Participating Preferred Stock

Participating Preferred Stock is a preferred stock wherein stocks are entitled to additional dividends other than the fixed dividend promised in the agreement. So, in addition to the preferred dividend, this stock is entitled to additional benefits like a common shareholder in case of higher profit. These rights are generally expressed in the company's memorandum or article of association.

Fully participating preferred stock is entitled to receive fixed dividends plus additional dividends where an additional dividend is a positive difference between the dividends paid to the common stockholder and the fixed amount that is set to be paid to that preferred stockholder, making the total dividend amount paid to participate preferred stockholder equal to that of the common stockholder.

• Participating preferred stockholders get fixed and supplemental dividends, with additional payments representing a surplus over the dividends given to common stockholders.
• Preference shares holders may get a percentage of the company's profits. The corporation pays dividends to the common shareholders after each accounting year if it is profitable.
• Employees may benefit from a financial incentive, which may assist the business in inspiring staff. Nobody loses money on the deal if anything goes wrong and the stock price doesn't increase.

Participating Preferred Stock represents a distinctive class of stock that holds unique rights and privileges, combining features of both preferred and common stock. Investors in participating preferred stock receive preferential treatment when it comes to dividend distributions and liquidation proceeds, making it an appealing option for investors seeking a balance between security and the potential for additional returns.

One key characteristic of this investment is its entitlement to receive dividends before common stockholders. These dividends are often fixed, providing a steady income stream for investors. Moreover, participating preferred stockholders have the opportunity to participate in additional dividends beyond their fixed rate. In the event, the company distributes surplus profits, participating preferred stockholders receive a share.

Participating in Preference shares takes part in the company's profit. So, if the company posts profit in a particular accounting year, the remaining sum is distributed among the common shareholders as a dividend after the payment of preferred dividends. In case of liquidation, fully participating preferred stock is entitled to the leftover/surplus sum of assets.

Also, in the case of liquidation, these shareholders are provided with the purchasing price of these shares on a pro-rata basis. While participating preferred stock offers attractive features, it's essential to note that these advantages may come at the cost of a higher initial investment compared to common stock. Investors should carefully assess the terms of the stock issuance, including the dividend rate, participation rights, and liquidation preferences.

So why do companies choose to issue convertible participating preferred stock or otherwise? They can issue either common or preferred stocks separately. The answers to this lie below:

• The company is unsure of its profitability, and on tough days, it does not want to take the additional burden of shareholder voting and management decisions.
• The dividend rate in this stock is generally lower than that of preferred stock as the company gives its investor the option to be involved in profit distribution above a preferred rate of dividend.
• They provide a lower cost of capital.
• In the case of a loss-making year, the burden of fixed dividends is reduced significantly.
• Issuing preferred stocks allows them to have a higher valuation than other avenues.
• From the Venture capital fund perspective, this method is the fastest way to raise money as it gives an investor extra confidence about the company and its operations.

Why investors should invest in fully participating preferred stocks is a question that needs to be answered for more clarity around the concept. Let us do so through the points below.

• The benefits for investors to invest in participating preferred stocks take a little bit of additional risk to get a higher rate of return.
• In the case of a loss-making year, investors are entitled to the fixed rate of dividends.
• In the case of a profit-making year, these investors are entitled to additional dividends and participate in the company's profit.

Now that we understand the basics of this concept, let us understand its practicality through the examples below.

Example #1

Let us assume a situation where you invest in a company that gives a dividend of $1 per share. So, during a typical year of operation, you will receive this dividend if the company is making a profit or a loss. But in good times, when a company made a considerable profit, it easily distributed its dividends on all its preference shares. After that, assume the company is still left with $100 million to distribute among its shareholders. In this case, participating shareholders are entitled to receive the additional dividends on a pro-rata basis.

Now let us consider another example when the company files for bankruptcy and is liquidating:

So in this scenario, let us assume that the company had collected a total of $100 million from participating preference shareholders, which accounts for 20% of the company's total valuation. The rest, 80%, was raised through common shareholders accounting for $400 million.

• And now, when the company liquidates, assume it liquidates at the valuation of $600 million, which is $100 million more than the sum of money it raised. In this scenario, participating preference shareholders will get their investment back plus the promised dividends, and in addition, 20% of whatever is left out is 20% of $100 million.
• So here, the participating preferred shareholder made more money than common and preference shareholders as others were given only the dividends and their investments back.

Example #2

KBC Limited issued preferred stock with a 10% dividend rate at a $100 par value in 2009.

• In this case, each preferred share is entitled to a dividend of $10 for the investment of $100 yearly. Let's now assume that in 2011, KBC had performed very well, so it gave the preferred dividend at the rate of 10% and gave $11 per share as a dividend to its common shareholders.
• A non-participating preferred shareholder just received a dividend of $10 per par value of $100. Still, a participating preferred shareholder would have an opportunity to share in its profit with common shareholders and receive an additional dividend of $1 per share based on the participation provision of participating preferred stock.
• It has an upside potential to receive additional dividends along with common shareholders when the company distributes dividends to its common shareholders.

Example #3

Beacon has officially entered into an agreement with Clayton, Dubilier & Rice, LLC to buy back 400,000 outstanding shares of Series A Preferred Stock from CD&R is set at an aggregate amount of $804.5 million, inclusive of accrued and unpaid dividends as of the repurchase date. The funding for this transaction is anticipated to come from a combination of new and existing debt, along with available cash resources. The completion of the transaction is slated no later than August 11, 2023.

The decision to proceed with this repurchase was thoroughly evaluated and approved by Beacon's board of directors. Importantly, this endorsement followed the recommendation of a special transaction committee, comprised solely of disinterested directors, ensuring a comprehensive and unbiased assessment of the proposed transaction.

Let us understand the distinctions between both these types of preferred stock as they directly influence their potential returns and rights in various financial scenarios. While it majorly depends on the risk appetite of the investor and preferences, let us understand the differences for the sake of clarity.

Participating Preferred Stock

• Participating preferred stockholders are entitled to receive fixed dividends, often at a specified rate, providing a steady income.
• In favorable scenarios, these stockholders have the right to receive additional dividends beyond the fixed-rate, participating in surplus profits.
• These stockholders receive their liquidation preference, typically the initial investment amount, before common stockholders in case of a liquidation event.
• Additionally, fully participating preferred stockholders may have the opportunity to participate in the remaining proceeds alongside common stockholders.

Non-Participating Preferred Stock

• Non-participating preferred stockholders receive fixed dividends at a predetermined rate, offering a stable and predictable income stream.
• Unlike their counterparts, non-participating preferred stockholders do not have the right to additional dividends beyond the fixed rate.
• In the event of a liquidation or sale, non-participating preferred stockholders receive their liquidation preference before common stockholders but do not participate in the remaining proceeds.

This article has been a guide to what is Participating Preferred Stock. Here we explain why companies issue such stocks, examples, and vs non-participating stock. You may also have a look at the following accounting articles to learn more –

• Formula of Floating Stock
• Redeemable Preference Shares
• Preemptive Rights
• Statement of Retained Earnings Examples