Preference Shares for Singapore companies
Small businesses seeking to expand usually raise funds through debt, equity, or even hybrid instruments, such as debt which is convertible into equity. Debt typically means getting a bank loan. For small businesses, banks often ask for personal guarantees from the company’s owners. Such loans may therefore be indirectly secured through the owners’ personal assets, such as family homes. Collateral-free loans tend to have higher interests rates or are usually limited to smaller amounts. If you are a small business owner seeking to raise capital but are not comfortable with personally guaranteeing your company’s debts, issuing equity can be a more attractive alternative to debt financing.
Equity is essentially a stake of ownership in a company, embodied in the form of shares purchased from an existing shareholder, or issued afresh by the company. However, it can be hard to convince investors, or even close friends and family, to invest in your business. Further, selling or issuing shares to outsiders may result in loss of majority control by the founder. Issuing preference shares has since become a tried-and-tested fund raising strategy which provides a form of heightened capital protection for the investor and yet enables the founder to retain management control.
What are shares?
Most businesses are incorporated as companies limited by shares, which means that each owner (or investor) owns a certain percentage of the company expressed as a number of shares. Unlike a sole proprietorship or a partnership, the owners of a company and the company itself are separate legal persons and, theoretically, potential losses to the owners are limited to the value of their shares.
If a company only issues ordinary shares, then the default position is that all shareholders would have equal voting and dividend rights in proportion to the value of their shareholding, although ordinary shares can also be divided into classes (e.g. Class A Ordinary Shares and Class B Ordinary Shares which may have different rights).
The most versatile feature of preferential shares is that their terms are a matter of commercial agreement, subject to certain restrictions imposed by the Companies Act (CA). As the name suggests, preference shares commonly confers certain preferential rights on the preferential shareholder, over and above the right of the ordinary shareholder. Companies can also issue share options and warrants to raise funds as well.
Dividends are usually paid when the company makes a profit. The dividend paid per share is decided at the discretion of the management unless some sort of guaranteed minimum had been specified when the shares were first issued.
A preference share typically confers priority of dividend payment over ordinary shares. They could get a higher dividend per share and/or a right to receive a dividend even where there is insufficient profit to pay any dividend to ordinary shareholders. In return, preference shareholders often forego voting rights. Usually, the annual dividend rate of preference shares is stipulated as a percentage of the issue price (e.g. 5% at an issue price of $100 per preference share), on a cumulative or non-cumulative basis.
If a company makes a loss in FY201X and subsequently is unable to pay any dividend to either the ordinary or preference shareholders, what happens in FY201X+1 where the company makes a profit? If the preference shares are cumulative, then preference shareholders must be paid dividends in respect of FY201X and FY201X+1. If their preference shares are non-cumulative, then they only need to be paid dividends for the year FY201X+1, leaving more funds available for disbursement to ordinary shareholders.
If the company becomes insolvent and is wound up, depending on its terms, preference shares may confer upon preference shareholders a share of the company’s net assets in priority to ordinary shareholders. In most cases, preference shareholders would still rank junior to creditors, which is therefore the main advantage of debt over equity from the perspective of the debt-holders.
As enshrined under the CA, shareholders have the right to vote on major matters, such as the issue of shares and alterations to the constitution. However, shareholders usually do not have the right to participate in the day-to-day running of the company, unless reserved matters are stipulated in the constitution requiring shareholder approval (e.g. incurring a debt in excess of S$100,000).
Whether a preference share confers voting rights depends on the terms of the preference shares. It is thus possible to issue preference shares with no voting rights, or increased voting rights in respect of certain matters (e.g. appointment of directors). Nevertheless, the CA entrenches certain specific voting rights on preference shares that cannot be deviated from, such as the right to vote in a voluntary winding up and in the case where a resolution is proposed to vary the right attached to a preference share.
Special types of preference shares
There are two special types of preference shares: redeemable and convertible. Redeemable preference shares are preference shares with a “buy back” option, meaning the company may buy back the preference shares from the holder at a fixed price, either at the option of the holder or of the company. Convertible preference shares are preference shares with an option to exchange the preference shares for another instrument in the capital of the company, such as ordinary shares. Again, the rate of exchange would be fixed by the company at the time of issuance.
The Securities and Futures Act (SFA) stipulates that “offers of securities” (which includes ordinary shares and preference shares) must be accompanied by a prospectus. Prospectuses (and offer documents) are comprehensive documents commonly issued to investors in initial public offerings, and the preparation process is often lengthy and expensive. In order to avoid the prospectus requirement, issuers of preference shares usually rely on the private placement exemption under the SFA. This exemption requires a series of conditions to be met, the most important of which is that the “offer of securities” must be made to no more than 50 persons within any period of 12 months.
How do I issue preference shares?
Shareholder approval by way of an ordinary resolution is required under Section 161 of the CA in respect of issuances of shares, including preference shares.
As issuing preference shares can be contrary to the interests of ordinary shareholders, who may oppose such issuances, it is in everyone’s interests if such a power, and the conditions under which preference shares are to be issued, redeemed or converted, is clearly specified in the constitution. Indeed, Section 75 of the CA states that preference shares may only be allotted where the constitution of the company sets out the rights of the preference shareholder ‘with respect to repayment of capital, participation in surplus assets and profits, cumulative or non-cumulative dividends, voting and priority of payment of capital and dividend in relation to other shares or other classes of preference shares.’
The process for amending a company’s constitution is specified in the CA and the constitution of the company. Under the CA, a special resolution (75%) of shareholder vote is required to amend the constitution. An Extraordinary General Meeting (EGM) is usually convened to effect the above-mentioned resolutions.
How do I convert or redeem preference shares?
Convertible or redeemable preference shares are issued according to the terms set by the company at the time of subscription. However, some restrictions apply to redemption. Only fully paid-up redeemable preference shares may be redeemed, when there are profits available for such redemption (subject to statutory exceptions), and a prescribed notice of redemption must be lodged with ACRA.
Should I issue preference shares?
Issuing preference shares in a smaller, privately-held company is relatively straightforward. However, the process of issuing preference shares would almost definitely require legal advice. Typically, a subscription agreement, a shareholders’ agreement and a revised constitution, along with the requisite director resolutions and EGM documents, are prepared to authorise the issue. Those seeking legal advice from corporate lawyers can consider referring to our directory of corporate lawyers. Finally, small business owners should have a clear plan as towards the capital raised as reasonable investors would expect to be informed about cash proceed usages, and in particular because the company or even its directors may be liable for misrepresentation if the wrong information was deliberately communicated to investors to induce investment.