Participating vs Non-Participating preferred stock

Stocks are the rewarding and best tool to leverage money. It makes the best use of your savings, it multiplies the money and protects it from inflation and taxes. In this article, I will help you to understand Participating vs Non-Participating preferred stock.

An investor has two choices to invest their money i.e Common Stocks and Preferred Stocks. The most usual choice is Common stocks as their essentials are easy to understand and apply.

Whereas Preferred Stocks are the most remunerative and lucrative investment tool in the market. It is also known as Preference shares, Preferred, or Preferred shares.

As the name says, preferred shareholders have greater preference over common shareholders. 

Preferred shares have higher seniority than common shares. Also, Preferred shares have lower seniority than bonds while claiming company assets. 

Preferred have a combination of unique features that sets them apart from common stocks. They are as follows:

Liquidation Preference: 

This is the most predominant feature in Preference shares. The holders get high priority while liquidating the company’s assets over common stockholders.

Dividend preference:

Preferred have a higher primacy while payment of dividends as in contrast to common stockholders.

Non-voting:

Assigning of preferred stockholders takes place without voting rights on corporate issues.

Call ability:

It refers to the ability of a corporation to redeem the shares before it matures at specified dates.

Convertibility:

It implies converting a set number of preference shares into a common share. 

Categorization of unique features of Preferred Stocks as :

• Cumulative & Non-Cumulative Preferred Stock: 

Cumulative preferred implies that if the issuer of shares misses any payment of dividends it will get added to the next payment of dividends. Also, for Non-Cumulative preferred further payments do not include the missing payments.

• Convertible & Non-Convertible Preferred Stock:

Convertible Preferred Stocks have convertibility quality which allows a set of numbers to exchange. This takes place with common shares of the company. Conversion of common shares to Non-Convertible Preferred Stocks never takes place.

• Exchangeable Preferred Stock:

Some security choices helps in the exchange of preferred stocks.

• Perpetual & Putable Preferred Stocks:

Issuance of perpetual preferred is without a redemption date or fixed date for repaying of the invested capital. 

• Participating & Non-Participating Preferred Stocks:

These are the most important criteria of preferred stocks. These preferred are categorized based on liquidation preference.

The purpose of this guide is to give deep insights into the Participating & Non-Participating Preferred Stocks. This will help you in decision-making while investing in the market. 

So let’s proceed,

•  Non-Participating Preferred Stock:

Non-Participating Preferred Stocks entails the shareholders to have preferential rights or high priority. This happens during liquidation or dividend payment. 

They receive a total amount which is equal to the initial investments plus accrued and unpaid dividends.

However, they will not enjoy a share of the surplus profits of the company.

The distinctive features of Non-Participating Preferred stocks are as follows:

• It has a fixed rate of dividends.
• Shareholders cannot enjoy the benefits of share in the company’s surplus profits.
• Limitations up to a maximum amount for each year in dividends.
• If the Article of Association is silent, then the Preferred Stocks are presumed to be non-participating.

Example of Non-Participating Preferred Stocks:

A Company has issued 10,000 shares with $1 million invested in preference shares for $100 par value. Let’s assume the liquidation preference to be “1x” & the company is sold for a value of $10M.

So the Non-Participating Preferred Stockholders receives:

1x of Sold Value $10M= $1M

The remaining $9M gets distributed to other Shareholders.

Thus, the Non-Participant Preferred will get only $1M+Accrued+Unpaid Dividends. So, They cannot enjoy the share in the remaining liquidation proceeds that stay with common stockholders. 

• Participating Preferred stock:

Participating preferred stockholders enjoy the same priority of being higher seniority during liquidation or dividend payment. 

The holder of this stock receives an initial investment amount plus accrued and unpaid dividends. 

Along with this, as a “participants” in common shares, they are beneficiaries of an additional dividend and a share in the surplus profit of the company. 

The distinctive features of Participating Preferred stocks are as follows:

• Shareholders enjoy a share in the surplus profits of the company.
• The dividend fluctuates depending on various conditions.
• Generally, the Article of Association includes Participating Preferred Stocks.
• This type of stock is rarely issued except for its use as a Poison pill in the market to protect it from getting acquired. 

The Participating Preferred stocks as two types. They are as follows:

• Partially Participating preferred stock:

The partially participating preferred holders can participate with common stockholders. This should be at a rate that is above the mentioned preferential rate on a pro-rata basis. 

Also, this should be without exceeding the rate specified on the stock certificate.

For eg: The Preferred Stock is issued at a 6% rate and allowed participation mentioned in Stock Certificate is 10%. Thus, the holder is entitled to receive a privilege that is limited to 4%.

• Fully Participating preferred stock:

The fully participating preferred holders enjoy a preference for the current year. This is at the predetermined preference rate. They also receive dividends above the preferred rate on a pro-rata basis.

For eg: A fully participating preferred stockholder receives payment at its 6% preference rate. This also involves additional dividends on a pro-rata basis of the total par value of the common stock.

So, two financial terms include Participating Convertible Preferred Stock & Participating Cumulative Preferred Stock.

• Participating Convertible Preferred Stocks (PCP): 

The PCP shareholder has the right to swap their preferred with common shares. This is as per their discretion along with additional key benefits with purchasing preference share. For eg: Liquidation preference, Dividend preference, etc

• Participating Cumulative Preferred Stocks:

In case of missing dividends, the shareholders of these stocks will receive all the cumulative or unpaid dividends. Hence, this will take place along with the current dividend on the first basis. 

Examples of Participating Preferred Stocks:

A Company has issued 10,000 shares with $1 million invested in preference shares for $100 par value. Let’s assume the liquidation preference to be “1x” & the company is sold for a value of $10M.

So the Participating Preferred Stockholders receives:

1x of Sold Value $10M= $1M

The remaining $9M is divided between the common stock and the preferred stock. This takes place on a pro-rata basis (50/50 in this case). 

Thus, Common Stockholder receives: $4.5M

Preferred Stockholders receive (only if they convert to common stocks): $4.5M + $1M i.e $5.5M in total.

Thus Participating Preferred enjoy double-dipping into the proceeds pool.

The liquidation preference protects the investor’s rights. On contrary, participating in liquidation preference led to some disadvantages in favor of entrepreneurs. Thus Caps is applied to protect an entrepreneur’s interest in issuing participating preferred.

The Cap is typically set as a multiple of the investment. Typically, the payout caps are around ‘2x-3x’ of the investment amount. 

For Example, A participating preferred stockholder has an initial ‘1x’ liquidation preference and ‘2x Cap’. 

So, an investor investing $1M with participating liquidation preference of ‘1x’ on ‘2x’ cap will receive up to $2M in total proceeds. This will take place only if they don’t convert to common stock.

An investor has to convert fully to common stocks to avail of a payout higher than the capped payout. Thus, caps establish a conversion gateway for the participant preferred holders.

So, this also helps to make them choose a single payout thus protecting entrepreneurs. 

The difference between Participating vs Non-Participating preferred stock:

Understanding the Preferred Stock Term Sheet:

A Preferred Stock Term sheet includes all detailed terms and conditions for venture capital financing.

It provides in detail provisions about varied Control rights and a blueprint for the Financial and economic terms. These terms are such as valuation/purchase price, dividends, liquidation preference, anti-dilution protection, etc.

Hence, check out this definitive guide, to understand its every parameter and to create your Term sheet

To Sum Up:

Issuance of the Preference Stocks takes place as non-participating preferred shares. Remember, participating preferred is rarely issued. Many founders face the risk of paying out large scales of sales proceeds to investors.

Thus, the founders should be fully aware of the possible implications of issuing participating preferred stocks. So, they can also negotiate for a capped participating preferred to avoid higher payouts.

Alcor Fund has a network of 5000+ investors to help founders get funding for the startup and build their business idea. 

You can also use our Venture Capital Pre Screening Assessments to evaluate your business and this will also help you in getting funding for your business in just 5 steps.

Let’s build a successful startup with Alcor Fund.