Ordinary vs Preference Shares for UK Startups: How to Protect Founder Equity

Understanding the Levers of Equity: Economics and Control

Before diving into specific share types, it’s crucial to understand that a share is not a single concept. It is a bundle of rights that can be adjusted along two primary levers: economics and control.

Economic Rights dictate who gets paid what, and in what order, when the company has a financial event like a sale, a merger, or a dividend distribution. This is about the cash return on an investment. For founders, this initially means a proportional claim on the company's future success.

Control Rights determine who has a say in the company’s big decisions. This includes rights like voting on board members, approving a sale of the company, or authorising new share issues. It’s about influence and strategic direction.

As a founder, your initial shares provide a balanced mix of these rights. Investors, however, seek to adjust these levers to protect their capital, which creates the need for a new, more complex class of shares.

Your Starting Point: Ordinary Shares Explained

When you first incorporated your company, you almost certainly issued Ordinary Shares. These are the most common type of equity and represent the purest form of ownership. For founders in the pre-seed or bootstrapped phase, their simplicity is a major advantage.

The holder of an ordinary share typically gets a straightforward package of rights: one vote per share, a right to a proportional share of any declared dividends, and a claim on the company’s residual assets if it is wound up. Crucially, this claim comes only after all creditors and preferred shareholders are paid. This makes ordinary shareholders the ultimate risk-takers in the business.

This simple structure works perfectly when the owners are also the operators. Everyone shares the same risk and reward profile. However, for an external investor, it lacks protection. If they invest £1 million for 20% of a company valued at £5 million and the company later sells for only £1 million, their 20% stake would be worth just £200,000. They would lose 80% of their capital. This downside risk is precisely why investors require a share class with enhanced economic rights, leading directly to the creation of preference shares. The difference between ordinary and preference shares UK startups must manage is central to any priced funding round.

The Investor's Toolkit: Why Preference Shares Exist

Preference shares are the standard instrument for venture capital investment in the UK. They are hybrid securities, blending features of both equity and debt. The 'preference' part of the name refers to a series of rights that give investors priority over ordinary shareholders in specific scenarios, primarily when it comes to getting their money back.

An investor’s goal is to secure downside protection while retaining the full upside potential of a successful exit. Preference shares achieve this by tilting the economic lever in their favour. For UK startups, especially those in capital-intensive sectors like deeptech or biotech where revenue is years away, offering preference shares is essential to attract professional investment.

These shares are also designed to be compatible with crucial government tax incentives. The reality for most early-stage startups is pragmatic: to secure funding from venture capitalists or angel investors seeking SEIS/EIS tax relief, you will need to create a new class of preference shares. Understanding the key terms associated with these shares is the first step in any successful negotiation. For a US comparison, see our guide on common versus preferred stock.

Decoding Investor Rights: What to Expect in a Term Sheet

Negotiating a term sheet is where you define the specific rights attached to preference shares. While the document can seem complex, the terms generally fall into a few key categories that address investor concerns about risk and return.

Liquidation Preference

This is the most important economic term. It dictates how proceeds are distributed in a ‘liquidation event’ such as a sale, merger, or winding up. It ensures investors get their money back before founders and employees see any return from their ordinary shares.

A '1x, non-participating' liquidation preference is the market standard for UK early-stage deals.

This standard term means investors have a choice. They can receive their original investment amount back (the '1x'). Or, they can convert their shares to ordinary shares and take their percentage ownership of the proceeds. They choose whichever option is greater; they do not get both.

Terms that deviate from this are significant red flags. For example, 'participating' preference shares would allow an investor to get their money back *and* their pro-rata share of the remaining proceeds, a highly founder-unfriendly structure. Similarly, liquidation preference multiples greater than 1x (e.g., 2x) are non-standard for competitive rounds and should be resisted.

Illustration: Liquidation Waterfall Example

Consider a SaaS startup that raised £1 million from an investor for a 20% stake, issuing 1x non-participating preference shares. The company is later sold for £3 million.

• Investor's Choice 1 (Take the Preference): The investor can choose to receive their £1 million back first. The remaining £2 million is then distributed among the ordinary shareholders (the founders).
• Investor's Choice 2 (Convert to Ordinary): The investor could convert to 20% of the ordinary shares, which would give them 20% of £3 million, equalling £600,000.

In this scenario, the investor obviously chooses the first option, taking their £1 million preference. Now, imagine the company sold for £10 million. In that case, converting to ordinary shares (20% of £10 million = £2 million) is more valuable than their £1 million preference, so they would choose to convert. The remaining £8 million would go to the ordinary shareholders.

Anti-Dilution Protection

This right protects investors if the company raises a future funding round at a lower valuation than the one they invested at, an event known as a ‘down round’. It adjusts the price at which their preference shares convert into ordinary shares, effectively giving them more shares to compensate for the valuation drop and maintain the value of their original investment.

The most common and founder-friendly anti-dilution mechanism is 'broad-based weighted average'.

This formula uses a weighted average to recalculate the share price, taking into account all outstanding shares (including options and warrants), which softens the dilutive impact on founders. Conversely, a 'full ratchet' anti-dilution mechanism is an extremely aggressive and rare term. It would re-price all of the investor's shares to the new, lower price of the down round, causing massive dilution to founders and other shareholders. This should be avoided at all costs.

SEIS/EIS Compliance for UK Startups

For UK startups, ensuring preference shares comply with the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) is critical. These schemes provide generous tax incentives to investors, making your company a much more attractive proposition.

HMRC has strict rules to prevent these schemes from being used for low-risk, debt-like investments. A key rule is that preference shares must not give investors an unfair advantage if the company is formally wound up.

To qualify for SEIS/EIS tax relief, preference share rights on a winding up must not be preferential. A preferential dividend right is permissible.

This means the 1x liquidation preference described above must only apply to a sale or merger, not a formal winding-up of the company where it goes out of business. In a winding-up, SEIS/EIS preference shares must rank equally with ordinary shares. This is a subtle but vital distinction that requires careful drafting in your legal documents.

Ordinary vs. SEIS/EIS Preference Shares at a Glance

Here is how the rights typically break down between the two main share classes in an early-stage UK startup.

• Voting: Both Ordinary and SEIS/EIS-compliant Preference Shares typically carry one vote per share, maintaining a balance of control on routine matters.
• Dividends: Ordinary shareholders receive a pro-rata share of any declared dividends. Preference shareholders usually have a right to a preferential dividend, meaning they are paid first, though this is often non-cumulative and rarely exercised in startups.
• Liquidation on a Sale: This is the key difference. Preference shareholders get to choose between receiving their investment back (typically 1x) or converting to ordinary shares to take their percentage of the sale proceeds. Ordinary shareholders receive their pro-rata share of whatever remains *after* the preference is paid.
• Rights on Winding Up: To comply with SEIS/EIS rules, preference shares must rank equally with ordinary shares in a formal winding up. This means they do not get their money back first in this specific scenario.
• Anti-Dilution: Ordinary shares have no protection. Preference shares typically come with broad-based weighted average protection against down rounds.

Making It Official: Documentation and Filings

Once terms are agreed in a term sheet, they must be legally documented and filed correctly with Companies House. Getting this wrong can create serious compliance issues and jeopardise future funding rounds. Inadequate documentation or late filings can expose the company to penalties and create ambiguity that leads to shareholder disputes.

The first step is to amend the company’s Articles of Association. This document is the company's internal rulebook and must be updated to create the new share class and define its specific rights. This is a significant change that requires formal approval.

Creation of a new share class requires a shareholder resolution with 75% approval.

This special resolution, along with the newly adopted Articles, must be filed promptly. The deadline is strict. Following shareholder approval, the new Articles of Association and the resolution must be filed with Companies House within 15 days.

Next, when the investment closes and the shares are formally issued, you must inform Companies House of the change to your company’s share capital. This is done by filing a Statement of Capital using Form SH01. This form details the new shares issued, the amount paid, and the updated capital structure. Late or incorrect filings are a breach of the Companies Act and can incur penalties. More practically, these errors will be flagged during due diligence in your next funding round, causing delays and potentially harming investor confidence.

Practical Takeaways for Founders

Navigating the difference between ordinary and preference shares is a critical step in your startup's journey. Getting the structure right protects your interests while meeting the legitimate requirements of investors who are providing the capital to grow.

1. Acknowledge the 'Why': Investors need preference shares to protect their capital from downside risk. Your goal is not to fight this but to provide this protection using standard, founder-friendly terms.
2. Stick to the Standard: A 1x, non-participating liquidation preference and broad-based weighted average anti-dilution are the UK market standards. Push back firmly but professionally on anything more aggressive, like participating rights or full-ratchet anti-dilution.
3. Prioritise SEIS/EIS Compliance: For most UK startups raising early-stage capital, compliance is non-negotiable. Ensure your legal documents are drafted by professionals who understand the specific requirements from HMRC, particularly the distinction between a sale and a winding-up.
4. Don't Neglect the Paperwork: The administrative side is just as important as the negotiation. Diarise the 15-day filing deadline for your new Articles and ensure Form SH01 is filed correctly after issuing shares. Clean corporate governance avoids major headaches later on.

By understanding these economic and control levers, you can negotiate your term sheet from a position of strength, securing the capital you need without giving away your future. For more on legal structures and reporting, see our hub on legal and reporting rules.

Frequently Asked Questions

Q: As a founder with ordinary shares, do I ever get preference shares?
A: Generally, no. Founders hold ordinary shares, which represent the underlying equity and upside of the business. Investors receive preference shares to protect their specific capital injection. Keeping these classes separate maintains a clean and understandable structure for future funding rounds and potential acquirers.

Q: What is the difference between a share class and a share series?
A: A 'share class' refers to a category of shares with distinct rights, like "Ordinary Shares" or "Preference Shares". A 'share series' refers to a specific issuance of shares within a class, often related to a funding round. For example, you might issue "Series A Preference Shares" in your first round and "Series B Preference Shares" in your next.

Q: How do preference shares affect my voting control as a founder?
A: While preference shares typically carry one vote per share (same as ordinary), investors will also negotiate for 'protective provisions' or 'veto rights'. These give them a veto over major decisions, such as selling the company or issuing new shares, regardless of their overall voting percentage. This is a key part of the 'control' lever.

Q: Can preference shares be issued to employees?
A: It is highly unconventional. Employees are typically granted options over ordinary shares through a scheme like an EMI option pool. This aligns them with the long-term growth and upside of the company alongside founders, rather than giving them the downside protection designed for capital investors.