This post was written by Matthew D’Ascenzo. 

I recently posted a series of blogs regarding the features of certain types of preferred stock. The posts were separate in order to keep things short and relatively simple. These types of preferred stock, however, contain a variety of related features, such as being non-convertible or convertible and participating or non-participating – that may be easier to understand in the context of a comprehensive overview of all of the types. I accordingly am reproducing all of the blogs in this single post for ease of reference.

As I have previously noted, preferred stock provides flexibility in structuring investments. It can furnish various dividend and participation rights (such as rights to participate with common stock in proceeds from company sales) in order to achieve a company’s capital raising goals and meet investors’ desired economic returns.

This very flexibility, however, results in a potentially off-putting thicket of legal terminology.  To pare back this thicket, I discuss below the attributes of the following types of preferred stock:

  • Non-convertible, straight preferred stock
  • Non-convertible, double dip participating preferred stock
  • Convertible, non-participating preferred stock
  • Convertible, conventional participating preferred stock
  • Convertible, double-dip participating preferred stock

This post is intended to provide a brief overview of the diverse types of preferred stock. If you are considering raising capital, you should discuss with legal counsel whether any of these classes of preferred stock are appropriate for your capital raise.

  1. Non-Convertible, Straight Preferred Stock.

Non-convertible, straight preferred stock is the most basic type of preferred stock. It is called “straight” preferred stock because it has a fixed dividend (often 8%) that continues to accrue if it is not paid. It also has a senior liquidation preference, meaning that the preferred shareholder receives back its invested cash plus all accumulated, unpaid dividends before common shareholders get paid.

The senior liquidation preference is all that the preferred shareholder receives. This type of preferred stock is “non-convertible,” meaning that it cannot be converted into common stock. Also, it is “non-participating” because it does not entitle the shareholder to participate in any remaining proceeds in excess of the senior liquidation preference upon a sale of the company.

This class of stock provides a stable, fixed return for the preferred shareholder. It does not, however, give the preferred shareholder any ability to share in any excess proceeds of a sale of the company and accordingly limits the shareholder’s return in case of a lucrative sale. This type of preferred stock often is seen in buyout deals, where the sponsor wants a relatively certain return.

  1. Non-Convertible, Double-Dip Participating Preferred Stock.

Like non-convertible, straight preferred stock, non-convertible, double-dip participating preferred stock has a fixed, accruing dividend and a senior liquidation preference pursuant to which the preferred shareholder receives back its invested money plus all accumulated, unpaid dividends before the common shareholders get paid. But, unlike non-convertible, straight preferred stock, it also participates with the common stock up to a stated fixed percentage of the sales proceeds in excess of the senior liquidation preference upon a sale of the company; for example, the preferred shareholders may receive 10% of any remaining sale proceeds.

This feature is known as a “double-dip” participation because the preferred shareholder receives both its senior liquidation preference and a percentage of the remaining sale proceeds in excess of the preference. Note, however, that this type of preferred stock cannot be converted into common stock.

This type of preferred stock is attractive to investors because it provides them with a preferred return, but also allows them to participate in any remaining proceeds of a sale of the company through the double-dip feature. It often is used in a buyout involving a rollover of common stock by the target company’s management or shareholders. The participation feature helps facilitate a tax-free rollover, deferring tax on any gain on the stock rolled over in the acquisition.

  1. Convertible, Non-Participating Preferred Stock.

Convertible, non-participating preferred stock has a senior liquidation preference pursuant to which the preferred shareholder receives back its invested money plus all accumulated, unpaid dividends before the common shareholders get paid. Unlike straight preferred stock, however, this type of preferred stock has the option of sharing in the appreciation in the value of the company by converting into common stock. Upon the sale of the company, the preferred shareholder can either (a) receive the senior liquidation preference or (b) convert to common stock and receive its share of the sales proceeds. The preferred shareholder can choose whichever option is more lucrative.

This type of preferred stock is commonly found in early-stage venture capital investments. Because of the speculative nature of these companies, an investor typically hopes for significant appreciation in the company’s value and is not relying on the stable, fixed-income aspects of preferred stock. This type of preferred stock also can be used in buyouts with a management rollover as an alternative to non-convertible, double-dip participating preferred stock.

  1. Convertible, Conventional Participating Preferred Stock.

Convertible, conventional participating preferred stock entitles the preferred shareholder to receive the greater of (a) the senior liquidation preference pursuant to which the preferred shareholder receives back its invested money plus all accumulated, unpaid dividends before the common shareholders get paid or (b) what the preferred shareholder would receive if the preferred stock was converted into common stock upon a sale of the company (commonly known as conventional participation). Note, however, that, as with convertible, non-participating preferred stock, the shareholder does not receive both the senor liquidation preference and participate in any remaining sales proceeds in excess of the senior liquidation preference (in other words, it is not a double-dip participation).

This type of preferred stock is often seen in both venture capital transactions and in later-stage growth stock investments. It can also be used in buyouts to help achieve a tax-free rollover.

  1. Convertible, Double-Dip Participating Preferred Stock.

Like non-convertible, double-dip participating preferred stock, convertible, double-dip participating preferred stock has a fixed, accruing dividend and a senior liquidation preference pursuant to which the preferred shareholder receives back its invested money plus all accumulated, unpaid dividends before the common shareholders get paid. However, unlike with non-convertible, double-dip participating preferred stock, the participation in any remaining sales proceeds in excess of the senior liquidation preference is not stated as a fixed percentage. Instead, it is the amount that the shareholder would receive if its preferred stock had been converted into common stock immediately prior to the sale of the company.

This type of preferred stock is economically very favorable to the preferred shareholder because it receives both its senior liquidation preference plus its pro rata share of any remaining sales proceeds in excess of the senior liquidation preference that it would have received if the preferred stock had been converted into common stock immediately prior to the sale. This type of preferred stock is most often used in a late stage, growth stock investment where the investor anticipates that the value of the investment will appreciate considerably. It can also be used in a buyout to help achieve a tax-free rollover due to the participation features of the stock.

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