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Participating Preferred Stock Explained

November 13, 2020 · 6 minute read

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Participating Preferred Stock Explained

When you turn on the cable news or you hear a friend talking about owning the latest hot stock, they are very likely referring to one specific style of stock, called common stock.

The value of common stock can both skyrocket or tank (or do very little at all), which makes it fantastic fodder for television or water cooler talk. Whether an investor is interested in the stock market or not, it’s easy to see why folks are drawn to the unpredictability and excitement of market moves.

Then, there’s another type of stock, called preferred stock.

Preferred stock isn’t nearly as chattered about as common stock, because it doesn’t have the same potential for price fluctuations as do common stocks. Why is that? Preferred stocks pay a fixed rate of return, like a bond. Because the payout is predictable and expected, there’s less potential for volatility.

There are several different varieties of preferred stock. One of these is participating preferred stock.

What is participating preferred stock? It is a type of preferred stock that may provide an additional dividend and other benefits as compared to both common stock and preferred stock.

Here’s a look at participating preferred stock versus non-participating preferred stock, when one might have the option to own participating preferred stock, and the benefits of participating preferred stock.

What Is Common Stock?

To understand both preferred and participating preferred stock, it’s helpful to first understand common stock.

A quick refresher on stocks: A stock represents a fixed percentage of ownership in a company. When an investor owns a stock, they actually own a piece of that company. That’s why stocks are sometimes called equities—because stock shareholders own equity in a company for which they own a stock.

Common stock has several distinct characteristics. The first thing to understand is how an investor could potentially make money on common stock. First, a stock can appreciate in value, via its share price—although that’s never a sure bet. Share prices can also depreciate.

Second, a company may dole out profits to shareholders in the form of a dividend. Usually, a dividend payment is made on a fixed schedule in cash, although it can also be made in shares of stock. With common stock, a dividend is not necessarily guaranteed, and the dividend could change over time.

For example, if a company has a less profitable year, they may decide to forgo all dividend payments to common stock shareholders. In a more bountiful year, they may decide to increase a dividend.

Also, not all companies pay dividends to their common stockholders. There are a number of reasons that a business may choose not to. For example, they may feel that it has strategic opportunities to reinvest those profits into the business.

Another benefit of holding common stock is that shareholders have voting rights at shareholder meetings. This gives shareholders a say in the direction of the company.

One downside to holding common stock is that shareholders are typically compensated last in the event of liquidation. Both bondholders and preferred stock shareholders come first.

For example, if a company goes bankrupt and all assets are liquidated, bondholders get first dibs on the proceeds. Common stock shareholders are on the bottom rung of that ladder.

Before moving on, a quick review of bonds for reference: A bond is an investment in the debt of a company. The investor is the lender, and the bond represents an IOU of sorts.

Investors are paid a fixed rate of return in exchange for loaning that company (or a government) their money, and then the initial investment—the principal—is returned to the investors at the end of the designated period.

Although bondholders do not own a stake of the company, they are first in line for reimbursement in the event that a company has a liquidation event.

What is Participating Preferred Stock?

Like common stock, preferred stock represents equity ownership in a company. That said, preferred stock can be thought of as a hybrid between stocks and bonds.

Shares of preferred stock tend to pay a fixed rate of dividend. Preferred stocks have dividend preference; they’re paid to shareholders before dividends are paid out to common shareholders.

These dividends may or may not be cumulative. If they are, all unpaid preferred stock dividends must be paid out prior to common stock shareholders receiving a dividend.

For example, if a company has not made dividend payments to cumulative preferred stock shareholders for the previous two years, they must make two years’ worth of back payments and the current year’s dividend payments to preferred shareholders before common stock shareholders are paid any dividend at all.

Because of the fixed nature of the dividend, the investments themselves tend to behave more like a bond. When an investment pays a fixed and predictable rate of interest, they tend to trade in a smaller and more predictable bandwidth. Compare that to stocks, whose future income stream and total return on investment are less predictable, which lends itself to plenty of price disagreement in the short-term.

Preferred stockholders do not typically enjoy voting rights at shareholder meetings. But, preferred stock shareholders are paid out before common shareholders in a liquidity event.

Participating preferred stock takes on all of the above features, but they may receive some bonus benefits, such as an additional dividend payment. This additional payment may be triggered when certain conditions are met, often involving the common stock. For example, an additional dividend may be paid out in the event that the dividend paid to common shareholders exceeds a certain level.

Upon liquidation, participating preferred shareholders may receive additional benefits, usually in excess of what was initially stated.

For example, they may have the right to receive back the value of the stock’s purchasing price. Or, participating preferred shareholders may have access to some pro-rata cut of the liquidation proceeds that would otherwise go to common stock shareholders.

To see the mechanics of participating preferred stock in action, finance expert Camilo Maldonado suggests an example. “Let’s assume a venture capital investor has invested $1,000,000 in exchange for 10% of an early-stage company in the form of participating preferred stock,” says Maldonado.

“A few years later, the company is sold for $20,000,000. The venture investor would receive their initial investment of $1,000,000 plus 10% of the remaining $19,000,000. Thus, they would earn a total of $2,900,000. This return represents a 14.5% ownership stake in the company, even though the initial investment was only for 10%.

This difference occurs because the investors owned participating preferred stock. If they had instead held common stock, they would have only been entitled to 10% of the sale price, or $2,000,000.”

Nonparticipating preferred stocks do not get additional consideration for dividends or during a liquidation event.

What is the Benefit of Participating Preferred Stock?

Participating preferred stock has advantages over both common and nonparticipating preferred stock. For those with access, participating preferred stock is an enticing investment. That said, a regular joe investor may not have the chance to, ahem, participate in participating preferred stock.

First, the issuing of participating preferred stock is rare. Further, access to this investment type is often limited. “In reality, very few people will have access to participating preferred stock because it is traditionally only used to entice venture capitals or private equity investors to invest in private companies,” says Maldonado.

“Investing in early-stage or smaller companies is very risky, so these investors may demand to receive participating preferred stock in exchange for an investment in the company.”

Accessing Stocks by Investing

Don’t have access to participating preferred stock? No need to worry. Though an investor might not have the chance to get involved with this particular investment opportunity, there are plenty of ways to get invested. In fact, investing in the stock market has never been easier and more accessible.

First, most anyone can invest in common stocks. Buy common stocks within an active brokerage account or using a trading platform like SoFi Invest®, where investors are able to buy partial shares. That means investors can buy their favorite stock for as little as a $1.00.

Not ready for picking individual stocks? That’s okay, too. An investor may be more interested in buying a mutual fund or an exchange-traded fund (ETF). A fund is like a suitcase that contains many different types of investments, with money spread out among them.

Instead of one stock, an investor could be buying 500 or 1,000 stocks via a fund. Funds offer some built-in diversification. Diversification aims to help an investor lower their portfolio’s risk and volatility.

Buy commission-free ETFs using SoFi active investing, or use the automated investing program to build and buy a fully diversified portfolio of ETFs. Whether an investor wants to be in the driver’s seat or would prefer someone else to take the reins, SoFi has an investing solution to fit.

SoFi Invest® offers no-commission trades, which has the potential to change the game for smaller investors. there are also no account maintenance fees and no account minimums with SoFi Invest®.

Get started with SoFi Invest®.

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