Participating Preferred Stock: A Guide to Double Returns

Have you ever wondered how venture capitalists protect their investments and still make a good return?

Participating preferred stock is one way they can do both. It’s commonly used in startup deals, but it can also affect the founders in important ways.

In this article, we’ll look at how it works, why it matters, and what it means for both investors and founders.

What is Participating Preferred Stock?

Participating preferred stock is a type of equity that gives investors both a fixed return and a share in any remaining profits.

This unique structure provides two main advantages:

1. Investors get paid first if the company is sold or liquidated.
2. They also share in any leftover profits with common stockholders.

In practice, this means participating preferred stockholders recover their initial investment before common stockholders receive anything. After that, they can still take part in any remaining profits, which can potentially double their returns.

This combination makes it an appealing choice for investors seeking both security and growth.

Key Features of Participating Preferred Stock

Participating preferred stock has several distinctive features that set it apart from other equity types.

1. Dividend Rights: Holders of participating preferred stock receive dividends before common stockholders, ensuring an income stream even if the company does not pay dividends to common shareholders.
2. Liquidation Preference: In the event of liquidation, participating preferred stockholders receive their initial investment back first, often with a multiple (e.g., 2x the original investment), providing a safety net.
3. Conversion Rights: Participating preferred stockholders may have the option to convert their shares into common stock, depending on the company’s future performance or other strategic decisions.

After years of analyzing venture capital trends, I’ve observed that participating preferred stock remains a powerful tool for maximizing returns.

Double-Dip Returns

One of the most attractive aspects of participating preferred stock is the potential for double-dip returns.

After receiving their initial liquidation preference, participating preferred stockholders can also participate in any remaining proceeds alongside common shareholders. This setup gives investors both priority and the chance to benefit from any extra value created by the company.

For example:

In a company liquidation where $10 million in assets are distributed, after paying $5 million to debt holders, participating preferred stockholders could first receive a specified liquidation preference (e.g., $2 million).

The remaining $3 million would then be shared among both common and participating preferred stockholders, allowing for additional gains.

Caps and Limits on Participation Rights

While double-dip returns are a significant advantage, participation rights often come with caps or limits to balance the interests of all stakeholders. The liquidation preference may be set as a fixed amount or multiple (such as 2x), capping the maximum payout participating preferred stockholders receive before common shareholders. In fact, approximately one-third (33.3%) of financings with participating preferred shares included caps on participation rights, showing how these limits are frequently used to ensure a fair distribution of value.

Once the cap on liquidation preference is satisfied, any remaining proceeds are then distributed pro-rata among all shareholders, ensuring a fair distribution of the company’s value. Additionally, if participating preferred stockholders have the option to convert to common stock, it can further impact the distribution of ownership and returns, potentially diluting the share of common shareholders.

Case Study: Participating Preferred Stock in Action

U.S. Government’s Use of Participating Preferred Stock in Bank Bailouts

During the 2008 financial crisis, the U.S. government employed participating preferred stock as part of its strategy to stabilize struggling banks under the Troubled Asset Relief Program (TARP).

Through TARP, the U.S. Treasury injected billions of dollars into banks in exchange for participating preferred stock. This approach allowed the government to provide immediate financial support to banks while also giving it a stake in any future recovery. If the banks rebounded, the government would benefit from priority payouts and a share in the profits, making it a strategic choice in high-stakes financial interventions.

This example illustrates how participating preferred stock offers both security and upside potential, demonstrating its flexibility and appeal in crisis management.

Ford Motor Company’s Restructuring with Preferred Stock

While not specifically participating preferred stock, Ford’s use of preferred stock during the 2009 recession is another example of how companies utilize preferred equity in challenging times.

Ford issued Series A preferred stock, convertible into common stock, with a high dividend rate to attract income-focused investors. This move provided Ford with crucial capital, helping it avoid bankruptcy. As the company recovered, the preferred shares were later converted into common stock, benefiting both the company and its investors.

Though this case involves standard preferred stock, it shows the power of preferred equity to attract capital and support a company’s recovery, much like participating preferred stock’s role in balancing immediate security with potential future gains.

These examples highlight the flexibility and benefits of preferred stock, including participating preferred stock, in various situations—from stabilizing financial institutions to supporting corporate restructuring during economic downturns.

Founder Challenges and Negotiation Strategies

Participating preferred stock can significantly impact founders’ control and potential financial gains. While this type of equity is attractive to investors, it often comes with trade-offs for founders who must balance securing funding with retaining influence over their company.

Impact on Founder Economics

Founders face specific challenges when dealing with participating preferred stock, including:

• Ownership Dilution: Participating preferred stock increases ownership dilution, meaning founders may see their influence in the company reduced.
• Reduced Payout: With investors receiving priority payouts and benefiting from double-dip returns, founders often receive a lower share of proceeds in a sale or liquidation.
• Financial Trade-Offs: To attract investment, founders may accept participation rights, which can limit their upside potential in favor of security for investors.

Another risk, as noted by Greg Miaskiewicz of Capbase, is that “participating preferred stockholders will receive a higher payout in the event of a liquidation or sale of the company, which can significantly reduce the amount of money that founders and common stockholders receive.”

Negotiating Participation Rights

Having collaborated with numerous startups, we understand the critical importance of negotiating participation rights in VC deals. When negotiating participation rights, founders must be strategic, as VCs look for strong leadership traits, which often correlate with a company’s long-term success.

Founders who can execute these negotiations effectively are better positioned to secure favorable terms, including:

• Caps on Liquidation Preference: Setting a maximum multiple on liquidation preference can limit investor returns to a fair level, preventing excessive payouts before founders see proceeds.
• Limits on Participation Rights: Caps on double-dip rights help ensure that founders retain a meaningful share of any remaining proceeds.
• Board Representation and Voting Rights: Negotiating for board seats or voting control allows founders to maintain influence over major decisions, even as they secure investor funding.

In short, founders must carefully weigh these financial and control implications, using negotiation strategies to align both investor interests and their vision for the company’s future.

The Global Perspective on Participating Preferred Stock

With extensive experience in the venture capital landscape, we’ve seen that, while the fundamentals of participating preferred stock are consistent, its terms can differ based on regional market conditions.

For example, in the United States, it’s commonly used in venture capital deals, often offering strong participation rights to investors. European markets may be more founder-friendly, with more balanced equity structures, while Asian markets often put more emphasis on long-term business relationships, sometimes leading to different participation rights terms.

Over time, these regional differences have shaped how participating preferred stock is structured, but the core concept remains a key part of modern venture capital financing.

Frequently Asked Questions

What is the difference between preferred stock and participating preferred stock?

Preferred stock generally provides investors with priority in receiving preferred dividends and liquidation payouts over common stockholders, but it doesn’t usually allow them to share in remaining profits. Participating preferred stock offers an added benefit—it allows investors to receive their initial return and still participate in any remaining profits after other obligations are met.

Why would founders agree to issue participating preferred stock if it limits their returns?

Founders might choose to issue participating preferred stock because it attracts investors by offering both security and upside. This can be especially helpful in securing funding from venture capitalists and other investors who prioritize financial protection. While it may limit founders’ financial share, the investment it brings can provide critical support for growth and stability.

What happens to participating preferred stock in a merger or acquisition?

In a merger or acquisition, participating preferred stockholders typically receive their liquidation preference first, as agreed upon in the investment terms. After this payout, they may also participate in any additional proceeds. The exact terms can vary depending on the specific rights and limits negotiated in the original investment agreement.

How does participating preferred stock affect a company’s valuation?

Participating preferred stock can influence a venture capital valuation by lowering its weighted average cost of capital (WACC), as it appeals to risk-conscious investors. This lowered cost can make the company more attractive to a wider range of investors and increase its valuation in the long run.

Conclusion

Participating preferred stock is a unique investment tool that benefits both investors and companies. It offers investors a blend of security and growth potential by giving them priority in payouts while allowing them to share in any remaining profits. For companies, particularly startups, it can be a practical way to attract investment, though founders must carefully weigh its impact on their control and future earnings.

Whether you’re an investor looking for a balanced investment or a founder exploring funding options, understanding participating preferred stock can help you make informed, strategic decisions. When you know its features, challenges, and opportunities, you can find a win-win in the world of venture capital.If you’re interested in VC, check out our article on how to get into venture capital.