Participating Preferred Stock Examples

Definition

Participating preferred stock is best characterized as stock that gives the shareholder the right to receive dividends that are equal to the ordinarily specified rate that the payment of preferred dividends takes place to preference shareholders and an additional dividend on the basis of a predetermined condition.

In other words, it is the preference share that gives venture capitalists a return on investment prior to the time the rest of the time that the remaining stockholders get their share earnings. It can also have liquidation preferences in the event of liquidation. A participating preferred stock can otherwise be referred to as participating preference share or participating preference stock.

In essence, a participating preference stock pays both preferred dividends and an additional dividend to shareholders. This additional dividend ensures that these shareholders receive a dividend that is equivalent to that of common shareholders. Also, the additional dividend paid to preference shareholders is mostly structured to be paid only in cases in which the amount of dividend received exceeds the specified per-share amount.

Oftentimes, this type of preference share is used in angel investment schemes when the investor desires a sure and quick return on investment on top of their company share in the venture. The equity of participating preferred stock comes first unlike common stock.

Like other forms of preferred stock, the participating preference share has more priority in a firm’s capital structure than common stock. However, it ranks below debt in an event of liquidation. Also in the event of liquidation, participating preferred shareholders also have the right to receive the purchasing price of the stock back as well as a pro-rata share of any remaining proceeds that the common stockholders receive.

Although the participating preferred stock is rarely issued, it is in one way used as a poison pill. Here, current shareholders receive stock that provides them the right to new common shares at a bargain price in the event of an unwanted takeover bid.

Participating preference stockholders can as well choose between two preferences in addition to receiving a specific dividend and receiving preference in the event of liquidation. These preferences are conversion preference and liquidation preference.

For the conversion preference, the participating preferred stockholder has the right to convert all their existing participating preference shares into common stock. On the other hand, for the liquidation preference, the shareholders gain the right to receive the capital they invested in the company first in the event of liquidation.

In an event of 2x liquidation preference, the participating preference shareholders would receive twice the amount of capital they contributed to the company if there are enough funds to meet this requirement.

Also, after the satisfaction of the liquidation preference and there is leftover capital from the liquidation, this leftover capital will then be rationed between the common stockholders and the participating preferred stockholders based on the assumption that all the participating preferred stocks will be converted into common stocks.

Participating preferred stock in practice

In practice, venture capital firms typically make use of the participating preferred stocks. Venture capital firms and private equity firms take on a significant amount of risk as they pursue investments. In this context, participating preferred stocks are a method in which venture capital and private equity firms have the ability to hedge against their portfolio risks as they carry out their investments.

Sometimes, companies make use of participating preferred stocks as a means of getting a higher valuation. Typically, the cost of capital for preference shares is lower than that of common shares. With this, the issuance of preference shares can be a method of lowering the weighted average cost of capital of a company in order to achieve a higher valuation.

Additionally, the funding that is achieved through participating preference shares may be the only large financing that is available to a company particularly if they are young, like a start-up. The financing that takes place from participating preferred stocks may bring about an increase in a company’s top line, enhancement in research and development, and more efficiency in operations.

Participating preferred example

Assuming Company X issues participating preference shares with a dividend rate of $1 per share. The preference shares also possess a clause on extra dividends for participating preference shares which are activated whenever the dividend for common stocks exceeds that of preference shares. During this quarter, if Company X announces the release of a dividend of $1.05 per share for its common stocks, this implies that the participating preference shareholders will receive a total dividend of $1.05 ($1.00 + $0.05) per share as well.

Now let us consider an event of liquidation. Company X has $10 million of participating preferred stocks outstanding which represents 20% of the company’s capital structure with the other which is 80%, or $40 million made up of common stock. The company liquidates and the proceeds are $60 million. The participating preferred stockholders would receive $10 million but would also have entitlement to 20% of the remaining proceeds, $10 million in this case (20 % x $60 million – $10 million). Nonparticipating preference shareholders would not enjoy this additional consideration.

Advantages of participating preferred stock

Advantages to the company

1. Usually, the company has no certainty with regard to its profitability and on tough days, it will not want to take the additional burden of shareholder voting and management decisions.
2. Generally, the dividend rate in the participating preference share is lower than that of preferred stock as the company gives its investor the option to involve in the distribution of profit above a preferred dividend rate.
3. In case the company incurs a loss in a particular year, there is a significant reduction in the burden of fixed dividends.
4. As earlier pointed out, this type of preference share allows a company to have a higher valuation than other avenues.
5. From the perspective of the venture capital fund, it is the fastest way of raising money as investors have extra confidence in the company and its operations.

Advantages to the investor

1. In the case of a loss-making year, that is a company running at loss in a particular year, investors still enjoy entitlement to a fixed dividend rate. In essence, holding this type of stock lowers investment risks in startups and company expansions. Here, if a company goes through liquidation and is unable to pay all the investors, the investors that hold the participating preference shares will get paid even if other investors do not.
2. In the case of a profit-making year, on the other hand, the investors can enjoy additional dividends as well as participate in the company’s profit. In essence, taking part in this stock option has extensions beyond fixed dividend payments such as earnings rights and liquidation rights. Earnings right gives the investor a guarantee of extra earnings above the dividend if the company earns a certain amount of profits. Liquidation right guarantees an investor a percentage of the sale amount.

Disadvantages of participating preferred stock

1. Participating preference shares may not include certain guarantees such as voting rights and power over sale decisions. This type of stock can also make use of cumulative stocks which implies that investors have little or no control over the choices of the company. Also, earnings from investing in the participating preference shares are being taxed at the rate of general income tax.
2. For investors to get more participating rights, they might want to go for the option of non-participating preference stock options. They will still get preferential stock as well as dividend payments, but not guaranteed return on investment. Still, if the value of the company increases over time, these investors will get more money back than those with participating preferred stock.
3. It is very rare for companies to issue participating preferred stocks and this is usually employed as an antibody to thwart hostile takeover efforts. There are other regulatory aspects that could also be the force driving the issuance of participating preferred stocks. In some cases, institutional investors prefer participating preference shares because of favorable tax treatment.

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