Participating preferred stock is preferred stock whose holder, after receiving its stated dividend or liquidation preference ahead of common stock, then shares again in the remaining distribution alongside common stock rather than stopping at the preference. A nonparticipating class takes its preference and stops there, so that second claim on the residual is the whole of what the word participating adds.
The right is contractual rather than inherent in the class. The capital structure standard defines participation rights as contractual rights of security holders to receive dividends or returns from the security issuer’s profits, cash flows, or returns on investments (FASB Statement No. 129, paragraph 2). What the label preferred settles on its own, and what it does not, is in preferred stock.
Participation Is Not Cumulation
Cumulative and participating are separate axes and they get collapsed into one. Cumulative asks what happens to a dividend the board passes over, since an unpaid preference on such a class accumulates. Participating asks what is left to claim once the preference has been satisfied.
Delaware makes each a drafting term. A preferred class’s dividends are cumulative or noncumulative as shall be so stated and expressed (8 Del. C. § 151(c)), and participation is one of the special rights a class carries only as stated and expressed in the certificate of incorporation or the board resolution providing for the issue of the stock (8 Del. C. § 151(a)), so a class can be cumulative and nonparticipating, noncumulative and participating, or cumulative and participating at once. Arrears on the cumulative side, and why they are disclosed rather than recorded as a liability, are in preferred stock.
Where the Right Comes From
In Delaware nothing supplies participation by default, and the statute names the right directly. A Delaware class or series may carry such designations, preferences and relative, participating, optional or other special rights as shall be stated and expressed in the certificate of incorporation or in the resolution or resolutions providing for the issue of such stock adopted by the board of directors (8 Del. C. § 151(a)). The word participating sits inside that list, so the right exists only where one of those two documents creates it, the same way the liquidation preference it attaches to does, in common stock.
A Worked Example
Say a corporation is distributing assets and its charter gives one preferred class a stated liquidation preference per share plus full participation with common on a per-share basis.
Distributable amount 1,000,000
Preferred shares outstanding 10,000
Stated liquidation preference per share 10
Common shares outstanding 90,000
Preference paid first 10,000 x 10 = 100,000
Remainder 1,000,000 - 100,000 = 900,000
Participation, pro rata across all 100,000 shares
preferred 10,000 / 100,000 x 900,000 = 90,000
common 90,000 / 100,000 x 900,000 = 810,000
Preferred class total 100,000 + 90,000 = 190,000
Common class total = 810,000A nonparticipating class on the same facts takes its preference and stops, so the whole remainder goes to common. The second line the preferred class collects is what participation is worth, and it comes out of what common would otherwise have received.
What Participation Does to Earnings Per Share
Participation is what can pull a preferred class into the per-share computation as a participating security. The standard describes capital structures that include securities which may participate in dividends with common stocks according to a predetermined formula, at times with an upper limit on the extent of participation, its own example of such a limit being up to, but not beyond, a specified amount per share (FASB Statement No. 128, paragraph 60). A class drafted with that ceiling stops sharing once it reaches the stated amount, which is what separates a capped participating class from the full participation the worked example above assumes. Securities convertible into common stock run through the if-converted method if the effect is dilutive, and those not convertible into a class of common stock run through the two-class method (FASB Statement No. 128, paragraph 61). The convertible route is in diluted earnings per share.
The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared or accumulated and participation rights in undistributed earnings, allocating the earnings that remain after those dividends to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed (FASB Statement No. 128, paragraph 61). Under that allocation the earnings left after those dividends are divided between common stock and the participating security rather than falling to common alone, so the earnings allocated to common are less than the whole of what remains. It works from the numerator defined in earnings per share, and its codified home is Subtopic 260-10, under the heading Participating Securities and the Two-Class Method (FASB Accounting Standards Update 2020-06).
Any preferred class, participating or not, is one more security outstanding, so the entity is not one with only common stock outstanding and it fails the simple capital structure test in capital structure.
Where a US Firm Meets Participating Preferred Stock
The work starts in the charter rather than in the trial balance. Before income available to common is computed, the certificate of incorporation or the issuing resolution has to be read for whether the class participates, on what formula, and whether the participation is capped, because none of that shows up in the ledger.
The rights then have to be described. An entity explains, in summary form within its financial statements, the pertinent rights and privileges of the various securities outstanding, and the examples the standard names include dividend and liquidation preferences and participation rights (FASB Statement No. 129, paragraph 4).
Two classification questions sit alongside that one and are answered elsewhere: whether the class is a liability rather than equity, and which Regulation S-X caption it takes in an SEC filing, both in preferred stock, which also carries the one-class-of-stock trap that any preference springs on an S corporation client. The share count the charter authorizes across every class is in capital stock.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own equity roll-forward and per-share schedule work through a trial task before a client filing depends on it.
