What is a cap on a participating preferred liquidation preference?
June 18, 2007
A cap on participation limits the amount received by the preferred stock to a fixed amount. The cap is typically fixed as a multiple of the original investment, such as 2x or 3x. Once holders of preferred stock have received the cap amount, they will stop participating in distributions with the common stock. Thereafter, holders of common stock receive all proceeds until holders of common stock have received the same amount per share as the preferred. After that transaction value, holders of preferred stock will be economically incentivized to convert to common stock in order to receive maximum value. Unfortunately, this math is not particularly easy to understand.
Imposing a cap on participation allows the holders of preferred stock to receive a return on their investment without having to convert their holdings to common stock, but leaves the incentive to convert in place where the sale or liquidation occurs at a high valuation.