Cap Table Waterfall: Different Types of Preferred Shares

When it comes to raising capital for your startup, understanding the intricacies of preferred shares is essential. Preferred shares are a common form of equity investment that provide certain rights and privileges to investors.

However, not all preferred shares are created equal. There are different types of preferred shares that startup founders should be familiar with. If you are a founder, understanding these in detail helps you gauge whether the investors you are bringing onto your cap table are worth it.

Key Types of Preferred Shares

1. Convertible Preferred Shares: Convertible preferred shares are a popular type of preferred shares that provide flexibility for both investors and founders. These shares have the option to convert into common shares at a predetermined conversion ratio, typically during a future financing round or a liquidity event. Convertible preferred shares offer investors downside protection in the form of preferred rights while allowing them to participate in the potential upside of the company’s growth.
2. Participating Preferred Shares: Participating preferred shares grant investors the right to receive both their initial investment amount and a share of the remaining proceeds upon a liquidation event. This means that participating preferred shareholders can “double dip” by first receiving their liquidation preference and then participating alongside common shareholders in the distribution of the remaining proceeds. This type of preferred share provides investors with an enhanced return potential.
3. Non-Participating Preferred Shares: Non-participating preferred shares, on the other hand, limit investors to only receive their liquidation preference upon a liquidity event. They do not participate in the distribution of the remaining proceeds with common shareholders. While this may seem disadvantageous for investors, non-participating preferred shares can be beneficial for founders as they allow for a more straightforward capital structure and potential retention of a larger portion of the company’s value.
4. Cumulative Preferred Shares: Cumulative preferred shares ensure that any unpaid dividends accumulate and must be paid to shareholders before common shareholders receive any distributions. If a company skips dividend payments in a particular year, the unpaid dividends are carried forward to subsequent years until they are fully paid. This feature provides greater certainty to preferred shareholders regarding the receipt of their dividends.
5. Redeemable Preferred Shares: Redeemable preferred shares come with a predetermined maturity date or a redemption option. This means that at a specified future date, or under certain conditions, the company has the right to repurchase the shares from the preferred shareholders at a predetermined price. Redeemable preferred shares provide an exit mechanism for investors or can be utilized by founders as a mechanism to regain control over the company.

As a startup founder, understanding the different types of preferred shares is crucial for structuring your cap table, negotiating with investors, and planning for future growth. Each type of preferred share carries unique rights and considerations that can impact ownership, return potential, and investor relations. By grasping the nuances of convertible, participating, non-participating, cumulative, and redeemable preferred shares, you can navigate the complexities of equity financing with confidence and position your startup for success.

Remember, it is always recommended to consult with legal and financial professionals who specialize in startup financing.

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