Participating preferred stock is a share that gives its holder participation in the additional earnings of a business. The participation feature increases the value of such a share, which allows the issuer to sell it at a higher price.
This participation is in addition to the usual fixed dividend associated with most types of preferred stock. Participation can take several forms, such as the following:
- Earnings rights. If the business generates a certain amount of income, the holder of participating preferred shares will be paid a certain proportion of that income, in addition to the normal dividend.
- Liquidation rights. If the business is sold, the holder of participating preferred shares will be paid a certain proportion of the net sale price received.
These additional payments are usually made in the form of dividends. Also, participation rights are sometimes activated only when the amounts that a company earns, either through its operations or sale of the business, exceeds a certain threshold level. Depending on the level of the threshold, participation payments may be relatively rare.
Participating preferred stock agreements may or may not include other features, such as:
- Holders of the shares may have the authority to approve certain actions, such as the sale of the business or larger assets.
- Holders of the shares may have voting rights similar to those held by the holders of common stock.
- The shares may be cumulative, so that unpaid dividends must be paid before any dividends can be issued to the holders of common stock.
If participation rights are likely to generate a return, the price of participating preferred stock can be quite high, which makes it an attractive feature for investors holding these shares. However, it reduces the amount of funds that might be distributed to the holders of common stock, so it tends to depress the price of common stock.
An investor should buy participating preferred stock when he believes that a business is likely to have unusually strong earnings or be sold for a high price, so that he can participate in those gains.
As an example of the terms of this type of stock, ABC Company issues 100,000 shares of participating preferred stock, which entitles the holder of each share to an annual dividend of $5.00. In addition, the holder is entitled to his pro rata share of 20% of all company earnings that exceed a baseline earnings level of $10 million per year.