Like common stock, preferred stocks represent partial ownership in a company. Preferred stock shareholders may or may not enjoy any of the voting rights of those holding common stock. Also, unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate. Often the dividend is cumulative. Thus, the company must pay all unpaid preferred dividends accumulated during previous periods before it can pay dividends to common shareholders. If the company is unable to pay this dividend, the preferred shareholders may have the right to force a liquidation of the company.
Venture capital and private equity firms prefer participating preferred stock because it mirrors the terms on which they raise money from their investors. The typical VC or PE fund structure returns money to their investors plus a preferred return (of 7 or 8%) and then the general partners of the fund participate in 20% of the upside (carry), with 80% going to the investors. A VC or PE fund that uses a participating preferred security should be willing to agree to higher valuations or higher option pools.
Participating preferred is often used as a "bridge" between a company that desires a higher valuation and a VC that believes in a lower valuation. A VC will agree to a higher valuation if it is accompanied by a participating preferred security—essentially challenging the company to earn the upside of the higher valuation.
The main benefit to owning preferred stock is that the investor has a greater claim on the company’s assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before the holders of common stock. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible.