Many investors have heard of stocks, but don’t know the full range of stock types that exist. Participating preferred stock is one such type of investment that is worth exploring in detail. It is a type of preferred stock that gives the holder the option to receive dividends equal to or greater than the customarily defined rate at which preferred dividends will be paid to preferred shareholders. The holder can also receive an additional dividend depending on a predetermined condition. Participating preferred stock shareholders may also be eligible for liquidation preferences in the event of a liquidation.

 

To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.

 

Takeaways:

• Participating preferred stock is a form of preferred shares that entitles holders to receive dividends equal to or greater than the customarily defined rate for dividend payments. In addition, shareholders may be eligible for an additional dividend depending on predetermined conditions.
• Participating preferred stock is not as common as other forms of preferred stock, and is typically issued as part of a poison-pill strategy to respond to hostile takeover bids.
• These types of shares are different from other forms of preferred stock because they entitle shareholders to more rights than typical preferred stock holders, such as the right to participate in liquidation preferences or receive additional dividends.

What is Participating Preferred Stock and How Does It Work?

Participation in preferred stock grants the holder the right of a specific dividend distinct from common stockholders’ and received before common stockholders.

 

In addition, holders of participating preferred shares may be entitled to an additional dividend depending on predetermined conditions, such as the company’s profitability, or other performance metrics.

 

These types of shares are different from other forms of preferred stock because they entitle shareholders to more rights than typical preferred stock holders, such as the right to participate in liquidation preferences or receive additional dividends.

 

More precisely, the first dividend rate that owners of participating preferred shares get is equal to the rate or amount preferred stockholders obtain and receive another dividend determined by a condition in clauses of participating preferred stock.

 

Participating preferred stock is not as common as other forms of preferred stock, and is typically issued as part of a poison-pill strategy to respond to hostile takeover bids. If a company is in the midst of a hostile takeover, it may issue participating preferred stock to the target company’s shareholders in order to incentivize them to make other stockholders remain loyal and fend off potential acquisition attempts.

 

Understanding Participating Preferred Stock

Preferential stock, like other types of preferred stock, takes precedence in a company’s capital structure but ranks below common stock in liquidation events. Typically, the additional dividend to preferred shareholders in liquidation event will only be paid if the total dividends received by common shareholders exceed a specific per-share amount.

 

Participating preferred shareholders may also be entitled to the stock’s purchase price back and a pro-rata share from any proceeds the common shareholders receive in the event of liquidation.

 

If there is a liquidation, whether an investor’s preferred stocks are participating will affect the amount of consideration the preferred stock receives. This includes any dividends due to the investor and the liquidation value.

 

Participating preferred stockholders are entitled to any value left after liquidation, just like common stock. The preferred shareholders not participating in the liquidation will receive their liquidation value, any arrears unpaid dividends, if any, but no other consideration.

 

Although preferred stock participation is rare, it can be used as a poison pill. Current shareholders receive stock that allows them to purchase new common shares at a discounted price in the case of a hostile takeover bid.

Example of Participating Preferred Stock

Let’s say Company A issues preferred shares with a $1 dividend per share. A clause in the preferred shares provides additional dividends to participating preferred stock if the common share dividend exceeds the preferred share dividend. Participating preferred shareholders will also receive fixed dividend of $1.05 per share if Company A announces during the current quarter that it will pay a dividend for its common shares of $1.05 each ($1.00 + 0.0.05).

 

Consider a liquidation. Company A holds $10 million worth of preferred participating stock. This represents 20% of preferred participating stock outstanding the company’s capital structure. The remaining 80% (or $40 million) comprises common stock. The proceeds of liquidation for Company A are $60 million. Participating preferred shareholders would be eligible for 20% of the remaining proceeds and $10 million in cash. This amount would be $10,000,000, which is 20% x ($60million – $10million). Additional consideration would not be given to preferred shareholders who are not participants.

Participating in Preferred Stock

Venture capital firms and private equity firms typically use participating preferred stock. Venture capital and private equity firms are subject to significant risk in pursuing investments. Venture capital and private equity firms can hedge against the risks associated with investing by participating in preferred stocks.

 

Participating preferred stock can be used by companies to increase their valuation. Preferential shares typically have a lower cost of capital than common shares. Therefore, preferred shares can be used to reduce a company’s average weight cost of capital (WACC) and achieve a higher valuation.

 

Participating in preferred stock funding may also be the best option for a young company, such as a start-up because it provides large amounts of financing. Participating in preferred stock financing can increase the company’s top line, better research and development, and more efficient operation.

 

Participants vs. non-participating preferred stock

After liquidation preferences have been satisfied, what happens to the capital determines the difference between participating preferred stock and non-participating preferred stock.

 

Owners of non-participating preferred stock and participating preferred stockholders will receive liquidation preference. Common stockholders will not be paid, but creditors will.

 

After the liquidation preference has been satisfied for all participating preferred stockholders and capital remains, participating preferred stockholders can be treated as ordinary shares. They will then split the remainder profit on the basis that they are owners.

Bottom line

Participating preferred stock provides holders with special rights that are not available to common stockholders. This offers investors the chance to protect their investments if the company goes bankrupt and liquidates its assets.

 

It also gives them the right to receive a preferred dividend before common stockholders, and convert to common stock should they choose.

Participating preferred stocks can be a great tool for investing due to the multiple rights associated with them.

 

Overall, participating in preferred stock grants its holders certain special privileges, and can be an attractive investment option for those looking for more sophisticated ways of participating in a company’s growth.