Participating preferred stock

What it means

Preferred stock carries a liquidation preference, a right to be paid before the common shareholders when the company is sold. Non-participating preferred takes the better of two outcomes: its preference amount, or its percentage of the proceeds as though it had converted to common. It cannot take both. Participating preferred takes its preference and then also shares in the remainder alongside the common, which is why it is sometimes called double dipping. A participation cap limits the second bite, usually at some multiple of the amount invested.

Why it matters

On any exit short of a large one, participation is the term that decides how much the founders and the employees actually receive. It comes out of the common shareholders in full, and it bites hardest exactly where it hurts most, which is a modest or middling outcome rather than a spectacular one. On a very large exit the difference vanishes, because the investor's percentage is worth more than their preference and they convert either way. So participation is a term that costs nothing in the scenario everyone is imagining when they sign it, and a great deal in the scenario that actually happens.

Worked example

An investor put in EUR 5m for a twenty five percent stake with a 1x preference, and the company sells for EUR 20m. Non-participating, they take the better of EUR 5m or twenty five percent of EUR 20m, which is EUR 5m, so they take the EUR 5m and the common splits the remaining EUR 15m. Participating, they take the EUR 5m first and then twenty five percent of the remaining EUR 15m, which is EUR 3.75m, for EUR 8.75m in total. The common is left with EUR 11.25m rather than EUR 15m. The single word participating moved EUR 3.75m, which is nineteen percent of the entire sale price.

The common mistake

Reading the multiple and stopping. Founders check for a 1x rather than a 2x preference, are relieved to find 1x, and do not read the next clause, which is the one that says whether the preference is participating. A 1x participating preference is worse than a 1.5x non-participating one across most realistic exit values. The second mistake is ignoring the participation cap when there is one, because a capped participation is a materially milder term than an uncapped one and is often available for the asking. Checking the multiple and stopping there is how a founder ends up surprised by a term they read and did not register.

In practice

Non-participating 1x is the European and UK standard and is what you should be holding out for. Participation turns up in later rounds, in structured deals where the valuation has been pushed up in exchange for terms, and in growth rounds where the investor is protecting a high entry price. When someone offers a higher valuation with participating preferred, model both offers at three or four plausible exit values before deciding which is better, because the higher headline number frequently loses.

What to ask

Ask whether the preference is participating, and do not accept the multiple as an answer to that question, because they are two separate terms and a 1x participating preference is worse than a 1.5x non-participating one across most outcomes. If it is participating, ask whether the participation is capped and at what multiple of the invested amount, since a cap turns a severe term into a moderate one and is frequently available simply for asking. Then ask for the same offer priced without participation, so you can compare a lower valuation with clean terms against a higher one with structure. Model both at three exit values you consider plausible rather than at the optimistic one, because participation costs nothing in the good case and a great deal in the likely one. Ask for the answer as a payout at three exit values rather than as a description of the clause, since a table settles this faster than an argument.

Related terms

• Dead zone The band of exit values across which the common shareholders receive nothing extra, however much the price rises.
• Liquidation preference stack The order in which several rounds of preferred shares get paid when there is not enough to pay them all.
• 1x non-participating preference The founder friendly liquidation preference: money back once, or the percentage, whichever is larger, never both.