Participating preferred stock are entitled to receive fixed dividends plus additional dividends where additional dividend is the positive difference between the dividends paid to the common stockholder and the fixed amount which is set to be paid to that preferred stockholder making the total dividend amount paid to participating preferred stockholder equal to that of the common stockholder.
What is Participating Preferred Stock?
Participating Preferred Stock is a kind of preferred stock wherein stocks are entitled additional dividends other than the fixed dividend, which was promised in the agreement. So, in addition to the preferred dividend, this kind of stock is entitled to additional benefits like a common shareholder in case of higher profit. These rights are generally expressed in the memorandum or article of association of the company.
- Participating Preference share takes part in the company’s profit. So, in a particular accounting year, if the company post profit, then after the payment of preferred dividends, the remaining sum is distributed among the common shareholders as a dividend.
- In case of liquidation also, 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 Companies Issue Participating Preferred Stocks?
So why companies choose to issue participating preferred stock, they can issue either common stocks or preferred stocks separately. The answers for this lies below:
- The company is not sure of its profitability, and in case of tough days, it does not want to take additional burden of shareholder’s voting and management decisions.
- The rate of dividend in this stock is generally lower than that of preferred stock as the company is giving the option to its investor to involve in profit distribution above a preferred rate of dividend.
- They provide a lower cost of capital.
- In the case of the loss-making year, the burden of fixed dividends is reduced significantly.
- Issuing participating preferred stocks allows them to have a higher valuation compared to other avenues.
- From the Venture capital fund perspective, this method is the faster 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 the loss-making year, investors are entitled to the fixed rate of dividends.
- In the case of the profit-making year, these investors are entitled to additional dividends and participate in the profit of the company.
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 amount of dividend be the company is in profit or loss. But in good time when a company made a considerable profit, and it easily distributed its dividends on all its preference shares. After that, assume that 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.
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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 total valuation of the company, and rest 80% was raised through common shareholders accounting $400 million.
- And now when the company liquidates assume that 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 dividends, and in addition to that, 20% of whatever left out, that is 20% of $100 million.
- So here, the participating preferred shareholder made quite additional money than common and preference shareholders as others were given only the dividends and their investments back.
Example – #2
KBC Limited issues preferred stock with a 10% dividend rate at $100 par value in the year 2009.
- In this case, each preferred share is entitled to the dividend of $10 for the investment of $100 every year. Lets now assume that in the year 2011, KBC had performed very well, so it gave the preferred dividend at the rate of 10% and also 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 preference shareholder would have got an opportunity to share in its profit along with common shareholders and received 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 are Participating Preferred Stock? Here we discuss How Participating Preferred Stock Works, why companies issue such stocks along with practical examples. You may also have a look at the following accounting articles to learn more –