages of Non-Cumulative Preference Shares
- Loss of unpaid dividends: The primary downside of non-cumulative preference shares is the loss of unpaid dividends. If the company is unable to pay dividends in a given period, the missed dividends are not accumulated or paid in the future. This can make returns less predictable and might be unappealing to some investors.
- Limited voting rights: Non-cumulative preference shares typically come with limited voting rights, allowing investors to have a say in only specific matters or decisions. This may not be ideal for investors seeking more control over the company’s strategic direction.
Comparison: Non-Cumulative vs. Cumulative Preference Shares
The primary difference between non-cumulative and cumulative preference shares lies in the treatment of unpaid dividends. Cumulative preference shares accumulate unpaid dividends, which must be paid out in full before any dividends are distributed to common shareholders. On the other hand, non-cumulative preference shares do not accumulate unpaid dividends, and investors are not compensated for missed dividend payments.
Non-cumulative preference shares can be an attractive option for startup investors who prioritize growth and capital appreciation over a stable, predictable income stream. While they come with certain preferential rights, such as dividend priority and liquidation preference, they do not guarantee regular dividend payments. As a first-time startup investor, it’s essential to understand the features of non-cumulative preference shares and weigh their advantages and disadvantages before participating in a fundraise.