The Difference Between Participating and Non-Participating Preferred Stock

I often get questions from founders about different types of stock or equity they can offer investors. In preferred stock offerings (e.g., a Series Seed Preferred Stock financing), one of the key things founders should pay attention to when evaluating a term sheet is whether the preferred stock is “participating” or “non-participating.”

Here’s a quick explanation.

Q: What is participating preferred stock? What distinguishes it from non-participating preferred stock?

A: As the name indicates, holders of preferred stock get preferential treatment; in a sale, they typically get paid first, before holders of common stock. When there is not enough money to go around to pay back the preferred stockholders’ investment, the preferred stockholders get everything. When there is enough to pay back all preferred stockholders with additional money left to distribute to other stockholders, whether the preferred stockholder is participating or non-participating will determine how the rest of the money is distributed.

Participating preferred stock holders are entitled to receive a share of any remaining liquidation proceeds on an as-converted to common stock basis, after they have already gotten back their liquidation preference, whereas non-participating preferred stock holders either get (i) their liquidation preference back, or (ii) the amount they would have gotten had they converted to common stock. In other words, participating preferred gets its cake, and gets to eat it too.

Participating Preferred Example

For example, if a company that issued $1 million dollars in participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the participating preferred stock would be entitled to receive a $1 million liquidation preference (or more, if specifically agreed upon), plus 10% of the remaining $9 million in proceeds, for a total of $1.9 million.

If the same company sold instead for $15 million, the participating preferred stockholders would be entitled to $1 million plus 10% of $14 million dollars for a total of $2.4 million in total distributions. 

Non-Participating Preferred Example

In contrast, non-participating preferred stock is preferred stock that only entitles the holder to the greater of either (1) the preferential liquidation payment and not a share in any remaining liquidation proceeds, or (2) the amount the holder would receive if they had converted to common stock.

Using the example above, if a company issued $1 million dollars in non-participating preferred stock (representing 10% of the company) and then liquidated in a transaction for $9 million, the holders of the non-participating preferred stock would take only their $1 million liquidation preference, and the remaining $8 million in proceeds would be distributed to the other stockholders.

Note, however, that if the company was sold instead for $15 million, the holders of non-participating preferred stock would be treated as if they converted their holdings to common stock in order to receive 10% of $15 million, or $1.5 million, an amount greater than their liquidation preference.

Thus, from an investor’s perspective, participating preferred stock is preferable to non-participating preferred stock as it allows for both a preferred payment upon liquidation and participation in the upside if the company is sold at a premium.

But from a founder’s perspective, non-participating preferred is better. It is also the most common in today’s early stage deals. If you do end up issuing participating preferred, then definitely think about trying to cap the participation at a multiple of the liquidation preference. The example below will help explain why. 

Capped Participating Preferred Example

Let’s assume a company issued $1 million dollars in participating preferred stock that was capped at a 2X participation, and that the stock represented 10% of the company.

Capped participation means the holders either get the capped amount OR they participate on an as-converted to common stock basis (in other words, it is just like non-participating preferred stock with a multiple liquidation preference). For an example of how this would appear in a term sheet, this is how the NVCA.org documents do it:

“[Alternative 3 (cap on Preferred Stock participation rights):  First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred.  Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).]”

In my above example, if the company liquidated in a transaction for $14 million, the holders of the 2x capped participating preferred stock bought for $1M would take their 2X ($2M) and not participate at all in the remaining $12M in proceeds, because $2M is greater than 10% of $14M.

If the company was sold for $50M, however, the 2x capped participating preferred would be paid an on as-converted to common basis, and take 10% of $50M.

Conclusion

Make sure to understand what type of preferred stock your investors are asking for. If they are asking for participating preferred, and you can’t get them to back off, consider trying to negotiate for a capped participating preferred. Have fun, and be careful out there.

This article is not intended to be legal advice. You should always consult with an attorney before making an investment.


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