VC GLOSSARY

Preferred stock is the type of shares that gives the holder a higher right to the dividends generated by the company. Those who hold participating preferred stock have an even higher claim to the dividends of a company.

Common stockholders have the least claim to the dividends of the company compared to preferred stockholders and participating preferred stockholders.

But in the event of liquidation, common stock owners have a higher claim than the other stockholders. Participating preference stocks have a lower claim than even preferred shareholders.

The distinctions between the dividend claims of common stockholders, preferred stockholders, and participating preferred stockholders are better understood with examples.

Consider a company, ABC, that has issued three different types of stocks: common stock, preferred stock, and participating preferred stock. Common stockholders do not have any fixed claims to the dividends. Preferred stock and participating preferred stock has a fixed dividend of $2 when the earnings is greater than $10M in a financial year. 

Now the company has grown fast with very high earnings. New earnings gives common stakeholders a dividend of $2.50, but the dividend for preferred stock owners will be fixed at $2. This is where the difference between preferred stock and participating preferred stock materializes.

When the common stock has a higher dividend claim than the preferred stock, the participating preferred stock will have a claim to the same dividend as that of the common stockholder. In this scenario, the participating preferred stock owner will receive a dividend of $2.50 when preferred stock shareholders get only a dividend of $2.

The exact terms of the share distribution will be in the inception document for the participating preference shares. The advantage for such stock over preferred stock is only in the case when the company has grown beyond expectations. Due to the higher claims to the company’s dividends, they can charge a premium when issuing participating preferred stock. Dividends and liquidation events are where these two types of preferred stock have a difference.

Participating preferred shares are issued very rarely and are commonly deployed as a poison pill tactic to thwart hostile takeover efforts. Other regulatory aspects could also be the driving force behind issuing participating preferred stocks. In some instances, institutional investors prefer participating preferred stock due to favorable tax treatment. 

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