Preferred shares hold rights which enhance their value relative to common stock. Here are the some of the most frequently-seen preferred rights:
Liquidation preference. When a venture-backed company is sold, preferred shareholders typically rank senior to common in the distribution of sale proceeds. No proceeds are paid to the common shareholders until preferred shareholders have received a specified minimum, such as the original investment amount. The preferred stock agreement may stipulate that the preferred shareholder receives a multiple of the original investment. The higher the multiple, the more preferred shares are worth relative to common.
Dividends. Preferred shareholders may require dividends that are cumulative or non-cumulative. Non-cumulative dividends that are not declared in a given year do not become payable in subsequent years. Cumulative dividends may accrue from the day preferred shares are issued, whether or not declared. Cumulative dividends increase the amount due to the preferred shareholder upon sale of the company and enhance the value of preferred shares relative to common.
Participation. When preferred stock is non-participating, the preferred shareholder must make a choice. Either he elects to receive the liquidation preference or to convert to common. (If the company is being sold at a favorable price, the preferred shareholder may receive more by converting to common than he would by taking the liquidation preference.)
If the preferred is participating, no choice is necessary. The preferred shareholder receives the liquidation preference plus a portion of any remaining proceeds paid to the common shareholders. Participation rights enhance the value of preferred shares relative to common.
Participation Cap. If participation is capped, the preferred shareholder receives the liquidation preference plus distributions to common up to a defined limit. The limit may equal a multiple of the original investment. Once the payout reaches the participation cap, no additional proceeds are paid to the preferred shareholder unless he elects to convert to common. All other things being equal, participating preferred with no cap is more valuable than capped participation.