Non-participating Preferred Stock vs Participating Preferred Stock

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Preferred stock (see Common Stock vs Preferred Stock) is of different types: participating, convertible, adjustable rate and straight or fixed-rate preferred stock. Whether a preferred stock is "participating" determines whether preferred stockholders participate in the distribution of proceeds to the common stock holders.

Distribution of proceeds - common vs. preferred stock

Upon a liquidation event, non-participating preferred stockholders typically receive an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event in accordance to the liquidation preference (1X or 2X). Holders of common stock then receive the remaining assets. For example, if

Preferred stock (non-participating) - 10,000 shares - $1 million invested with a 2X liquidity preference
Common stock - 90,000 shares
Company being sold for $74 million upon liquidation

In this example, preferred stock holders will receive $2 million upon liquidation ($200 per share). The remaining $72 million is distributed among the common stockholders for a distribution of $800 per share.

Since the holders of common stock would receive more per share than holders of preferred stock, holders of preferred stock would be better off converting their shares into common stock and give up their preference in exchange for the right to share pro rata in the total liquidation proceeds. If the non-participating preferred stock is convertible, and the stockholders choose to give up their preference, the distribution of the proceeds will be as follows:

Preferred stock (non-participating): 10,000 shares - 10% of proceeds - $7.4 million ($740 per share)
Common stock: 90,000 shares - 90% of proceeds - $66.6 million ($740 per share)

Participating preferred stock allows holders to double-dip. If the preferred shares are participating, they share in the proceeds of the liquidation that are distributed to common stock holders also. Therefore, in the above example, the distribution will be as follows:

Preferred stock (non-participating) - 10,000 shares - $1 million invested with a 2X liquidity preference - $2 million
Remaining proceeds: $72 million distributed as
- Preferred stock: 10% of 72 million = $7.2 million
- Common stock: 90% of 72 million = $64.8 million

The bottom line, therefore, is $920 per share for preferred stockholders and $720 per share for common stockholders.