What is a Participating Preferred Stock? Definition, Feature, And How Does It Work?

Definition:

Participative Preferred Stocks are a sub-category of preferred stocks, entitled to their agreed-upon dividend yield, and the dividend paid out to the company’s common shareholders. This means that the payout for participative preferred stock is higher than other stockholders, primarily because they are entitled to two different dividends.

The additional dividend that they receive brings their dividend similar to that of the common shareholders.

However, it must be noted that participating preferred stock is similar to preferred stock in that participating preferred stock does not have any voting rights, and they are entitled to their dividend that is declared at the end of the year.

Even though their dividend payout is variable (similar to that of common stockholders), it can be seen that participating in preferred stock is not very common. It is mostly issued in response to a hostile acquisition bid which is part of the poison pill strategy.

Features of Participating in Preferred Stock

Participating Preferred Stocks have the following features:

  • They are entitled to two dividends – The first dividend is based on the par value of the shares, whereas the second dividend is based on the profits that the company generates (and the dividend that is issued for the common shareholder)
  • They have no voting rights, meaning they do not have a say in how the company functions.
  • They are entitled to preferential settlement treatment, in the case where the company faces bankruptcy and liquidation.
  • In the case of the takeover, participating preferred shares are also entitled to post-liquidation value. However, non-participating preferred shares are not entitled to any revaluation after the acquisition.
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How do Participative Preferred Stocks work?

As mentioned, it can be seen that participative preferred stocks are stocks that have dual yields. The example below illustrates the working and functionality of participative preferred stocks.

Hilo Co. has a capital structure comprising $ 100,000 in participating preferred shares, representing 10% of the company’s share. On the other hand, the remaining 90%, or $900,000 are attributable to the common shareholders.

Hilo Co. has issued participating preference shares entitled to a dividend of $2 per share.

Since they are categorized as participating preference shares, they are entitled to dividends similar to the common shareholders.

During the year ended 31st December 2019, the common shareholders were entitled to a dividend of $2.5 per share.

When it ended on 31st December 2020, Hilo Co. was taken over by Giant Inc. for a valuation of $2,000,000.

In the example above, two events are involved—the dividend payout at the end of 2019, and the takeover at the end of 2020.

For the year ended 31st December 2019, Hilo Inc. will be entitled to a dividend of $2 + $0.5 of dividends. This is because their payout is supposed to stay similar to the dividends received by common shareholders.

Similarly, for the year ended 31st December 2020, Hilo Inc. will receive a liquidation value of $2 million.

Therefore, the participating preferred shareholders will be entitled to their investment (i.e. $100,000) plus 10% of the remaining proceeds. In other words, they are going to be entitled to:

10% of $2,000,000 = $200,000 – $100,000 = $100,000 (for the extra valuation part)

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Therefore, the total payout for participating preferred stock would be $200,000, which is the sum of their principal investment and their share in the extra valuation.

Advantages of Participative Preferred Stocks

The greatest benefit of participative preferred stocks is the fact that these stocks do not cumulate dividends.

This means that if the company misses a dividend payment for a particular year, the dividend will not be carried forward to the next year.

In the case of a cumulative preferred stock, the dividend will be carried forward from one year to the next.

In the same manner, it can be seen that the return of the participative preferred stock is variable. This means they will only be paid the same amount as the common shareholders if they get a dividend.

Similarly, from the company’s perspective, participative preferred stocks do not have voting rights.

Therefore, it gives options to companies to raise substantial finance, without having to worry about diluted decision-making structure within the company.

Limitations of Participative Preferred Stocks

Participative Preferred Stocks have few drawbacks or disadvantages from the company’s perspective.

However, the greatest disadvantage is that participative preference shares are supposed to get a dividend payout similar to common shareholders.

This implies that companies might need to pay higher dividends in the case of participative preferred stocks.