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.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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