Participating Preferred Stock: What Startup Founders Need to Know

For many early-stage startups, securing funding can be a make-or-break moment for their business. One of the most common methods for receiving funding is the issuance of preferred stock, which grants investors certain privileges and rights over common stockholders. Participating preferred stock is a category of preferred stock that provides additional benefits to investors but also comes with some potential downsides for startup founders.

It’s worth noting that participating preferred stock is the least favorable for founders to give away, as it contains liquidations preferences and terms that are primarily benefiting and securing investors’ interests.

However, participating preferred stock is a byproduct of your talks with investors, and as such, it can be negotiated away. If you’re a founder organizing a fundraising round, you should aim to have at least a few competing term sheets. This way you can use that as a leverage to take the unfavorable terms off the table.

• Participating preferred stock is a type of stock that gives investors special rights beyond the fixed dividend payment. Still, it also gives them the right to receive additional dividends or payments in certain situations.

• One of the main benefits of participating preferred stock is that it can attract investors looking for higher returns on their investment, which can help startup entrepreneurs secure the future rounds they need to grow.

• Participating preferred stock comes with potential risks for startup founders, such as dilution of ownership and the possibility of reduced payouts to owners of the common stock in case of a liquidity event.

• To mitigate the risks of participating preferred stock, startup founders can negotiate for favorable terms, such as caps on payouts to preferred stockholders or combinations with other types of financing.

Participating preferred stock is a class of stock that entitles its holders to receive a certain dividend payment before common stockholders. However, it also grants investors the right to receive additional dividends or other payments based on a predetermined formula.

This means that in the event of a liquidation or sale of the company, participating preferred stockholders will receive a return on their investment plus a percentage of the remaining proceeds in proportion to their ownership stake.

Need to take a step back? Read our Quick Guide To Preferred Stock For Startup Founders.

In startup investing, participating preferred stock is attractive to angel investors and venture capital firms because it gives them the potential for higher returns. Unlike regular preferred stock, which typically only entitles investors to a fixed dividend payment, participating preferred stockholders can earn more if the company does well. Because of those favorable terms granted by participating preferred stock, investors might be more inclined to fund a startup that issues that type of stock.

While participating preferred stock can be a valuable tool for securing success in funding rounds, it also comes with some potential downsides for startup founders.

One of the main risks is that participating preferred stockholders will receive a higher payout in the event of a liquidation or sale of the company, which can significantly reduce the amount of money that founders and common stockholders receive.

This means that participating preferred stock can be dilutive to the ownership percentage of existing shareholders.

Are you a founder looking to issue equity? Find out How Many Shares Should a Startup Authorize.

There are several ways that startup founders can mitigate the risks associated with participating preferred stock.

• Negotiate favorable terms: Startup founders should negotiate the terms of the participating preferred stock with investors to protect their ownership stakes. This can include negotiating a cap on the amount of money that holders of preferred stock can receive in a liquidation or when the company undergoes an IPO.

• Combine with other types of financing: Startup founders can mitigate the risks of participating preferred stock by combining it with different kinds of financing, such as debt financing or convertible notes. This can help to reduce the overall amount of funding that is provided in the form of participating preferred stock and can help to protect the ownership stakes of the founders.

• Consider alternative funding options: Startup founders should consider alternative funding options that do not involve issuing participating preferred stock, such as equity financing or revenue-based financing. This can help to minimize the risks associated with participating preferred stock and provide more flexibility in the long run.

• Seek legal advice: Startup founders may be wise to seek the advice of a law firm before issuing participating preferred stock. It will help to ensure that the term sheet is written in a way that's fair and reasonable. This can help protect the founders' interests and ensure that they are not exposed to unnecessary risks.

The key distinction between these two types of stock is that participating preferred stock gives venture capitalists the potential to receive additional dividends or payments based on a predetermined formula. In contrast, non-participating preferred stock only entitles investors to a fixed dividend payment.

Although participating preferred stock can be attractive to investors looking for higher returns, it also comes with potential risks for startup founders, such as dilution of ownership and reduced payouts to holders of common stock options in the event of an IPO, liquidation, or sale of the company. Non-participating preferred stock may be a more attractive option for startup founders looking to minimize these risks and protect their number of shares in the company.

Participating preferred stock can be a valuable tool for startup founders looking to secure initial investment for their business. However, it also comes with some potential risks that must be carefully considered.

By understanding the benefits and drawbacks of participating preferred stock, founders can make informed decisions about structuring their financing rounds and protecting their cap table.