Participating Preferred Stock: Definition, Feature, And How Does It Work?

Definition:

Participative Preferred Stocks are a sub-category of preferred stocks, which are entitled to their agreed-upon dividend yield, and the dividend that is paid out to the common shareholders of the company.

This means that the payout for participative preferred stock is higher as compared to other stockholders, primarily because of the fact that 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 the sense that participating preferred stock do not have any voting rights, and they are just entitled to their dividend that is declared at the end of the year.

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

Features of Participating 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, which means that 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 has taken place.
See also  Cumulative Preferred Stock: Definition, Feature, And How Does It Work?

How do Participative Preferred Stocks work?

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

Hilo Co. has a capital structure that comprises $ 100,000 in participating preferred shares, which represents 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 which are entitled to a dividend of $2 per share.

Since they are categorized as participating preference shares, they are entitled to get 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.

During the year ended 31st December 2020, Hilo Co. was taken over by Giant Inc. for a valuation of $2,000,000.

In the example above, there are two events 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. is going to 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.

In the same manner, for the year ended 31st December 2020, Hilo Inc. is going to receive liquidation value of $2 million.

Therefore, the participating preferred shareholders are going to 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:

See also  What is a redeemable debt? Definition, Advantages, Disadvantages, Pro and Con

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

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 dividend.

This means that in the case where the company misses a dividend payment for a particular year, the dividend is not going to be carried forward to the next year.

In the case of a cumulative preferred stock, the dividend is going to 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 that they will only be paid the same amount as the common shareholders if the common shareholders get a dividend.

In the same manner, from the perspective of the company, 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 little drawbacks or disadvantages from the perspective of the company.

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

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

Scroll to Top