Stock investing is probably the best-known type of investing in the world, and virtually everyone who knows anything about finance has heard of it. But did you know there are different types of stock, including participating preferred stock, and non-participating preferred stock?
Don’t let the names scare you off. As with all things related to investing and trading, it’s actually a lot simpler than it sounds, and in this quick guide, we are going to break down what each type of stock means, and the benefits of investing in each.
By the end, you will have a much better idea of which type of stick is in your interest.
First, it will help to get clear about exactly what the differences between these two stock types are.
Non-Participating Preferred Stock
If there is a liquidation of the firm, preferred stockholders will usually receive an amount equal to the initial investment, plus any dividends, if applicable.
Participating Preferred Stock
This sort of stock gives an investor priority over everybody else in terms of receiving payments and dividends, if a liquidation occurs.
These stockholders will also get a share of anything left at the time of the liquidation. We will outline exactly what this means with an example below.
Simple enough, isn’t it?
Basically, those who hold participating preferred stock are in a sort of exclusive club where they have first dibs on anything if the worst should happen, plus a little extra, if it’s available.
Differences Between The Two
To understand the key difference between these two types of stock, you have to understand them in the context of a liquidation, which means the sale of the company for cash.
In this case, participating preferred shareholders receive back their initial investment amount, any dividends owed, AND a pro-rata share of the rest of anything left to be divided up between common stockholders.
On the other hand, non-participating stockholders will receive their investment back, along with any dividends, but will not have a consideration in anything else.
It’s a subtle difference, but one which could matter a lot in the event a liquidation occurs.
An Example of Participating Preferred Shares in Action
Imagine you invest in a company that has a dividend of $1 per share. There will likely also be a clause in that should the dividend rise for common shareholders, participating preferred stockholders will receive the same dividend matched to the cent.
Now imagine the company liquidates.
The company holds $100 million in participating preferred stock, making up 20% of the total value of the company. The rest is common stock, with 80% totaling $400 million.
Yet when the company liquidates it does so for $600 million. This is more than the total value of all stock by $1000 million.
In this case participating preferred stockholders will get their investment back, plus dividends, plus 20% of whatever is left over, in this case $100 million.
No other stockholders will be entitled to a share of anything other than the value of their stock plus dividends.
As you can see, that entitlement can mean a large chunk of money.
Why is Participating Preferred Stock the Better Option?
Both companies and investors can gain advantages from participating preferred stock.
For a company, issuing this allows them to set a slightly higher initial valuation.
From the investor’s side, this kind of stock gives him a set return on investment.
From a venture capitalist’s perspective, this can be useful for raising funds quickly because of the sense of security it gives investors.
It can also be useful for up and coming firms who may not be ready for full-on large scale capital funding.
Frequently Asked Questions
Does a preferred stockholder have all the same rights as a common stockholder?
In some cases, yes, and in others, the only real downside of holding preferred stock is you might not have the same voting rights as common stockholders.
Consider this against the upsides and it isn’t so bad at all.
How does an investor buy participating preferred stock?
Ask your broker to keep an eye out for any offers which arise.
These stocks are commonly used by venture capital companies and private equity investors, so it won’t exactly be advertised to everyday Joe on the street.
Is it true this can be used to artificially pump up company valuations?
No, this is not true.
It is true that a company might issue participating preferred stock to seek a higher valuation, but this does not equate to artificially pumping up the price. This is earning a higher valuation.
As you can see, there are lots of advantages to buying participating preferred stock if it is an option.
Take into consideration the fixed return on investment which does not fluctuate, the fact that you would have first preference in the event of a liquidation, and the sense of security that brings in uncertain economic times, and you have a lot of good reasons to go participating preferred.