Participating Preferred Stock

Participating preferred stock is a type of preferred stock that gives the holder the right to receive dividends equal to the normally specified rate that preferred dividends are paid to preferred shareholders, as well as an additional dividend based on some predetermined condition. Participating preferred stock can also have liquidation preferences upon a liquidation event.

Participating preferred stock– like other forms of preferred stock – takes precedence in a firm's capital structure over common stock but ranks below debt in liquidation events. The additional dividend paid to preferred shareholders is commonly structured to be paid only if the amount of dividends that common shareholders receive exceeds a specified per-share amount. Furthermore, in the event of liquidation, participating preferred shareholders can also have the right to receive the stock's purchasing price back as well as a pro rata share of any remaining proceeds that the common shareholders receive.

When there is a liquidation event, whether an investor's preferred stock is participating or nonparticipating will determine if that investor receives additional consideration over the liquidation value of the preferred stock and any dividends owed to the investor. If an investor's preferred stock is participating, that investor is entitled to any value leftover post-liquidation as if that stock had been common stock. Nonparticipating preferred shareholders, on the other hand, receive their liquidation value and any dividends in arrears if applicable, but they are not entitled to any other consideration.

Participating preferred stock is rarely issued, but one way in which it is used is as a poison pill. In this case, current shareholders are issued stock that gives them the right to new common shares at a bargain price in the event of an unwanted takeover bid.

Suppose Company A issues participating preferred shares with a dividend rate of $1 per share. The preferred shares also carry a clause on extra dividends for participating preferred stock, which is triggered whenever the dividend for common shares exceeds that of the preferred shares. If, during its current quarter, Company A announces that it will release a dividend of $1.05 per share for its common shares, the participating preferred shareholders will receive a total dividend of $1.05 per share ($1.00 + 0.05) as well.

Now consider a liquidation event. Company A has $10 million of preferred participating stock outstanding, representing 20% of the company's capital structure with the other 80%, or $40 million, made up of common stock. Company A liquidates, and the proceeds are $60 million. The participating preferred shareholders would receive $10 million but also would be entitled to 20% of the remaining proceeds, $10 million in this case (20% x $60 million - $10 million). Nonparticipating preferred shareholders would not receive the additional consideration.