Ordinary shares vs preference shares: what preference rights mean for value

Why are ordinary shares in a startup worth less than the shares an investor just paid for?

Start-Up Valuations, a division of Valuation Group, prepares these allocations for Australian companies, their boards and their advisers. In our experience, priced venture rounds are commonly made in a preference class, although earlier money often comes in through SAFEs, convertible notes or ordinary shares. Where an investor does buy a preference share, the price agreed is a price for a specific bundle of rights attached to that class, negotiated at that point in the company's life. Founders usually hold ordinary shares, and employees usually hold options or rights over them; ordinary shares usually rank behind the preference stack in a sale, a wind up or another liquidity event. The two classes can look similar on a share register, one line, one number of shares, but they are different assets with different claims on the same pool of value.

This is why a headline post money figure from a round is not, on its own, the value of an ordinary share. It is evidence about what one investor paid for one class, under one set of rights, on one date. What an ordinary share is worth depends on how much equity value is left for ordinary shareholders once the preference rights ahead of them are satisfied, under the scenario or scenarios a valuer works through. Our guide to what a recent funding round does and does not tell you covers that comparison; this page sets out the rights that create the gap, and how a valuer allocates value once those rights exist.

What rights do preference shares typically include?

Preference share terms are negotiated between the company and its investors and recorded in the term sheet and the subscription agreement for the round, and often also in the constitution or a shareholders' agreement. In our experience, the same five kinds of rights recur across most rounds, though the specific terms attached to each of them vary considerably.

None of these rights is standard. Each is negotiated, and the combination across every class on the register is what an allocation exercise has to reflect.

Why do these rights vary from one company to the next?

There is no default set of preference rights. Two companies at the same stage, raising the same amount, can end up with materially different preference terms depending on bargaining power and the advice each side received at the time. A single company can also carry several different preference terms across its own history, a Seed round on one set of terms, a Series A on another, layered on top of each other. There is no default liquidation preference or conversion ratio; the rights attaching to each class are the ones actually adopted for it, and the transaction documents, read together with the company's constitution, record what was agreed. Those documents have to be read, not assumed. Where a founder or an early employee is transferring or being bought out of ordinary shares, the rights of the classes standing ahead of them are central to what that parcel is worth; our founder share transfers page covers that scenario and names the basis of value that applies, which is not automatically the same as the market value used for a tax event.

How is total equity value allocated across share classes?

Once a company has more than one class of shares outstanding, working out what each class, and each shareholder's parcel within it, is worth requires an explicit allocation step. In our experience, three techniques are commonly used in valuation practice internationally to do this. Which one is appropriate, and how it is applied, is a matter of judgement, not a mechanical formula, and no Australian standard mandates any one of them for this purpose.

• A waterfall at an assumed exit (the current value method). Models how proceeds would be distributed across every class, under its real rights, at one assumed total equity value, as if a liquidity event happened on that date, working out for each non participating class whether taking its stated preference or converting to ordinary is worth more at that value. Transparent and simple to follow, but it resolves that choice at one assumed figure only; it does not capture how the answer might change across a range of possible outcomes, which the next two techniques address.
• Probability weighted exit scenarios. Models several plausible future outcomes, for example a modest sale, a stronger sale or an IPO, runs the waterfall under each, weights by an estimated probability and discounts back to the valuation date. Captures a range of outcomes, but depends on judgement about which scenarios to include, their probabilities and the discount rate.
• An option pricing allocation. Treats each class's claim on total equity value as a set of options with strike prices set by the preference and conversion terms, priced using an option pricing framework. Can suit a company a long way from a defined exit, spreading value across a continuous range of outcomes, though it still depends on judgement inputs such as assumed volatility and time to exit.

In our view, the right technique depends on how close the company is to an identifiable liquidity event, how many classes and how layered the rights are, and the purpose the valuation serves. These three techniques come from wider international valuation practice, not from any Australian valuation standard. Separately, a tax instrument, LI 2025/19, prescribes its own preference adjustment in Method Two, for the start up concession test only ¹; applying one of the three general techniques does not itself turn the result into a fact rather than a reasoned conclusion.

One exception is not left to judgement in the same way. Under LI 2025/19, the ESS start up concession safe harbour instrument, Method Two (the net tangible asset method) prescribes its own calculation instead: net tangible assets, disregarding preference shares, less the amount needed to discharge the preference share obligations, divided by the ordinary shares plus any preference shares that participate in residual assets on a winding up ¹. Where a company is eligible for, and chooses to use, Method Two, the instrument's formula replaces any of the three techniques above ¹; a company may instead use Method One or an alternative method, such as a valuation prepared for capital raising purposes, and remain protected if the value produced is not less than an approved method it was eligible to use ^{2, 3}. How ESS valuations work sets out when Method Two is available.

The waterfall at two assumed exits, worked through with fictional numbers, shows the mechanism.

Method Two asks a different question again, based on the balance sheet at a point in time rather than an assumed sale, and it applies its own fixed formula rather than a choice of technique; it only ever applies to the ESS start up concession's market value test, never to a shareholder transfer, a capital raise or any other purpose. How ESS valuations work works a Method Two calculation through with fictional numbers.

What are we actually valuing: the whole company, one class, or one parcel?

Once class rights are in the picture, the question "what is the company worth" is usually the wrong question, or at least an incomplete one. A valuation has to name the unit it is answering for, because each of the following is a different number:

• Enterprise value, the value of the startup's underlying operating business, before surplus cash, debt and debt-like items, and before any allocation across classes.
• Total equity value, enterprise value plus surplus cash, less debt and debt-like items, after deciding whether each SAFE or convertible note on issue is treated as debt or as converted; this is the figure allocated across the share classes.
• The value of one class, for example the ordinary shares as a class, taking into account every preference right, liquidation preference, participation, conversion and anti dilution, that ranks ahead of it.
• The value of a parcel, a specific shareholder's specific holding within a class, such as a founder's post vesting holding, which may also need to account for whether that holding is a controlling or a minority interest, and any transfer restrictions in the constitution.
• The value of an option or right, for example an employee's grant under the ESS start up concession, which depends on, among other things, the value of the underlying ordinary share and the exercise price the holder has to pay.

The unit also has to match the right basis of value for the purpose at hand. An ESS grant under the start up concession is tested against the market value of an ordinary share at the time the interest is provided ⁴. A shareholder transfer or exit is usually governed by whatever basis the constitution or shareholders' agreement itself defines, which can differ from market value. For most other tax purposes, market value takes its ordinary meaning, the price a hypothetical willing but not anxious buyer and seller would agree, at arm's length, at the valuation date, for the interest held, unless the particular provision defines it specially ⁵; for an ESS interest taxed outside the start up concession, an unlisted right may instead be valued under the regulations at the employee's choice, using the underlying unlisted share's market value as an input ^{6, 7}. Valuing one class or one parcel, rather than the whole company, is common work in its own right. Our founder share transfers and capital raise valuations pages set out the class and parcel questions each engagement asks first.

Does the ESS safe harbour value or a recent funding round set the ordinary share value instead?

Two related questions come up often enough to flag here, though each has its own guide. For the ESS start up concession, the relevant test is the market value of an ordinary share at acquisition ⁴. Method One does not prescribe a preference adjustment: it requires the CFO or a suitable valuer to take four matters into account on a reasonable basis, including uplifts and discounts for control premiums, lack of marketability and key person risk ¹, so how the preference stack is reflected is left to the valuer's reasoned judgement. Method Two applies its own fixed adjustment, as set out above ¹. Which method is even available also depends on conditions unrelated to the class rights themselves, including capital raised in the past 12 months, and both methods require that directors do not reasonably anticipate a change of control within 6 months ¹; see how ESS valuations work and our ESS and ESOP valuations service.

Where a round issues a preference class, its price relates to that class, not the ordinary class, and we have found no ATO rule that treats a round price as the market value of an ordinary share on its own ^{5, 8}. That gap is the allocation question this page addresses; what a recent funding round does and does not tell you works through how much weight a round carries once the gap is accounted for.

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