Raising investment? Know your preferential rights

When you raise investment, you’re not just offering shares or ownership in your company - you’re also offering specific terms that will shape how your business is governed.

Investors will often ask for preferential rights that give them additional protections or advantages when compared to ordinary shareholders.

These rights are traditionally attached to preference shares, and are designed to manage risk, minimise downside scenarios, or provide investors with greater levels of visibility or control.

Preferential rights are a standard part of institutional raises, but they can also significantly affect ownership, decision-making, and exit proceedings.

Understanding them early helps you negotiate confidently and structure your round in a way that helps you to negotiate terms with confidence, and structure your investment round in a way that works for you and your investors.

Let’s break down what preferential rights are, what they look like in practice, and when they appear in the fundraising journey.

What are preferential rights?

Preferential rights are special rights granted to certain shareholders, usually investors, that give them special advantages when compared to ordinary shareholders.

They usually fall into three categories:

Economic rights: These affect how money is distributed (for example, during dividends or exits).

Control or governance rights: These influence how decisions are made within the company.

Information rights: These ensure investors receive regular updates on the company’s performance.

These rights are commonly granted through preference shares, which are a separate class of shares granted during a funding round.

For founders, this means investors may receive more than simply their percentage of equity. Their shares may carry additional protections that have an influence on future funding rounds, governance decisions, and exit outcomes.

When preferential rights appear in the fundraising journey

Preferential rights don’t necessarily appear at every stage in the fundraising journey. Early-stage investors, particularly those investing in SEIS and EIS, typically cannot receive certain preferential rights due to eligibility criteria that govern these tax-advantageous schemes.

SEIS and EIS restrictions

To qualify for the Seed Enterprise Investment Scheme (SEIS), or the Enterprise Investment Scheme (EIS), shares must generally:

• Be ordinary shares
• Carry no preferential rights to dividends
• Carry no preferential rights to assets
• Not offer guaranteed returns or reduction of risk.

These schemes are designed to encourage genuine risk investment to satisfy the risk-to-capital condition as set out by HMRC.

This means investors claiming SEIS or EIS can’t usually receive shares with economic preferences, including liquidation preferences, guaranteed dividends, and mechanisms that protect their own capital.

However, limited governance or information rights may still be granted through a shareholder’s agreement.

Later funding rounds

Preferential rights usually become more common during later, larger, and more institutional funding rounds, including Series A+, VC, and large angel rounds.

At this stage, the stakes are higher, and investors often negotiate preference shares with structured rights in order to protect their investment.

Common types of preferential rights

Liquidation preferences

A liquidation preference determines who gets paid first when a company distributes proceeds, usually during:

• A company sale, or
• A liquidation event

These ensure investors recover their initial investment before ordinary shareholders receive proceeds.

Non-participating liquidation preference

This structure is the most common form of liquidation preference, and means the investor receives (usually whichever is greater of):

• Either their original investment back, or
• Their pro-rata share of the exit proceeds

For example: An investor puts £1m into a company for 20% equity.

• If the company sells for £3m, the investor would receive their £1m preference stake.
• If the company sells for £10m, the investor would take their ordinary shares at 20%, receiving £2m.

This structure is considered as striking the best balance between satisfying investor expectations whilst still being founder-friendly.

Participating liquidation preferences

With participating preferences, investors receive their investment back first, and a share of the remaining proceeds.

For example: An investor puts £1m into a company for 20% equity.

If the company sells for £10m, the investor would receive their £1m initial investment back, and then 20% of the remaining £9m.

Their total returns would be £2.8m.

This is less founder-friendly, as it can significantly reduce the amount available to founders and other shareholders.

Dividend preferences

Preferred shareholders may also receive priority access to dividends. In early-stage startups, this is likely to be theoretical, as most often profits will be reinvested back into the business.

However, dividend preferences can affect how proceeds are allocated during exits. Two common structures are:

Non-cumulative dividends: A dividend may be declared, but does not accumulate if unpaid (due to cashflow constraints).

Cumulative dividends: A fixed percentage or amount accrues each year, and must be paid before other shareholders receive their distribution.

If accumulating over several years, cumulative dividends can stack up and give preference shareholders significant rights and shift a large proportion of exit proceeds in the direction of preferred shareholders.

Anti-dilution preferences

Anti-dilution protects investors if the company raises money down the line at a lower valuation - this is known as a down round.

Without sufficient protection, earlier investors would be more severely diluted than those entering in at the down round. Anti-dilution preferences adjust the investor’s shareholding to compensate for this.

Two common methods are:

1. Full ratchet: This is when the investors share price is adjusted fully to the new price. This can result in a large number of additional shares being issued to the investor and can significantly dilute the founders’ equity.

2. Weighted average: This is a more founder-friendly approach that adjusts the share price based on a formula factoring in the size of the new round and the total number of shares outstanding.

Governance and control rights

Preferential rights aren’t necessarily financial - investors may also request governance rights that affect and influence company decisions.

These might include:

Board representation: Large investors may request the right to appoint a board director or observer. This provides oversight, and ensures investor interests are represented throughout key strategic decisions.

Veto rights: Investors may negotiate veto rights over key decisions, such as:

• Share issuance
• Selling the company
• Taking significant loans or debt
• Changing the business model
• Amending the Articles of Association (AoA)

These rights may also be referred to as reserved matters. They are usually structured so that a class of investors must approve certain actions, rather than giving a veto to a single individual investor, to keep things moving as seamlessly as possible.

Information rights

Investors may also request enhanced access to company information, including financial information, budget updates, and regular reports.

These rights help investors monitor performance and report to their own stakeholders, and are particularly common for professional investors and institutional funds.

Where preferential rights are documented

Preferential rights are usually documented in two places: the Shareholder’s Agreement, and the Articles of Association. 

Most detailed rights such as veto powers, reporting requirements, and investor protections, are written into the shareholders’ agreement. Certain rights attached directly to share classes, such as dividend rights or liquidation preferences, may also be included in the AoA.

The cumulative impact of preferential rights

Preferential rights don’t just affect founders - they can also affect earlier investors. As a company grows and raises additional funds:

• New investors may request more senior liquidation preferences
• Earlier investors may accidentally become subordinated
• Preference stacks may develop

This means that the order of payout may become overcomplicated, or that a large preference stack may result in very little making its way back to founders or employees - this is why understanding the mechanisms of preferential rights is so important, early-on.

Key considerations for founders

It’s not so much that preference rights are inherently good or bad - they’re simply considerations that balance risk for both founders and investors.

For founders, the key questions are:

• How will these rights affect future funding rounds?
• How will this affect the distribution of exit financials?
• Are these rights reflective of standard terms, or are they restrictive?
• Will they create complications with SEIS and EIS eligibility?

In many cases, investors requesting preferential rights are simply seeking reasonable downside protection, but it’s important that founders understand exactly what they’re agreeing to and how it affects the cap table over time.

Raise smoothly with InVestd

Raising investment comes with a lot of moving parts - from structuring your round and issuing shares to understanding what you’re giving away, and what that means long term.

With InVestd Raise, you can manage the whole process on one seamless digital platform. Structure your investment properly, issue investor shares, keep your cap table clean, and handle key steps like SEIS/EIS advance assurance and compliance statements - all in one place.

Book a free demo with our team to see how Vestd can support your raise.