Participating Preferred Stock
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Participating preferred stock is capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. It is used by private equity investors and venture capital firms but not very often. Holders of participating preferred stock get both their money back (with interest) and the money that is distributable with respect to the percentage of common shares into which their preferred stock can convert. Participating preferred allows VCs to give founders a valuation that appears much higher - its somewhat a dirty game that investors try and play with founders. Participating preferred stock is rarely issued because it creates misaligned incentives and complexities between the investors and the promoters. It leaves a bitter taste in the mouth of founders at the end of the deal.
Like common stock, preferred stocks represent partial ownership in a company, preferred stock shareholders may or may not enjoy any of the voting rights of those holding common stock. Also unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate. Often the dividend is accumulated. If the company is unable to pay this dividend should it lack the financial ability to do so, the preferred shareholders may have the right to force a liquidation of the company.
Venture Capitalists typically want to get participating preferred stocks in the deals. Typically, no one takes participating preferred for all valuations. Some firms would do it only upto the valuation that meets their minimum hurdle rate (like 20%). If some firm is trying to take participating preferred stock for all valuations, either you are having a down round or the investor is trying to bully his way in. Most top US VCs do not try to impose participating preferred because when they invest they believe in the business. Tier 2 & tier 3 VCs would try and do that so they could make a lot more money when the business even grows slightly. Avoid VCs who take participating preferred without any valuation cap.
Participating preferred can backfire in a manner similar to a high jump in which the bar is set so high that the jumper doesn't even really try. In one recent situation it became clear that the value of the company was not large enough to provide any meaningful return to management and after much hand wringing the investors waived the participating preference so that management had some incentive to work to sell the company.
The main benefit to owning preferred stock is that the investor has a greater claim on the company’s assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before the holders of common stock. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible.
