Fundraising Jargon 06: Participating & Non-participating Preferred Stock

There are several types of preferred stocks, each giving its holder different rights, and this is where things start to get a little complicated. For our purposes of immediate understanding, the rights of participating and non-participating stockholders are most relevant.

As we know, preferred stock owners often get a 1X liquidation preference, meaning that in the event of a sale or bankruptcy, they get their money back at the 1X value before common stockholders get a chance to recoup anything.

Let us consider that a company realizes a successful exit, and common stockholders are left with equity worth 4x what preferred stock owners paid per share at the time of their investment. In this case, preferred stock owners can still exercise their liquidation preference to get their money back, but if everyone else is making four times that money, it makes more sense to convert those preferred shares into common stock to enjoy the 4x gains. During successful outcomes, preferred stock owners are essentially forced to convert to common stock. Participating preferred shareholders are also entitled to additional dividends and the predetermined dividend rate. This means they receive a share of any additional dividends paid to common shareholders. For non-participating stockholders, this is where it ends. They convert their shares to common stock and enjoy the same 4x returns as everyone else. Simple enough.

Participating preferred stock works differently and allows venture investors to essentially double dip in the company's gains. Participating stockholders get to exercise both their liquidation preference and enjoy a pro-rata share of common stock gains simultaneously. So, if a participating stockholder owns 25% of the company at the time of a liquidation event, they get their money back plus 25% of the remaining proceeds.

Let us better understand the differences through an example - 

Assume, company sells for = INR 10Cr

Original Investment = INR 2.5Cr @ post-money valuation = INR 5Cr 

Hence, share ownership of investors = 50%

In case of non-participating preferred shares - obligation of converting those shares to common stock

Earnings of Investors = 50% x INR 10Cr = INR 5Cr

Now let us say these investors instead own participating preferred stock. The outcome changes significantly:

Exercising 1X liquidation preference = 1 x 2.5Cr (original investment) = INR 2.5Cr

Also entitled to 50% share of the remaining INR 7.5Cr = 50% x INR 7.5Cr = INR 3.75Cr

Total Earnings = INR 2.5 Cr + INR 3.75Cr = INR 6.25Cr

In this case, they capture most of the exit’s value even while owning just half of the company.