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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 Mike’s 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 Tom’s 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).