This article explores seed investor preference shares, while a later column for Fintech Business will explore co-founder vesting.

Before we get started, it is worth clarifying a bit of jargon around what a ‘seed’ investment is compared to a ‘Series A’, ‘Series B’, etc. A seed investment, as the name suggests, is a very early (possibly the first) investment.

The next investment round is referred to as the Series A, then Series B, and so on. This discussion is all in the context of seed and Series A rounds of investment.

Seed investor preference shares

Seed investors, such as venture capital (VC) funds, like to make their cash investment in start-up companies by way of a separate class of shares known as ‘seed preference shares’.

These shares differ from ordinary shares because they give the investor greater upside potential and a level of downside protection in return for their investment.

Examples of some of the preferred rights a VC who holds seed preference shares will include the following:

Board seat and veto rights

Although a VC may only take a shareholding of 20-35 per cent, to protect their investment they will want to have a seat on the board and veto rights on certain matters.

This gives the VC the power to block certain corporate actions, even if the founders are all in agreement.

When negotiating with a VC on this point you should only focus on the scope of the decisions on which they require veto rights.

The correct balance here will recognise that certain matters will potentially have an effect on the VC’s investment (e.g. sale of the company and issue of new shares) but also that the founders do not want to have to beg for permission at every turn while trying to run the day-to-day operations of the company (e.g. a decision to enter into a low-value contract or employ a new employee).

Liquidation preference

The word liquidation in 'liquidation preference' doesn't just refer to an insolvent liquidation of the company (for which downside protection is afforded by the preference shares) but also an exit event such as a sale of the company (for which upside potential is afforded).

The effect of a liquidation preference is that the VC will be entitled to take from the proceeds of sale or winding up an amount equal to their preference (based on the amount invested) before the founders will be paid. 

A VC that is not intent on squeezing the life out of the founders and wants to ensure there is sufficient reason to keep the founders motivated will only ask for a 1 x preference. Any more than that, and the sounders end up working more or less for the exclusive benefit of the VC.

For example: Assume a VC invests $1 million in seed preference shares with a 1 x liquidation preference, and the company is subsequently sold for $1.5 million. In this case the VC will be entitled to the first $1 million and the founders the balance of $500,000.

But if we change it slightly, and the seed preference shares have a 2 x liquidation preference, then the VC will take all of the $1.5 million because it has a preference of $2 million. There will be no pay day at all for the founders.

Anti-dilution protection

Seed investors will often want to ensure that they are not adversely affected if money is subsequently raised at a discount to the price paid by the investor for their shares.

Because seed preference shares will convert to ordinary shares upon a key event such as liquidation, the price at which the shares convert is important.

For founders a 1:1 ratio is best because it means they will not be diluted on conversion of the seed preference shares. 

For a basic example of how anti-dilution works, assume a VC was issued 100 seed preference shares at a price of $1 and there was all subsequent capital raisings were at a price greater than $1 per share.

In this case, on conversion of the seed preference shares the VC will be issued 100 ordinary shares. However, if the company conducts a subsequent capital raising at $0.50 per share, then on conversion the VC would be issued 200 ordinary shares.

There a couple of ways in which anti-dilution can take effect, but the most founder-friendly is based on the weighted average price of subsequent capital raisings.

This means that founders can minimize any excessive dilution by one-off small but low-value subsequent capital raisings.

The situation is improved again for the founders if there is a larger and higher value raising, which will average the conversion price up closer to the desired 1:1 ratio.

A tip for founders

When negotiating each of the above aspects of a VC’s investment, especially at the seed or Series A level, there might be a temptation to give in to a VC’s demands for protections and rights above what you believe is reasonable to secure the funding.

We get it that a start-up’s relative bargaining position may be weak if it really needs the money, but remember that whatever you give the seed investor now the next round of investors will probably want the same treatment (thereby compounding your problems). 

For this reason it is important to pick a VC (should you have the liberty to choose!) that understands your business and the business of investing in start-ups.

Brad Vinning is a partner, corporate and commercial, at ClarkeKann Lawyers.