Participating Preferred Stock: Definition & Benefits

Participating preferred stock gives the holder the right to a specific dividend which is separate from the dividends common stockholders receive and is also received before common stockholders. It is a clause that also gives preferred stock holders priority of accumulated dividends over common stockholders in the event that the underlying asset is faced with a liquidity eventLiquidity EventA liquidity event is a process by which an investor liquidates their investment position in a private company and exchanges it for cash. The main purpose of a liquidity event is the transfer of an illiquid asset (an investment in a private company) into the most liquid asset – cash..

More specifically, the dividend that participating preferred stockholders receive is equal to the amount or rate that preferred stockholders receive and obtain another dividend that is determined from a condition in the clauses of the participating preferred stock.

In addition to receiving a specific dividend and being given preference in liquidation events, participating preferred stockholders can also choose between two preferences: the optional conversion preference or the liquidation preferenceLiquidation PreferenceLiquidation preference determines the order in which a bankrupt firm’s liquidated assets are paid out to claimants of the firm. mentioned above.

For the optional conversion preference, the participating preferred stockholder owns the right to convert all of their existing participating preferred shares into common stock. Whereas for the liquidation preference, participating preferred stockholders are given the right to receive the capital they invested into the company first during a liquidity event.

In the case of a 2x liquidation preference, the participating preferred stockholders would get twice the amount of capital they contributed to the company (assuming there are enough funds to satisfy this requirement).

Also, after the liquidation preference is satisfied and there is leftover capital from the liquidation, the leftover capital will be shared between the common stockholder and the participating preferred stockholders under the assumption that all participating preferred stocks would be converted into common shares.

Participating Preferred Stock in Practice

In practice, participating preferred stocks are typically used by venture capital firms and private equity firms. Venture capital firms and private equity firmsPrivate Equity FundsPrivate equity funds are pools of capital to be invested in companies that represent an opportunity for a high rate of return. They come with a fixed take on a significant amount of risk when pursuing investments. Participating preferred stocks are a method by which venture capital and private equity firms can hedge against their portfolio risks when investing.

Companies sometimes use participating preferred stocks as a method to get a higher valuation. Typically, the cost of capital for preferred shares is lower than that of common shares; thus, issuing preferred shares can be a method of lowering a company’s weight average cost of capital (WACCWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt.) in order to achieve a higher valuation.

In addition, the funding achieved through participating preferred stocks may be the only large financing available to a company if they are particularly young, like a start-up. The financing from participating preferred stocks may lead to an increase in the top line of a company, enhanced research and development, and more efficient operations.

Participating Preferred Stock vs. Non-Participating Preferred Stock

The difference between participating preferred stock versus non-participating preferred stock boils down to how the capital after the liquidation preferences are satisfied, is distributed. Both participating preferred stockholders and non-participating preferred stockholders receive liquidation preference and will be paid out after creditors but before common stockholders.

However, after the liquidation preference is satisfied for both participating and non-participating preferred stockholders and there is leftover capital, the participating preferred stockholders will be treated as if their shares are common shares and split the remaining profit with the common stockholders on the basis of ownership.

Summary

• Participating preferred stock gives the holder the right to a specific dividend.
• Participating preferred stockholders are entitled to a liquidation preference, which allows them to receive a multiple of their investments before distributions are made to common stockholders in liquidation events.
• Participating preferred stockholders also can choose to convert their shares into common stock.
• Non-participating preferred stock differs from participating preferred shares as participating preferred shares are treated as common shares after liquidation preferences are satisfied.

Additional Resources

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