Participating preferred stock may be the most desirable security for an equity investor to own. Shareholders who own preferred stock generally receive any payments made by the underlying company, such as dividends and liquidation, before most other shareholders. Depending on the nature of the stock they might also collect higher payments.
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Shareholders who own participating preferred stock enjoy all the priority benefits of preferred stock. They also, however, receive additional priority when it comes to payments, even beyond non-participating preferred stock. They can receive additional dividend payments and have extra claims to a company’s assets if it is liquidated.
The name is simple: As a participating preferred shareholder you have the highest degree of preference and participation in the profits of the business. To understand how that works, we need to understand share classes.
What Are Stock Classes?
When companies issue stocks they often do so in different classes. This is generally referred to as Class A shares, Class B Shares and so on. The letter classifications have no legal significance; a company can call its share classes by any name it chooses. Class A, B and C have simply become common use.
Stock classes represent different rights apportioned to the stockholders. The most common form is called “common stock.” Most shares issued by a company will be common stock; typically all or almost all of the shares a company releases during an IPO will meet this standard.
Common stock gives the shareholder no special rights. If the company issues a dividend, holders of common stock generally get paid last and receive the lowest per-share payment. The same holds true if the company is sold. During a liquidation, after everybody else gets paid the company will distribute whatever is left to the holders of common stock.
So, for example, a company could call its common stock “Class A shares.” This simply means that any time the company refers to Class A shares, it is referring to its common stock.
While common stock is what investors typically buy and trade on the stock market, companies will sometimes create additional privileges to reward more important investors. For example, investors who fund a company before it goes public might get shares like this. Most of the time, these shares are called “preferred” and “participating.”
So, for example, a company might have Class A, B and C shares of stock. Class A stock might be common stock, held by ordinary shareholders. Class B stock might be preferred stock, and Class C might be participating preferred stock.
What Are the Rights of Participating Preferred Stock?
Preferred stock means that each share of this stock comes with additional rights above that of common stock. Most often this applies when it comes to collecting payments from the company; typically in two situations: dividends and liquidation.
- Dividends. Shares of this stock typically get additional preference when it comes to paying dividends. This means they might get paid before the company issues dividend payments to holders of common stock, or that preferred stock might pay more per share than common stock.
- Liquidation. Preferred shareholders typically get what is called a “liquidation preference.” This means that, if the company is liquidated, they can choose to either take the per-share payment issued to shareholders of common stock or collect back the value of their initial investment. If they take the preference, they get this payment before common stock shareholders get paid, meaning that they’re more likely to get their money back.
Participating preferred stock is a form of preferred stock. It is unlikely that you will ever find participating common stock. Shareholders who hold participating preferred stock get additional priority when it comes to payments issued by the company above those granted to preferred stockholders. Participation typically comes in two forms:
- Additional dividend payments. If the company pays a dividend, participating shareholders may receive an additional payment on top of anything issued to holders of common and preferred stock.
- Pro-rata liquidation preference. If the company is liquidated, preferred shareholders get the liquidation preference available to all preferred shareholders. However, non-participating shareholders have to choose. They can either collect back their initial investment or take the per-share payout issued to all shareholders. Participating preferred stockholders can take both. They typically get their initial investment back and a share of the final distribution equal to their percent of ownership in the company.
So, for example, Grow Co. might issue three shares of stock: common stock, non-participating preferred and participating preferred. After three years in business, it issues a dividend. After five years, it winds down and liquidates. It might define those shares as follows:
- Common stock. When Grow Co. made its dividend payments, it paid $1 per share to each holder of common stock. When it liquidated, after paying the company’s debts and other obligations, it had $0.25 per share left. It made this payment to the shareholders.
- Preferred stock. When Grow Co. made its dividend payments, holders of preferred stock received an extra $0.10 per share on top of common stock payments, making their dividend $1.10 per share. When the company liquidated, its preferred stockholders had originally invested at $5 per share. As a result, they all exercised their liquidation clause and received their initial investment of $5 per share back.
- Participating preferred stock. When Grow Co. made its dividend payments, holders of participating preferred stock received the same $0.10 per share preference. As a result, their dividend was $1.10 per share. When the company liquidated, they exercised both their liquidation preference and their pro-rata participation. As a result they received back their initial investment of $5 per share as well as the pro-rata payment due to common stock holders, for a liquidation payment of $5.25 per share.
However, you should understand that these definitions can change. Every company can define the rights and responsibilities of preferred and participating stock as it sees fit. These are simply the most common uses.
Bottom Line
Investors who own participating preferred stock generally receive priority when it comes to dividends and any payment after liquidation. They will receive more money than holders of common stock and will receive it first, meaning that they’re more likely to get paid when money is tight.
Tips for Investing
- Consider talking to a financial advisor about the role that different classes of stock shares can play in your portfolio. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Buying stocks is one of the best things you can do with the speculative section of your portfolio. Although you won’t find preferred shares on the open market, our article on stock orders can help you buy common stock smarter.
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