Exit planning
Participating preferred and participation caps
Compare participating and non-participating preferred stock, see how a participation cap binds, and work through the sale values where each outcome changes.
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Three ways a preferred holder can be paid
At a sale, a preferred holder is generally choosing between taking its contractual preference and converting to common. Participation changes what the first of those is worth.
- Non-participating. Take the preference, or convert and take a share of the proceeds. Not both.
- Participating. Take the preference and then share in what is left, in proportion to the shares held.
- Participating with a cap. The same, until total proceeds reach a stated multiple of the money invested. Past the cap, converting to common is what pays more.
A cap is written as a multiple of invested capital, and the charter states whether the initial preference and accrued dividends count toward it. Those two choices change the arithmetic, not just the wording.
Work through a 3x capped participating class
Assume 1,000,000 common shares and 1,000,000 preferred shares bought for $1,000,000, a 1x participating preference, and a 3x cap that includes the initial preference. Ignore debt, other classes, dividends, fees, and escrow.
| Sale proceeds | Preferred receives | Why |
|---|---|---|
| $500,000 | $500,000 | Not enough to pay the $1,000,000 preference in full. |
| $1,000,000 | $1,000,000 | The preference is exactly covered; nothing is left to share. |
| $4,000,000 | $2,500,000 | $1,000,000 preference, then half of the $3,000,000 remainder. |
| $6,000,000 | $3,000,000 | The uncapped calculation would pay $3,500,000; the 3x cap binds at $3,000,000. |
| $8,000,000 | $4,000,000 | Converting to common pays 50% of $8,000,000, which beats the $3,000,000 cap. |
Between $6,000,000 and $8,000,000 the class is capped, so every additional dollar of sale price goes to the other holders until conversion becomes the better choice. That is the economic point of a cap, and the reason the common holders’ share of the proceeds rises fastest in that band.
Check what the cap counts
Whether the cap counts the initial preference changes where it binds. Keep the same company and change only that clause: with a 3x cap on the residual participation alone, a $7,000,000 sale pays the preferred $1,000,000 of preference plus $3,000,000 of capped participation, or $4,000,000 in total. Under a cap that includes the preference, the same class would stop at $3,000,000.
A cap constrains participation; it never reduces the senior preference the class is owed. When one class is capped and others are not, the proceeds that the capped class cannot take are redistributed to the participants that remain eligible, so a cap changes more than one holder’s outcome.
Model the terms rather than the outcome
Record participation and the cap as dated terms on the class, with the amendment they come from: see Configure common and preferred share classes. Only a participating class can carry a cap, and the terms apply from their effective date forward.
In Exit scenarios, the classes table marks a class whose cap is reached, every class’s election is settled together with the other classes’ choices taken into account, and a residual that no eligible participant can receive is reported as unallocated rather than assigned. Compare several sale values before drawing a conclusion from any single one.