Participating Preferred Stock: Everything You Need to Know
Participating Preferred Stock is a security that gives venture capitalists a return on investment before the rest of the stock holders get their share earnings.4 min read
What Is Participating Preferred Stock?
Participating Preferred Stock is a security that gives venture capitalists a return on investment before the rest of the stock holders get their share earnings. It is often used in angel investment schemes when the investor wants a sure and quick return on their investment on top of their company share in the venture. Unlike common stock, the equity of participating preferred stock comes first.
Why Is Participating Preferred Stock Important?
This stock option is important for venture capitalists because it lowers their investment risks in startups and company expansions. It also protects them if a company goes through liquidation and cannot pay all the investors. Those holding participating preferred stock will enjoy preference and get paid even if other investors or lenders do not.
There are different types of participating preferred stock, and in some cases the company caps the guaranteed amount at a percentage of the company value or participation. When companies seek investment from venture capitalists, they often offer this stock option.
Participation in this stock option is extended beyond fixed dividend payments, such as earnings rights and liquidation rights. Earnings rights guarantees extra earnings above the dividend if the company makes a certain amount of profits. Liquidation rights, a certain percentage of the sale amount is guaranteed for the owner of participating preferred stocks.
Reasons To Consider Using Participating Preferred Stock
One of the benefits for venture capitalists is the guarantee of earning rights. This means that if the company makes a certain amount of profit, the investor will receive their share of it as well as the dividend earned on the purchased shares. Secondly, investors gain liquidation rights, which means that a pro rata percentage of the sale proceeds will go to the investor if the company is ever liquidated.
By offering participating preferred stock, the company is more likely to raise funds and capital. While this choice is rarely issued, it is a form of guarantee that encourages people to buy the company's stock.
Reasons Not to Use Participating Preferred Stock
Participating preferred stock may or may not include guarantees, such as voting rights and power over sale decisions. This stock type could also use cumulative stocks, which means that investors have little or no control of the company's choices. Further, earnings from these investments are taxed at the rate of general income tax.
To get more participation rights, investors might want to get non-participating preferred stock options. They will still get preferential stock and dividend payments, but not guaranteed return of investment. Still, if the company's value goes up over time, these investors will get more money back than those with participating preferred stock.
Examples of Using Participating Preferred Stock
Let us assume that a company has invested $3 million into a venture. It represents 30 percent of the value of the firm. If someone buys the company for $30 million, the company gets its $3 million back plus the 30 percent of the remaining value. In other words, the company makes more money this way than by having common options. If the company sells for $10 million, it still gets its $3 million back.
It is best to buy participating preferred stock when the company is likely to have above-average growth and earnings and be sold at a large profit. In cases when high earnings are not likely, other choices might be better for venture capitalists. Further, investment experts state that issuing participating preferred stock might devalue companies' common stock, which means that venture capitalists get more out of it than the company.
Common Mistakes Related to Participating Preferred Stock
An overly positive outlook of the company might make founders issue participating preferred stock options too soon. This might discourage other common investors to capitalize the company, as preferred stock holders hold a priority in dividend and liquidation payouts.
Participating preferred stock agreements are complicated and can have hidden closures that hurt either the investor or the company. You should consult an investment and capital attorney before choosing stock options to avoid confusion and legal battles.
In some cases, participation rights are only triggered over a certain earning or capital threshold. This gives investors a false sense of security.
Business founders often do not properly judge their exit size or the amount the company will sell for after years of trading. If the exit size is likely to be small, participating preferred stock makes little or no difference. If it is big, it can encourage investment from venture capitalists looking for guaranteed high returns.
Frequently Asked Questions
- What is the difference between participating and non-participating preferred stock?
Participating preferred stock owners get back their investment and the dividend on their share when the company is liquidated. Non-participating preferred stock owners, however, are only entitled to their first investment, or the pro-rata sales proceeds, whichever is greater.
- What is Capped Participating Preferred Stock?
It is a preferred stock option that is capped at the percentage of the company value or investment. It is often used to cut the risk for other non-participating investors' risk
- What Happens if the Company is Sold at a Loss?
The participating preferred stock holder would still get their investment back.
- What is the preferred stock for common shareholders, such as employees?
Employees and common shareholders usually have non-participating preferred stock.
- Does Participating Preferred Stock encourage investment?
In some cases, it does. However, it only attracts venture capitalists and can devalue common stock.
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