Participating Preferred Stock

Participating preferred stock is a type of preferred stock that gives its holders two layers of return. First, they receive their stated preferred dividend, or their liquidation preference in a sale or wind-up, ahead of common shareholders. Second, they "participate" in any further dividends or proceeds alongside common stock holders, as if they also owned common shares. Ordinary, nonparticipating preferred stock receives only its fixed amount, no matter how profitable the company becomes.

Participating preferred stock is rare among listed companies but common in venture capital and private equity deals, where investors use it to secure both downside protection and upside in an exit. Its terms are negotiated in a term sheet and set out in the company's charter.

In the classic textbook form, participating preferred receives its stated dividend first. Common shareholders then receive a dividend at the same rate on their par value or per share, and any remaining amount is shared between both classes in proportion to their par values or share counts. Participation can be full, with no limit, or partial, capped at a maximum total return.

Suppose a company has 10,000 shares of $100 par, 6 percent participating preferred stock (total par $1,000,000) and 40,000 shares of $25 par common stock (total par $1,000,000). The board declares $200,000 of dividends.

• Preferred receives its 6 percent: $60,000.
• Common receives a matching 6 percent of its par: $60,000.
• The remaining $80,000 is shared in proportion to par, here 50:50: $40,000 each.

Preferred holders receive $100,000 in total and common holders $100,000. Nonparticipating preferred would have received only $60,000, leaving $140,000 for common. If the preferred is also cumulative, any dividends in arrears are paid first, as with cumulative preferred stock generally.

In venture deals, participation usually applies to exit proceeds rather than dividends. A fund invests $5,000,000 for preferred shares with a 1x liquidation preference that convert into 25 percent of the company. If the company is sold for $25,000,000:

• With nonparticipating preferred, the investor chooses the better of its $5,000,000 preference or converting to 25 percent of $25,000,000, which is $6,250,000. It converts and takes $6,250,000.
• With fully participating preferred, the investor first takes $5,000,000, then 25 percent of the remaining $20,000,000, which is another $5,000,000, for a total of $10,000,000.

Common holders, typically founders and employees, receive $15,000,000 instead of $18,750,000. Because of this "double dip," founders often negotiate a participation cap, for example limiting the investor's total to three times its investment, after which it would convert to common instead.

Participating preferred stock is presented in equity, or under US GAAP in temporary equity outside permanent equity if it is redeemable at the holder's option or on events outside the company's control. For earnings per share, ASC 260 requires the two-class method: undistributed earnings are allocated between common stock and participating securities according to their rights, so participating preferred reduces the earnings available to common shareholders. Unvested share-based awards that receive nonforfeitable dividends are also treated as participating securities. Other common features of preferred shares, such as conversion rights, are described in the entry on convertible preferred stock.