Participating preferred stock - which entitles the investor to a preferential payment upon liquidation, as well as a share of the remaining liquidation proceeds with common stockholders - has some critics, namely those who say it allows the holder to double-dip into the company gains. A common way to limit the dilution of value caused by participating preferred stock is to set a cap on the participation amounts. With this structure, the holder gets all the benefits of participating preferred stock, but the total return on invested capital is capped, unless the holder gives up its liquidation preference and converts to common stock (greater aligning its interest with the founders' interests).
The cap is often set as a multiple (2x or 3x) of the original investment. Once the investor has reached that ceiling, they can no longer share in the remaining payment distributions with common stockholders. For example, say the holders of participating preferred stock get 1x initial preference and a 3x cap on participation. Upon sale or liquidation, they would receive a) a distribution that is equal to their initial 1x liquidation preference and b) a pro rata distribution with common stockholders, until the distribution equals 3x the original purchase price.
There are circumstances - particularly when a sale or liquidation occurs at a high valuation - where the investor’s ownership would yield a higher return than its preference and participation cap allow. In these cases, the investor has an incentive to forgo their preference and simply participate as a common stockholder.