What is Participating Preferred Stock?

Participating Preferred Stock is a preferred stockPreferred StockA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more 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.

  • 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, 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.

Why Do Companies Issue Participating Preferred Stocks?

So why do companies choose to issue participating preferred stock, 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 involve 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 should Investors go for Participating Preferred Stocks?

  • 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.

Examples

Given below are the examples of participating preferred stock-

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 in profit or 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 dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, 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 dividendPreferred DividendPreferred dividends refer to the amount of dividends payable on preferred stock from profits earned by the company, and preferred stockholders have priority in receiving such dividends over common stockholders.read more 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.

This article has been a guide to what is Participating Preferred Stock? Here we discuss How Participating Preferred Stock Works and why companies issue such stocks, along with practical examples. You may also have a look at the following accounting articles to learn more –

  • Formula of Floating StockRedeemable Preference SharesPreemptive RightsStatement of Retained Earnings Examples