What are Participating Preferred Shares?

Participation rights give the shareholder the right to participate, along with other shareholders (the entrepreneur), in receiving any distributions from the sale of the business or other exit event. 

The participating stockholder receives a percentage of the funds distributed that is equal to her percentage of equity ownership in the business. Participation rights generally arise in the context of a liquidation preference.

 If the investor reserves a liquidation preference, she may also demand the right to participate along with other shareholders in any distributions above the amount of the liquidation preference.

• Example: Tom invests $10 in Mikes business with a 5x liquidation preference. He also gets equal participation rights with Mike. The business sells for $200. Tom will get $50. Mike and Tom will split the remaining $150 ($75 each).

The terms of the liquidation preference may allow the entrepreneur to catch up before the investor receives any amount above the liquidation preference.

• Example: If Mike had catch-up rights then Tom would receive $50, Mike would receive $50. Tom and Mike would then participate equally in the remaining $100 of proceeds ($50 each).

While participation rights are often combined with a liquidation preference, an unlimited participation right is generally seen as overly generous to the investor and is frequently capped. As such, the participation rights will generally have a cap at a negotiated amount.

• Example: In the first scenario above, if Toms participation rights were capped at $50, the distribution of proceeds would be 1) Tom would receive the first $50 as his liquidation preference, 2) Tom and Mike would participate equally up to $100 ($50 each), 3) Mike would receive the remaining $50 (as Tom reached his participation cap).

Example of Participating Preferred Stock

Let's say company A issues the participating preferred shares having dividend rate of $1 a share. The preferred shares bear a clause on additional dividends for the participating preferred stock that is triggered whenever dividend of common share will surpass the preferred shares.If, in the current quarter, the company makes an announcement to issue dividend of $1.05 per share for its shares, while the participating preferred shareholders will also get a dividend of $1.05 a share. 

Now let's think of a liquidation event. Company A possesses $10 million of preferred participating stock outstanding, which represents 20% of the capital structure of the company with the other 80%, or $40 million, consisted of common stock. Company A liquidates, and the proceeds are $60 million. The participating preferred shareholders will get $10 million but also would get 20% of the remaining proceeds, $10 million in this case (20% x $60 million - $10 million). Nonparticipating preferred shareholders will not get any additional consideration.