Participating vs. Non-Participating Preferred Stock

From time to time we are going to give a brief primer on common terms and issues in venture financings.  Today, we’re tackling participating vs. non-participating preferred stock, a fundamental economic term in VC deals that goes to the heart of the business deal between investors and management in connection with a sale of the Company.
 
Generally, upon the sale of a company, a holder of either participating or non-participating preferred stock is entitled to a preferential return (typically the investor’s initial investment amount, and often plus an accruing dividend), before any payment is made to the holders of common stock (i.e., management).
 
The difference between the two types of preferred stock is that participating preferred stock, after receipt of its preferential return, also shares with the common stock (on an as-converted to common stock basis) in any remaining available deal proceeds, while non-participating preferred stock does not.  Put another way, participating preferred stock entitles the holder to its investment amount back (plus an accrued dividend, if applicable) first AND its pro rata “common upside” in the company, while nonparticipating preferred stock entitles the holder to the GREATER OF its investment amount back (plus an accrued dividend, if applicable) OR its pro rata “common upside” in the company.  In a poor outcome where a company is sold or liquidated at a price that less than the aggregate investment amount of the preferred, the distinction is irrelevant, as both securities give the investors “downside protection” with no proceeds being available for distribution to the common.  However, in a moderate or successful outcome, the distinction can have a significant impact on the allocation of deal proceeds between the investors and management.

For example, Company A has one series of non-participating preferred stock with a liquidation preference of $6 million representing 50% of the capital stock of Company A.  If Company A were to be sold for $10 million, the investors would receive $6 million (as the $6 million investment amount is greater than the preferred’s 50% share of the $10 million sale proceeds) and the remaining $4 million of proceeds would be distributed to management.  Company B also has one series of preferred stock with a liquidation preference of $6 million representing 50% of the capital stock of Company B, but its preferred stock is participating.  Upon the same $10 million sale event, the investors would receive $8 million (the $6 million liquidation preference plus 50% of residual $4 million of sale proceeds) and the remaining $2 million of the proceeds would be distributed management.  Thus, in the same $10 million sale, the different between participating vs. non-participating preferred resulted in a $2 million shift in economics away from management to the investors, which represents one-half of the return that management would have received had the preferred stock been structured as non-participating.

This post on Capitalization Issues was authored by Ian Engstrand.

 
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