What is Participating Preferred Stock?
How Does Participating Preferred Stock Work?
The capital stock structure of a company is typically divided into two main groups: common stock (usually ownership by management, employees, and directors with voting rights), and preferred stock. Preferred stock is composed of a variety of types, as well. Among them are convertible preferred stock (which allows the stock holder to convert to common stock at a set price or after a certain point in time) and participating preferred stock.
Participating preferred stock is a method of conferred equity interest in a company that gives a specific return on the investment (usually deferred until it is exercised) in addition to the value of the shares themselves. In addition, similar to other preferred shares, the distribution of proceeds from dividends or liquidations is given to the preferred shareholders before anything is distributed to common shareholders.
The structure of participating preferred stock may differ from deal to deal. However, it usually takes the form of a preferred stock position at a designated valuation of the company in addition to an accrued interest on the investment itself. For example, the investor receives interest from the "note" to the company as well as equity through a stock position in the company.
Why Does Participating Preferred Stock Matter?
Using a participating preferred stock structure enables a company to set a slightly higher valuation and gives the investor a set return on his investment. This targeted return is useful for venture capitalists, for example, who typically have specific investment thresholds which can meet with the accrued interest. This structure is also useful for young companies who are not yet ready for large-scale venture capital funding and need some early stage funding from venture capitalists to act as a "bridge" without having to give up control of too much of the company.