Participating preferred stock is a type of preferred stock. In a liquidation or acquisition, investors who hold participating preferred stock will first receive their liquidation preference and then also receive proceeds equal to their ownership percentage. That is, they will "participate" along with the common stockholders in receiving proceeds from the liquidation or acquisition in addition to their liquidation preference. Participating preferred stock is not commonly used in US venture financings, as it's seen as overly investor-friendly. Non-participating preferred stock is much more commonly used.
Let's consider an example to help illustrate the impact of participating preferred stock. Let's say an investor named Terry invests $1 million in Acme Inc., an early stage startup, in exchange for a 1x participating preferred stock. This means that in a sale Alex will get his liquidation preference (i.e., $1 million investment back) and then also participate in any remaining proceeds as if thought he'd converted his shares into common stock.
Let's say Acme Inc. is sold for $10 million two years later at which point Alex effectively owned 10% of the company. In that case, Alex would receive the first $1 million as his liquidation preference. The remaining $9 million in sale proceeds would be divided among the remaining shareholders. Since Alex owns 10% of the company, he would receive an additional $900,000 of these proceeds in addition to his liquidation preference. That would bring his total gain from the sale to $1.9 million.
Having participating preferred stock gave Alex an effective 19% ownership in the company in the sale. Whereas if his stock was nonparticipating preferred, he only would have had an effective 10% ownership of the company in the sale.
Common stock does not sound exciting. Preferred stock does. First-time founders are looking for excitement—especially when it comes to their millions of initial shares—and so they’re often surprised to hear that they’ll be receiving common, rather than preferred stock when the startup is incorporated.