The Startup Series: Ordinary shares vs preference shares – what founders give up and why it matters

This is the second article in The Startup Series – a collection of short articles covering key concepts for early stage companies in Australia that are establishing a business or raising capital.

Early considerations for founders

When founders talk about ‘giving up equity’, they are usually thinking about dilution. What is often missed is that preference shares do not simply affect ownership percentages. They can re-order risk, reshape control and determine who gets paid in an exit scenario.

Most founders begin their journey holding ordinary shares. By contrast, professional investors typically invest via preference shares, which come with additional rights and contractual protections designed to manage downside risk.

This article explains what preference shares are, why investors use them, and what they mean for founders.

Ordinary shares: the founder baseline

Ordinary shares function as the company’s residual risk capital.

They typically carry:

• voting rights at shareholder meetings;
• an entitlement to dividends if declared; and
• a right to the remaining proceeds once all other claims and preferences are satisfied.

Founders and employees almost always hold ordinary shares. This means they absorb losses first and get paid last but participate fully if the company performs well.

Importantly, ordinary shares provide no built‑in downside protection. That protection is introduced only once preference shares are issued.

Preference shares: contractual protection on top of equity

Preference shares are not simply ‘another share class’. They are a negotiated risk allocation tool inserted into a company’s capital structure as part of financing.

They sit alongside ordinary shares but operate ahead of them in defined scenarios, most notably:

• a company sale or change of control; or
• a capital restructuring or insolvency.

As a result, preference shares affect economic outcomes and decision‑making, even where founders retain a majority ownership position.

Liquidation preference 

A liquidation preference determines what happens to investor capital in a liquidation event.  Liquidation events typically include insolvency or a sale of all or substantially all of the company or its assets.

Market standard: 1x non‑participating

The most common structure in Australian early-stage venture deals is a 1x non‑participating liquidation preference.

Under this structure, investors may elect to:

• receive a return of their invested capital before ordinary shareholders; or
• convert to ordinary shares and receive their pro‑rata share of the exit – whichever is higher.

This structure protects investors on the downside without allowing them to “double‑dip” on returns. It is generally considered market standard in Australian early stage deals.

Participating preferences: compounding returns

A participating preference allows investors to recover their capital first and then participate again in the remaining proceeds. Even at relatively modest exit values, this structure can materially disadvantage founders.

The key point for founders is that liquidation preferences do not change ownership percentages, they change the order in which exit proceeds are distributed.

Dividends

Another common preference is the payment of dividends. Where dividends attach to a preference share, the holder is entitled to receive dividends before holders of ordinary shares.

While in practice dividends are rarely paid by early-stage startups, cumulative dividend rights can accrue over time and materially reduce founder proceeds on an exit if not carefully negotiated.

Conversion rights

Preference shares are designed to manage downside risk, not to cap upside.

A liquidation preference is valuable if the company underperforms, as it entitles the investor to get their capital back first. However, this protection becomes economically irrelevant once the company succeeds.

When the exit value is sufficiently high, an investor’s pro‑rata share of the company as an ordinary shareholder will be worth more than the liquidation preference. Conversion allows investors to participate fully in that upside.

Conversion rights give holders of preference shares the ability to convert their shares into ordinary shares in specified circumstances or on defined triggers. For example, an initial public offering (IPO) or a subsequent funding round commonly triggers mandatory conversion.

Anti-dilution

An anti-dilution mechanism protects investors if the company later issues shares at a lower price than what was originally paid when the preference shares were issued, commonly referred to as a down round.

Rather than losing value due to a lower issue price, anti‑dilution mechanisms adjust the investor’s effective price or provide additional shares.

There are two main types of anti-dilution mechanisms:

1. Full-ratchet anti-dilution, adjusts the investor’s share price all the way down to the share price of the new round; and
2. Weighted average anti-dilution, adjusts the investor’s share price only partially.

Voting rights

Preference shareholders often receive enhanced voting or consent rights. These typically take the form of veto rights over key company actions, such as issuing new shares, amending the constitution, or approving an exit.

Board representation

Investors also commonly seek the right to appoint a director to the board. Board representation can influence both strategic direction and operational decision‑making, particularly as the company scales.

Key takeaways

Preference shares are a standard feature of venture capital financing. They exist to protect investors, but they can also materially change who controls the company and who receives proceeds on an exit.

Founders should understand how preference shares operate, focus on the terms that matter most, and approach negotiations with a clear view of the commercial trade‑offs being made. Informed attention to these issues will improve outcomes when capital is raised and when exits are ultimately negotiated.

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Authored by: 

Vaughan Petherbridge, Partner
Emilie Reddish, Graduate