In The Know: Redeemable convertible preference shares: The devil is in the details

This article first appeared in Wealth, The Edge Malaysia Weekly, on September 26, 2022 - October 02, 2022.

"ECF is not for the faint-hearted. Even if there’s the redeemable feature, it doesn’t mean you can get your money back.” - Ho

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If you are an equity crowdfunding (ECF) investor, you would probably have heard of redeemable convertible preference shares, or RCPS. Some individual investors who invest just a few thousand ringgit in micro, small and medium enterprises (MSMEs) may not research this investment instrument thoroughly, but there are profound implications on investors’ money when something good or bad happens to the companies they invest in. 

For instance, RCPS allow investors to redeem their shares from the company at a certain price. But what are the circumstances under which such redemption cannot be done? Or, when the company you have invested in is slated for an initial public offering, can RCPS investors be put at a disadvantage? The answers could be more complicated than many would have thought. 

To better understand RCPS, Wealth talks to Shawn Ho, partner and head of corporate, property and tax at law firm Donovan & Ho. 

Over the years, Ho has represented clients in corporate acquisitions, restructuring exercises, joint-venture agreements and shareholder agreements, among other matters. He also regularly advises Malaysian start-up founders and has assisted venture capital funds in seed, Series A and B funding rounds.

 

Wealth: What are RCPS and why are they often offered to ECF investors?

Ho: RCPS is a type of preference share. To touch a bit on history, the issuance of preference shares by companies is permitted under the Companies Act 2016 [the 2016 Act]. It was already allowed in the older version of the Act, which was the Companies Act 1965. When the Act was overhauled later, the issuance of preference shares was retained.

Preference shares are often offered to ECF investors as they can be designed differently from the ordinary shares to be more attractive to investors for fundraising purposes. For instance, there is the redeemable feature where the holder of preference shares can demand from the company a redemption of a certain investment amount. They can also convert their preference shares to ordinary shares according to terms and conditions.

Investors also like preference shares as it provides them with steady dividends akin to the coupon on bonds. 

 

Can you tell us what investors should look out for regarding the redemption feature of preference shares? 

From an investor’s point of view, it is important to look at the terms of the redemption, whether it can be redeemed by the company or the investors. Of course, it is more favourable to the investors if they are the ones who have the right to redeem those shares. 

Yet, even if investors have such a right, they will have to be mindful that the 2016 Act has requirements for the redemption to actually take place. The 2016 Act allows companies to only redeem the shares out of three things: profits, fresh issuance of shares or capital. 

To simplify things, the 2016 Act wants to ensure that companies have sufficient surplus of capital or solvency to effect redemptions. 

 

Can you elaborate on ‘fresh issuance of shares’? 

This means the companies issue new shares in exchange for/to redeem preference shares from investors. However, there’s an additional requirement when a company wants to redeem its preference shares out of capital, which is to pass the solvency test. It is a new concept under the 2016 Act.

In layman’s terms, it means that company directors must be confident enough to declare that, after the redemption is done, the company will still be able to meet its obligations to creditors, or that its assets are still more than its liabilities in the next 12 months. They must be sure that the company will remain solvent. 

 

Is there a limit to how much a company can raise through the issuance of preference shares, including RCPS?

There’s no limit, according to the Companies Act. It comes down to valuation. If the company can convince its investors that, say, its portion of shares is worth RM30 million, then that is how much the company can raise. It is a willing buyer, willing seller situation. 

Just to add one point. Some redemption clauses even promise investors a premium at the end of the term, which means you are not just getting back your investment principal after redemption, but also an IRR (internal rate of return) of, say, 10% per annum for five years. Such a clause is attractive to investors. 

 

What about the convertible feature of preference shares? 

Such a feature allows investors to convert their preference shares into ordinary shares. Similar to the redemption feature, it is an option to either the investors, or the company, to initiate the conversion. 

Could this benefit the investors? Yes. For instance, when a company goes for listing, its shares will be floated on the market and become tradable. You can check its trading activities and prices on the bourse and the prices change every day. After converting their preference shares to ordinary shares, investors can sell their shares on the exchange, which provides them with potential upside deriving from capital gain and ease of disposal. 

Such a feature is useful when the investors feel like they want some control over the company through exercising their votes, for whatever reason. Ordinary shares come with a right to vote, whereas preference shares typically don’t have such a right, or just very limited. 

The conversion feature is relevant when an M&A (mergers and acquisitions) event takes place. Say Company A that you invested in is going to be acquired by a big company at a very good valuation. The potential buyer will ask Company A to clean up its cap table (a spreadsheet that details who has ownership in the company), by converting all its preference shares to ordinary shares, before it buys over Company A’s ordinary shares.

 

What happens to preference shareholders when a company is liquidated? 

Preference shareholders are ranked higher than ordinary shareholders in a liquidation event. Hence the word ‘preference’. However, they are still ranked behind a long list of people including secured creditors, unsecured lenders, the Inland Revenue Board, employees who are owed salaries and others. It is only after these parties are paid off that it is the shareholders’ turn, at the bottom of the pile. 

While preference shareholders are ranked higher than ordinary shareholders, what their rights are depends on the terms of the contract. Now, we are venturing into this term called ‘liquidation preference’.

The default liquidation preference allows you to claim back your investment amount. Nothing more, nothing less. However, some venture capitalists, the more aggressive ones with bargaining power, could say, ‘I want to receive at least 1.5 or two times my investment amount. As an early investor of your company, I still want some returns if you go bust. That at least makes it worth my time investing in you.’ 

In short, liquidation preference protects the downside of investors as most of them want to secure their initial investment when the company goes under. 

However, what about the upside? Even when a company is wound up, it could have a huge amount of assets and surplus cash to be distributed while having very little debt and liabilities. There could be a lot of money left with it. 

Are preference shareholders entitled to these surpluses beyond their initial investment amount? This is where another legal term called ‘participation rights’ comes in. 

Without participation rights, preference shareholders can only get back their initial investment, according to their liquidation preference. The surpluses left by the company are then distributed pro-rated to ordinary shareholders. But with participation rights, preference shareholders are allowed to participate in the upside of the distribution of the company’s surplus assets and cash. 

 

The devil is in the details. The terms of the constitution are very important. Is this correct? 

They are very important. This is also where things can get very technical. What is more difficult is knowing what those terms mean to you in different situations. One can read and understand them, like conversion or redemption. But what do they mean in this or that situation? That’s when things get complicated.

 

Is it correct that shares of ECF investors are held through a nominee and special purpose vehicle (SPV)? 

Under the Companies Act, private limited companies can only have a maximum of 50 investors. This is unlike public-listed companies that can have an unlimited number of shareholders. This is a reason why ECF operators set up an SPV, as a nominee, to hold all the shares of the retail investors, so as to keep the number below 50. 

Secondly, it makes administrative work easier to manage. Say a private company has 50 shareholders, it is a nightmare getting resolutions from all of them. The most logical thing to do would be for the issuer company to have a nominee to hold the shares of ECF investors through an SPV. 

Then, there is a nominee agreement, or a trust deed, between the nominee (or the SPV) and the investors, to state that the nominee only acts as a middle person. If any shares are disposed of or the dividend is distributed, the nominee will escalate it up to the shareholders. 

 

What is your advice to ECF investors?

They have to clearly know the difference between equity investors and debt investors. Your risk as an ECF investor investing in private, unlisted companies is high. Even if the company doesn’t go bankrupt, you may still get stuck. Who would buy your shares? It’s illiquid. 

Looking from a different perspective, some investors think this space used to be dominated by the venture capitalists, those who have huge dry powder. To be an investor or partner of theirs, you need to be a high-net-worth individual. Some investors think ECF platforms allow them to put in as little as RM1,000 in a potential unicorn. If the start-up/company does well, they can perhaps get back 20 times their initial investment. That kind of potential gain justifies the high risk of them losing their capital. 

ECF is not for the faint-hearted. Even if there’s the redeemable feature, it doesn’t mean you can get your money back. It’s not capital protected like a fixed deposit by PIDM (Perbadanan Insurans Deposit Malaysia), or the unit trust funds that are tightly regulated. 

Again, buyer beware. You want to put in money as an investor, read through the terms and understand them. Seek advice if you don’t. No one is forcing you to make an investment decision. Of course, the issuers cannot misrepresent, lie or provide false information to investors. All these are regulated. However, they can put in any terms they want, or don’t want, in the contracts.

 

Is there anything interesting you observe about ECF investing?

Some ECF issuers throw in vouchers and monetary perks that, in a sense, lower investors’ resistance [to invest in them], which is something quite new and interesting. You don’t see companies going on an IPO do this. 

I think it is because savvy investors know their investment could potentially go to zero. But they consider ECF to support their friends and businesses. So, the issuers throw in these vouchers and promotions to attract the investors. If your investment goes to zero, you still have something, like perhaps this 50% voucher, to fall back on.