Participating vs. Non-Participating Preferred Stock
Q: What is participating preferred stock? What distinguishes it from non-participating preferred stock? Who prefers participating preferred stock, and who prefers non-participating preferred stock?
A: Participating preferred stock is preferred stock that entitles the holder to a specified preferential payment upon liquidation and a share in any remaining liquidation proceeds on an as-converted to common stock basis. For example, if a company that issued $1 million dollars in participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the participating preferred stock would be entitled to receive a $1 million liquidation preference (or more, if specifically agreed upon), plus 10% of the remaining proceeds available for distribution, for a total of $1.9 million. If the same company sold instead for $15 million, the participating preferred stockholders would be entitled to $1 million plus 10% of $14 million dollars for a total of $2.4 million in total distributions.
In contrast, non-participating preferred stock is preferred stock that only entitles the holder to the preferential liquidation payment and not a share in any remaining liquidation proceeds. Using the example above, if a company that issued $1 million dollars in non-participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the non-participating preferred stock would be entitled only to their $1 million liquidation preference, and the remaining $9 million in proceeds would be distributed to the other stockholders. Note however that if the company was sold instead for $15 million, the holders of non-participating preferred stock would typically elect to convert their holdings to common stock in order to receive 10% of $15 million, or $1.5 million, an amount greater than their liquidation preference.
Thus, from an investor’s perspective, participating preferred stock is preferable to non-participating preferred stock as it both allows for a preferred payment upon liquidation and participation in the upside if the Company is sold at a premium.
This article is not intended to be legal advice. You should always consult with an attorney before making an investment.