Participating preferred stock increases the return to investors holding preferred stock on a sale of the company. After payment of the liquidation preference (their money back), the investors with participating preferred will share in remaining sale proceeds on an as-if converted to common stock basis.
Participating preferred stock increases the returns to investors on a sale of the company.
If the liquidation preference is non-participating, it means that it is capped at the “up front” amount, so the investors holding Preferred Stock have “down side” protection in a distressed sale of the corporation, but the “up side” of owning the preferred is limited. See related blog post Term Sheet 101: The Liquidation Preference. The Preferred Stock is convertible into common stock, however, so the investors do have unlimited up side on the investment if they convert to common stock. When investors convert their preferred stock into shares of common stock, however, they forego the liquidation preference on their shares of preferred stock and share in sale proceeds on a pro rata basis according to their ownership of common stock (assuming conversion of the preferred stock).
Non-Participating Preferred Stock
Here is an example of preferred stock that is not participating preferred. Suppose that the investors put in $1MM for 25% of the corporation. If the corporation later sells for $2MM, the investors would want their money back through the liquidation preference and take 50% of the sale proceeds. This is how the liquidation preference provides “down side” protection. Even though the investors only own 25% of the stock, they receive 50% of the sale proceeds payable to the stockholders of the corporation.
If the corporation were sold for $8MM, however, the investors would be better off converting their preferred shares into common shares and taking 25% (their pro rata amount) of the total, and so $2MM. In this scenario with a non-participating preferred, the inflection point for converting to common stock is a sale that will yield $4MM to the stockholders of the corporation. At $4MM, keeping the liquidation preference or converting to common would produce the same result.
Participating Preferred Stock
With participating preferred, the investors enjoy both the liquidation preference (their money back first) and the up side of owning the shares of common stock issuable upon conversion of the preferred, sometimes called the underlying common shares or the “common stock equivalents” (CSEs). The investors in the $8MM sale scenario would receive their liquidation preference of $1MM, and then would “participate” (share) with the holders of common stock on an as-converted to common stock basis on the remaining $7MM and so receive $1.75MM of the remaining proceeds (25% * $7MM), for a total return of $2.75MM. Whether the preferred is participating can have a significant impact on how the pie is divided between preferred and common stockholders upon a sale of the corporation. For a additional information about how investors’ legal terms of preferred stock affect the economic returns of preferred and common stockholders, see related blog post Less Risk, More Reward
Capped Participating Preferred
Another wrinkle: sometimes the participation feature on participating preferred stock will be capped. So, for example, the investors get their money back first, then participate with the common stockholders until they have received a total of [2X - 5X] their investment, but then participation would stop. Illustrating this example if the investors had participation up to 3X of their investment, assuming the same scenario, if the corporation were sold for $10MM, the holders of Preferred Stock would receive $1MM “off the top” and then take 25% of the remaining $9MM, or 2,250,000. Add that to the $1MM off the top, and the sum is $3.25MM. Because that number exceeds the cap, however, the liquidation preference would be limited to $3MM. At a $10MM exit for the stockholders, this liquidation preference is still better than converting to common stock and taking 25% of the whole (which, at a $10MM exit, would yield $2,500,000). In fact, the inflection point for converting to common is now a $12MM exit, where a liquidation preference on participating preferred with a $3MM cap and 25% of the total balance out. Over $12MM, the investors would convert to common, forego their liquidation preference and take their pro rata share of the sale proceeds.
To play “what if” with different liquidation preference provisions, including unlimited participating preferred and participating preferred subject to a cap, download Bo’s Liquidation Preference Calculator.