Classes of shares explained: ordinary, preference and redeemable shares and their rights

There is no legal definition of an ordinary share. That means that, within reason, you can create any class of shares you want, with whatever rights and restrictions you choose to attach. The labels people use, ordinary, preference, redeemable, describe what those shares typically do. Here are the three most popular classes, when each one is useful, and the other rights and restrictions worth considering when you design your own.

The reason this matters is that most small companies start with a single class of ordinary shares, because that is what the standard model articles give you. The moment you bring in an investor, reward an executive or plan for a sale, one class is rarely enough. Knowing what the other classes do lets you choose deliberately rather than by default.

What are ordinary shares?

Start with the obvious one. Ordinary shares typically carry two rights: the right to vote and the right to dividends. The right to dividends is the right to be given a percentage, or a proportion, of the profits of the company after corporation tax.

Who are ordinary shares for? Typically, simply the founders and co-founders in a small company with no outside investors. They run the business, they vote, and they share the profits. In that setting there is no reason to split rights between people, because the same people hold all of them. Ordinary shares become less suitable once you want to give someone a return without a vote, or a vote without a full share of the profits.

What are preference shares?

Preference shares tend to be quite hands-off, but they have a greater chance of receiving dividends.

They are hands-off because, typically, they do not carry the right to vote. They have a greater chance of receiving dividends for two reasons: they are first in line for dividends, above everyone else, and typically they are guaranteed a fixed amount of dividend per quarter or per year. So if the company has profits to distribute, the preference shareholders are paid their fixed amount before the ordinary shareholders see anything, and if profits are thin, they are the ones most likely to be paid at all.

Preference shares can be great if you are taking investment from a hands-off angel investor who is not interested in helping you run the company or in its decisions, but believes in you and simply wants a greater likelihood of some kind of return. Separately, I have also seen companies and founders give preference shares to family members and friends, for the same reason: a return without a say. It keeps the relationship simple. The family member is rewarded for backing the business, and the founder does not have to involve them in every decision.

For a closer comparison of these first two classes, see ordinary shares vs preference shares.

What are redeemable shares?

Redeemable shares are among the most interesting shares, in my opinion. They are temporary shares. Typically, either the company has the right to decide to buy the shares back from the shareholder, or, in reverse, the shareholder has the right to request that the company buys their shares back. Which way round it works decides what the shares are good for, so the first question to ask is who holds the trigger.

• The company can buy back. This suits a company that wants to give shares to its executive team but keep the flexibility that, if an executive leaves, those shares can be bought back. That gives a clean break between the company and the departing executive, rather than a former employee sitting on the share register for years.
• The shareholder can demand a buyback. This can work as an alternative debt instrument. Say an alternative lender is willing to lend your company money, but the company is not rich in assets and does not have a strong balance sheet, for example a professional services company that does not need to own valuable assets. Instead of a loan, you give the lender redeemable shares. When the lender wants their money back, they call on the company, the money is repaid and the shares go back to the company. The lender gets the exit they would have had under a loan, and the company gets funding it might not have obtained on the strength of its balance sheet.

The mechanics of redemption, and how a buyback is funded, are covered in redeemable shares explained.

Drag-along rights explained

Beyond the class itself, there are three main kinds of rights and restrictions at your disposal. These are not classes of shares in themselves; they are terms you attach to a class, or to the shareholders generally, to control what happens on a sale or a fundraise. The first is drag-along.

Drag-along provisions, put simply, state that if enough holders of shares are willing to sell to a third party, those holders can drag along everyone else to sell their shares to that third party too.

Drag-along is fantastic if you are a founder taking on minority shareholders, for example investors, and you want to be sure that if a private equity buyer one day offers to buy the entire company, you can deliver the whole company rather than being blocked by a small holder. Buyers of whole companies generally want every share, so a drag-along right is often the difference between being able to accept an offer and not.

Tag-along rights explained

Tag-along provisions are similar but different. Put simply, if enough shareholders are willing to sell to a third party, the other shareholders can request to sell their shares to that third party too, at the same price.

Where drag-along protects the majority's ability to sell, tag-along protects the minority from being left behind in a company with a new owner they did not choose. Investors coming into a founder-led company will usually ask for tag-along for exactly that reason, and the two rights are often drafted together.

Anti-dilution clauses

Anti-dilution clauses are especially relevant if your company is going to do a few fundraising rounds and you have early-stage investors who want to avoid their shareholding being diluted as new shares are issued to later investors. An investor who took the most risk by coming in first will often want some protection against watching their percentage shrink with every later round, and this is the clause that gives it to them.

How founders keep control of the company

As a bonus, if you are looking to take on investors and shareholders but want to maintain control over your company, do one of these two things:

• Give your class more votes. Make sure the class of shares held by you and your important, valued co-founders carries more voting rights than everyone else. For example, for every one share you hold, you get 10,000 votes.
• Reserve decisions to your class. Reserve a specific set of decisions to your class of shares only, so that only your class can vote on those specified matters.

Either approach lets you bring in money without handing over the steering wheel. The first works on the arithmetic of votes; the second works by taking certain decisions off the table for everyone except your class. Which one suits you depends on how much of the company you expect to give away over time.

Next steps

If you are planning to create different classes of shares, make sure you comply with the Companies Act when you do it. Decide which rights each class needs, who holds votes, who gets dividend priority and whether anything is redeemable, then write those rights into the articles of association. The procedure is set out in how to create different classes of shares, and for anything beyond a simple structure, speak to a corporate solicitor.