What is Participating Preferred Stock?

Term sheets are often where the battle for the future value of a startup is won or lost. Among the many clauses and definitions you will encounter, few have as much impact on your final payout as the type of stock issued to investors. One specific term that founders must understand is participating preferred stock.

This is a specific classification of equity. It is distinct from common stock, which is what founders and employees typically hold. Preferred stock generally comes with a liquidation preference. This means the investor gets paid back before common stockholders do.

Participating preferred stock takes this a step further. It gives the holder the right to receive their liquidation preference first. Then, it gives them the right to share in the remaining proceeds with common stockholders on a pro rata basis. It is effectively a way for investors to get paid twice.

In a standard venture deal, you usually see non-participating preferred stock. In that scenario, the investor has a choice to make during an exit or liquidation event.

They can either take their liquidation preference amount or convert their shares to common stock and take their percentage of the company. They will naturally choose the option that yields the higher return. They cannot choose both.

Participating preferred removes the need to choose. The investor gets their cake and eats it too. The payout order looks like this:

• First, the investor receives their original investment amount (or a multiple of it).
• Second, that amount is subtracted from the total exit value.
• Third, the investor converts to common stock and takes their percentage share of the remaining pot.

This structure dramatically shifts the allocation of proceeds away from founders and early employees.

To understand the gravity of this term, it helps to look at the math of a hypothetical exit.

Imagine your startup sells for $50 million. You have one investor who owns 20% of the company and invested $10 million. They have a 1x liquidation preference.

Scenario A: Non-Participating Preferred The investor calculates their options. They can take their $10 million preference. Or they can take 20% of the $50 million, which is also $10 million. The result is the same. They walk away with $10 million. The remaining $40 million is split among the founders and employees.

Scenario B: Participating Preferred The investor does not have to choose. First, they take their $10 million off the top. This leaves $40 million remaining in the pot. Since they have participation rights, they now take 20% of that remaining $40 million. That equals an additional $8 million.

The investor walks away with $18 million total. The founders and employees are left with $32 million.

In this simple example, a single clause cost the common stockholders $8 million.

Because full participation can be so punitive to founders, you may see a variation called participating preferred with a cap.

This clause limits the total return an investor can receive. For example, a 3x cap means the investor can participate until they have received three times their original investment amount. Once that threshold is hit, they stop participating in the remaining proceeds.

At that point, the stock functions like non-participating preferred. If their ownership percentage as common stock would yield more than the cap, they will simply convert to common and forgo the preference entirely.

Participating preferred is not the standard for early-stage venture deals in a healthy market. It is often considered a non-market term for Seed or Series A rounds.

However, business is about leverage. This term tends to appear when a company is in a difficult position or when the overall economic climate shifts in favor of investors. It is a tool used to protect downside risk while maximizing upside potential.

Founders must weigh the risks. Is the capital necessary for survival? Does accepting this term set a precedent for future investors? Later investors often expect the same rights as early investors. Accepting participation rights early on can stack up, creating a liquidation overhang that eventually leaves common stock with very little value.

You have to analyze if the immediate cash is worth the long-term cost to your equity.