What it means
Preferred shares rank ahead of ordinary shares when a company is sold or wound up. The investor gets a set amount back first, known as the liquidation preference, before ordinary shareholders receive anything.
The convertible feature lets the investor swap the preferred shares for ordinary shares at an agreed ratio. The participating feature is what makes these shares unusual.
After receiving the liquidation preference, the investor also takes a share of what is left, as if the preferred shares had already been converted. A non-participating share, by contrast, forces the investor to choose between the preference and the converted share.
Venture capital and private equity investors often ask for this feature because it protects the downside while keeping the upside. Founders tend to resist it, since it takes value away from ordinary shareholders in a sale.
A common compromise is to cap the total payout, so participation stops once the investor has received a multiple of the original investment. Finance teams model these terms carefully.
The split of sale proceeds depends on the price, the preference, the ownership percentage and any cap, so a small change in terms can shift hundreds of thousands of dollars between investors and founders. The nuance is that the headline ownership percentage can mislead.
An investor with 25% of the shares may take much more than 25% of the proceeds in a modest sale, which is why founders look at the payout table and not just the ownership table. Accounting for these shares can be tricky for the issuing company.
Depending on the terms, they may be shown in equity or as a liability, and the participation feature can affect earnings per share calculations because the investor shares in profits. Auditors will review the legal documents closely, so finance teams should keep the executed agreements and a clear summary of the terms on file.
In practice
Real-world examples.
Example
A start-up raises $2,000,000 from an investor who insists on participating preferred shares. When the company is sold for $10,000,000, the investor takes its $2,000,000 back first and then a share of the remainder. The founders receive less than their ownership percentage suggests. Employee option holders sit behind the preferred investor in the order of payment, so they are affected too.
Example
A founder negotiating a funding round asks for a cap on participation at three times the original investment. The investor agrees. The cap limits how much the investor can take and leaves more value for employees holding options. The investor accepts a cap because the company agrees to a higher valuation.
Example
A finance analyst at a growth company builds a payout table showing proceeds to each class of shareholder at sale prices from $5,000,000 to $50,000,000. The table shows that at low prices the investor takes most of the money, and that where a cap applies, converting becomes more attractive at high prices. This helps the board see at what price each group would be indifferent to a sale.
Formula
Calculation
Investor payout = liquidation preference + (as-converted ownership % x (sale proceeds - liquidation preference))
An investor puts $5,000,000 into a company for shares that would convert to 25% ownership, with a 1x liquidation preference. The company is sold for $20,000,000. The preference is 1 x 5,000,000 = $5,000,000. The remaining proceeds are 20,000,000 - 5,000,000 = $15,000,000, of which the investor takes 25%, or 0.25 x 15,000,000 = $3,750,000. Total payout = 5,000,000 + 3,750,000 = $8,750,000, compared with $5,000,000 for a non-participating share that either takes the preference or converts to 25% of $20,000,000.Case study
Seen in the real world.
Quillfeather Labs is an illustrative, fictional software start-up that raised $4,000,000 from an investor in exchange for participating convertible preferred shares equal to 20% of the company. Two years later it received an offer to be acquired for $15,000,000.
The founders expected the investor to receive 20% of the price, or $3,000,000. The finance lead built a payout table and showed that, with the preference and participation, the investor would take $4,000,000 plus 20% of the remaining $11,000,000, which is $2,200,000, a total of $6,200,000.
In the illustrative outcome, the founders renegotiated the terms in the next round, asking for a cap on participation. The lesson was that the ownership percentage alone says little about who gets paid in a sale. The founders also asked their adviser to run the table at several different sale prices before signing the next term sheet.
Watch out
Common mistakes.
- Assuming a 20% shareholder receives 20% of the sale price, when the preference and participation can lift the payout well above that.
- Ignoring the cap, which changes the point at which converting becomes more valuable than participating.
- Treating all preferred shares as the same, when participation, conversion and preference terms vary widely between deals.
Questions
People also ask.
What does convertible mean here?
It means the holder can exchange the preferred shares for ordinary shares at an agreed ratio, usually when that would pay more than keeping the preference. The holder normally converts only when the converted value is higher than the preference plus participation, which happens most often with a cap.
Why do investors want participation?
It gives them their money back first and a share of the upside as well, which reduces risk in modest outcomes. Participation increases the investor's return in modest sales, so it is one of the most debated terms in a funding round.
What is a participation cap?
It is a limit on the total payout to the participating investor, often expressed as a multiple of the original investment.
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