Why participating preferred stock investments require a higher valuation than common stock

I was recently discussing the pros and cons of different financial instruments as a means to investing in startups with a late stage investor. At the seed stage, investments are generally made in the form of convertible debt or common stock. At later stages there tends to be relatively more certainty around a company’s cash flows so there is less incentive to delay the valuation to the next funding round. As a result convertible debt investments which serve this purpose are rarely used in later stages. In addition to common stock, later stage investments are most commonly made through participating preferred stock. The main difference between participating preferred stock and common stock is that the former provides investors with a debt-like return prior to sharing the proceeds of an exit according to each investor’s common stock holdings.

A numerical example may help clarify the difference. Let’s say an entrepreneur raises $5M at a post-money valuation of $20M. The investor now owns 25% of the company. Assuming that there is no future dilution, if the investment is in the form of common stock, the investor will receive 25% of the exit value. If the investment is made through participating preferred stock, the investor will receive his $5M principal plus dividends before the remaining exit proceeds are split 25%-75% between the investor and the entrepreneur. The participating preferred stock can also carry a multiple. For instance, a 2X participating preferred stock investment of $5M will return investors twice their principal plus dividends, so $10M plus dividends, before the remaining proceeds are split.
Ignoring dividends, in the event of a small exit of $25M, the investor receives his $5M principal plus 25% of the remaining $20M. The investor’s proceeds are $10M and the entrepreneur earns $15M. Effectively, the investor takes home 40% of the exit value while owning 25% of the company’s shares. If the investment had been made as common stock, the investor would earn $6.25M, leaving $18.75M for the entrepreneur. 
In the event of a large exit of $100M, the investor takes home $5M plus 25% of the remaining $95M. So the investor’s total return is $28.75M, which leaves $71.25M for the entrepreneur. Effectively, the investor takes home 28.75% of the exit value while owning 25% of the company’s shares. If the investment had been made as common stock, the proceeds would have been split $25M-$75M.
As these examples show, the larger the exit, the smaller the difference between the actual share ownership of the investor and the share of the exit proceeds that he takes home. The goal of participating preferred stock is therefore to provide the investor with sufficient compensation in the event of a small exit. One consequence of this is that the investor is more willing to support smaller exits. He is therefore less likely to pressure the entrepreneur to take unnecessary risks in order to create a home run scenario. This can serve to better align the incentives of the investor and the entrepreneur.
Another way to look at the difference between participating preferred stock and common stock is from the perspective of the entrepreneur. Since an entrepreneur always earns more from an exit if the investment is made in the form of common stock, he should demand a higher valuation for a participating preferred stock investment. A savvy investor can exploit these dynamics to differentiate himself from competing investors and secure a lower valuation for himself. Specifically, by making an entrepreneur with serious home run potential a common stock offer when other investors are demanding participating preferred stock, the savvy investor can justify a lower valuation and still win the deal. 
For example, if the investor believes in the $100M exit, he can offer a common stock investment of $5M for 28.75% of the company, which values the startup at $17.4M, while still remaining competitive with participating preferred stock investors valuing the startup at $20M. In the event of an exit greater than $100M, the additional 3.75% ownership that the investor secures as a result of the common stock offer will be much more valuable than the insurance provided by the participating preferred stock.