In this lesson, you will learn how dividends and liquidation proceeds are distributed to participating preferred stock shareholders. We will also discuss why venture capital firms use this financing vehicle to raise funds.
Participating Preferred Stock
Imagine owning a business in need of a capital infusion to support growth. You have engaged a venture capital (VC) firm for some creative solutions to your problem. After providing the VC with all the requested information they prepare a financing proposal for your review.
Participating Preferred Stock
In this situation, the VC might propose using participating preferred stock to raise the much-needed funds for your company. Participating preferred stock differs from common stock in several significant ways. Shareholders usually do not vote, but they do receive preferred dividends. Preferred stock normally carries a par value and a stated dividend rate based on that par value. So, for instance, a preferred stock issue with a $100 par and a 7% dividend rate should receive annual dividends of $7 per share.
Participating preferred stock receives not only its contractually required dividend, but also may receive additional dividends based on predetermined conditions. Common stock cannot receive any dividends prior to the preferred stock receiving all of its required dividends. The participation in the common stock dividend is an additional incentive for an investor to fund your company. The investor not only receives the stated dividend, but also participates in the ‘upside’ the common stock might experience.
Example of Participating Dividends
Suppose your company issues preferred stock with a 10% dividend rate and a $100 par value. Each share of preferred stock is entitled to receive dividends of $10 in the current year. Your company has done well and not only pays the preferred stock dividend, but also can afford an $11 per share common stock dividend. A non-participating preferred stock would receive a dividend of just the contractually required $10 per year. A participating preferred stock would ‘participate’ with the common stock and receive up to an additional $1 per share dividend based on the participation provisions of the preferred stock. A participating preferred has ‘upside protection’ and will receive an additional dividend if the common stockholders receive a dividend.
Preferred stock always has a liquidation preference over common stock. In a liquidation or bankruptcy debtors are paid first, followed by the preferred stock shareholders and then the common stockholders. So, in our example each outstanding share of non-participating preferred stock would receive its par value prior to the common shareholders getting paid, or $100. In addition, the preferred stockholders would receive any dividends due to them.
A participating preferred receives its par value back in liquidation, but also receives a portion of the proceeds received by the common stock shareholders. Suppose in our example, the common shareholders receive liquidating dividends of $80 per share and the preferred stock calls for payment of not only its par but also the same amount a share of common stock receives. In this situation, a share of preferred stock would receive a dividend of $180.
Preferred stock is a favorite financing vehicle for venture capitalists. In this situation, the VC would receive the return of its investment (the $100 par), plus a return on its investment ($80 of participating liquidating dividends), plus the preferred dividends paid throughout the time the preferred stock was outstanding. If the preferred stock was also cumulative, any unpaid dividends in arrears would also have to be paid as well before common shareholders would receive any liquidating dividends.
Suppose you wish to sell your company and there is a participating preferred outstanding. In many cases the participating preferred will be convertible preferred stock. This allows the preferred stock to be converted to common stock at a predetermined ratio, called the conversion ratio. In this way the participating preferred stock vanishes and does not impede any proposed transaction.
Preferred stock must receive the contractually required dividends and/or liquidation proceeds prior to common shareholders receiving either. Participating preferred stock receives the contractually required dividends and liquidating dividends based on its par value, plus additional dividends based on a predetermined calculation when the common stock also receives dividends.
Upon liquidation, a participating preferred stock will also receive a greater amount than the par value of the preferred if the common stock is receiving a distribution. Participating preferred stock is a financing vehicle commonly used by venture capitalists because it provides ‘upside participation’ for the venture capitalist.