When raising an equity round, entrepreneurs should pay close attention in the term sheet to determine whether the investors are seeking participating preferred stock or non-participating preferred stock.
As you are probably aware, preferred stock typically has a liquidation preference — that is, when the company is dissolved and liquidated, preferred stock holders get paid before common stock holders the amount of the preferred stock holders’ investment. Therefore, if there isn’t enough money left in the company to pay back the preferred stock holders, they get all of the money. If there is enough money to pay the preferred stock holders, then the common stock holders take the remainder (there must always be a class of common stock that takes the residue of the company’s assets after liquidation after creditors and preferred stock holders have been paid).
The difference between participating preferred stock holders and non-participating preferred stock holders is that participating preferred stock holders also get to share in the remaining liquidation proceeds as if their preferred stock was converted to common stock, in addition to receiving their liquidation preference. Non-participating preferred stock holders only get to elect between taking their liquidation preference, or sharing in the remaining liquidated proceeds with the common stock holders on an as-converted basis. Therefore, participating preferred stock holders get to take from the liquidation proceeds twice, as both a preferred stock holder and a common stock holder; a non-participating preferred stock holder must choose whether they would receive more money from their liquidation preference or to effectively convert their stock to common stock and take a share with the other common stock holders.
As you can probably see, participating preferred stock is preferable for investors since they get to double dip, whereas non-participating preferred stock is better for founders since it is more likely that there will be more liquidation money for the common stock holders (read: the founders) to receive. However, if investors are pressing for participating preferred stock, a middle ground option is to have capped participating preferred stock, which is like non-participating preferred stock in that the stock holder must choose between the liquidation preference or taking on an as-converted basis with the common stock holders, but provides a multiple (such as 2X) on the liquidation preference.
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