Participation Rights & Caps
In some cases, the investor will negotiate for the ability to participate with common shareholders in the distribution of proceeds after receiving the liquidation preference. That is, the investor is paid the full liquidation preference, then they participate with common shareholders in receiving a percentage of the remainder of proceeds from the sale or exit event. The percentage of participation is generally based on the ownership percentage represented by the preferred shares. The common shareholders are generally allowed to “catch up”, meaning that they receive an amount equal to the liquidation preference before the preferred shareholder participates in distribution of any remaining proceeds. This is obviously a very advantageous provision for investors. The advantage is slightly limited when a cap is placed on participation rights. This means that once the a preferred shareholder receives a certain amount or given percentage of proceeds, participation stops. Without caps on participation rights, it would never be advantageous for a shareholder owning participating convertible preferred to voluntary convert her shares to common shares. This only takes place when the total distribution to the preferred shareholder would be greater if he simply received the a distribution based on his ownership percentage in the company, rather than the liquidation preference plus capped participation amount.