7.1 Common and Preferred Stock
4 min read•august 14, 2024
Stocks are the backbone of corporate ownership and investment. gives shareholders and potential dividends, while offers fixed dividends and priority in asset claims. Both have unique advantages and drawbacks for companies and investors.
Issuing stock impacts a company's ownership structure and control. New shares can dilute existing shareholders' stakes, potentially shifting the balance of power. Companies use various strategies, like dual-class structures or preferred stock, to maintain control while raising capital.
Common vs Preferred Stockholders
Characteristics and Rights of Common Stock
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- Represents an ownership interest in a corporation
- Entitles the holder to voting rights on major corporate decisions (electing board of directors, mergers and acquisitions)
- Provides potential for receiving dividends at the discretion of the board
- Grants a residual claim on assets in the event of liquidation, after preferred stockholders and debtholders are paid
Characteristics and Rights of Preferred Stock
- Hybrid security combining features of both debt and equity
- Offers a fixed dividend rate, providing a more stable income stream compared to common stock
- Gives priority over common stockholders in dividend payments and asset claims during liquidation
- Generally does not include voting rights, limiting preferred stockholders' influence on corporate governance
- Can be structured with various features:
- Cumulative (missed dividend payments accumulate) or non-cumulative
- Participating (entitled to additional dividends beyond the stated rate) or non-participating
- Convertible (allowing conversion to common stock) or non-convertible
Advantages and Disadvantages of Stock Issuance
Advantages of Issuing Common Stock
- Allows a company to raise capital without incurring debt, thus avoiding interest payments and maintaining financial flexibility
- Provides a liquid investment for shareholders, enabling them to easily buy or sell their ownership stake
- Aligns interests with the long-term growth and success of the company, as common stockholders benefit from stock price appreciation
Disadvantages of Issuing Common Stock
- Dilutes the ownership percentage and voting power of existing shareholders, as new shares are added to the total outstanding
- May lead to a loss of control for founders or majority shareholders if a significant portion of new shares is issued
- Can be more costly than debt financing, as equity investors typically require a higher return to compensate for the added risk
Advantages of Issuing Preferred Stock
- Offers a company the ability to raise capital without diluting voting control, as preferred stockholders generally do not have voting rights
- Can be more marketable to risk-averse investors seeking stable dividends, particularly in low-interest-rate environments
- Provides flexibility in structuring the security's features (cumulative, participating, convertible) to attract specific investor types
Disadvantages of Issuing Preferred Stock
- Results in higher dividend costs compared to debt financing, as preferred stockholders typically require a higher yield than bondholders
- Lacks tax deductibility for dividend payments, unlike interest payments on debt which are tax-deductible for the issuing company
- May create a negative perception among investors if the company cannot maintain the preferred dividend, potentially impacting its ability to raise capital in the future
Stock Issuance Impact on Ownership and Control
Dilution of Ownership Percentage
- Issuing new common stock dilutes the ownership percentage of existing shareholders, as the new shares increase the total number of shares outstanding while the company's intrinsic value remains the same (absent any capital raised)
- The dilutive effect can be mitigated by issuing shares at a higher price than the current market value, thereby increasing the company's market capitalization
- Example: If a company has 1,000 shares outstanding and issues 500 new shares, an existing shareholder who owned 10% (100 shares) would now own 6.67% (100 out of 1,500 shares)
Shifts in Control and Voting Power
- Stock issuance can shift the balance of control within a company, particularly if a large block of shares is issued to a single investor or group
- Significant changes in ownership structure may lead to new majority shareholders or changes in board composition
- Companies can use different classes of common stock with distinct voting rights (Class A and Class B shares) to maintain control by insiders or founders while still raising capital
- Example: Facebook's dual-class structure allows Mark Zuckerberg to maintain voting control while owning a minority of the company's total equity
Anti-Takeover Measures and Protections
- Companies may implement anti-takeover measures to protect against hostile takeovers or activist investors gaining control through stock acquisitions
- Poison pills, also known as shareholder rights plans, allow existing shareholders to purchase additional shares at a discounted price if a potential acquirer reaches a certain ownership threshold, diluting the acquirer's ownership percentage
- Super-majority voting requirements can be put in place, requiring a higher percentage of shareholder votes (e.g., 80%) to approve significant corporate actions, making it more difficult for a single large shareholder to exert control
Preferred Stock and Control
- The use of preferred stock allows a company to raise capital without altering the voting control structure, as preferred stockholders typically do not have voting rights
- This characteristic enables companies to access additional funding while maintaining the existing balance of control among common shareholders
- Example: A company can issue preferred stock to raise capital for growth initiatives without diluting the voting power of the founders or other key common shareholders
Key Terms to Review (18)
Callability: Callability refers to the feature of certain securities, particularly bonds and preferred stock, that allows the issuer to repurchase or 'call' the security at a predetermined price before its maturity date. This ability provides issuers with flexibility to manage their debt obligations, particularly in changing interest rate environments. When a security is callable, it can affect its pricing and investor demand due to the uncertainty associated with potential early redemption.
Capital gain: A capital gain is the increase in the value of an asset or investment over time, which is realized when the asset is sold for a higher price than its purchase cost. This gain can apply to various types of assets, including stocks, real estate, and other investments. Understanding capital gains is crucial because they can have significant tax implications and impact an investor's overall financial performance.
Common stock: Common stock is a type of equity security that represents ownership in a corporation and typically comes with voting rights. Holders of common stock have a claim on the company’s assets and earnings, which means they can benefit from dividends and capital appreciation but are last in line during liquidation. This type of stock is crucial for understanding how companies raise capital and how investors participate in the ownership and decision-making processes of publicly traded companies.
Convertibility: Convertibility refers to the ability to exchange a security, such as preferred stock, into another form of security, typically common stock, under specific conditions. This feature provides investors with the option to switch their holdings based on market conditions or personal investment strategies, enhancing flexibility and potential returns. The convertibility of preferred stock is particularly significant as it allows investors to capitalize on appreciation in common stock value while enjoying the benefits of preferred dividends.
Dividend preference: Dividend preference refers to the priority given to preferred shareholders over common shareholders when it comes to the distribution of dividends. This means that preferred shareholders are entitled to receive their dividends before any dividends are paid to common shareholders, ensuring they have a more reliable income stream from their investment. This preference is a key characteristic of preferred stock and highlights the different rights and privileges between preferred and common equity holders.
Dividend yield: Dividend yield is a financial ratio that indicates how much a company pays in dividends each year relative to its share price. It is expressed as a percentage and helps investors understand the return on their investment through dividends, making it an important factor in evaluating both common and preferred stock. This metric can influence a company's dividend policy and is also essential when considering market anomalies, as changes in dividend yield may signal underlying inefficiencies in market pricing.
Earnings per Share: Earnings per Share (EPS) is a financial metric that indicates the profitability of a company on a per-share basis. It is calculated by dividing the net income of a company by the number of outstanding shares of its common stock. EPS serves as a key indicator for investors to assess a company's financial health and performance, often influencing stock prices and investment decisions.
Initial public offering (IPO): An initial public offering (IPO) is the process through which a private company offers its shares to the public for the first time, transforming into a publicly traded company. This event allows the company to raise capital from public investors in exchange for ownership stakes, usually in the form of common or preferred stock. IPOs serve as a significant milestone in a company's growth, providing funds for expansion and increasing its visibility in the market.
Liquidity: Liquidity refers to the ease with which an asset can be converted into cash without significantly affecting its market price. It plays a crucial role in ensuring that individuals and businesses can meet their short-term financial obligations, maintain operational efficiency, and navigate through financial markets effectively.
Preferred Stock: Preferred stock is a type of equity security that gives shareholders preferential treatment in terms of dividend payments and asset distribution during liquidation. It usually provides a fixed dividend, making it less risky compared to common stock, but it typically does not carry voting rights. This unique positioning makes preferred stock relevant in understanding the structure of corporate financing, stock markets, capital costs, and the implications for multinational corporations.
Sarbanes-Oxley Act: The Sarbanes-Oxley Act is a U.S. federal law enacted in 2002 aimed at protecting investors from fraudulent financial reporting by corporations. This legislation established stricter regulations on financial disclosures and internal controls, influencing corporate governance practices and ensuring transparency in financial reporting. Its impact extends to various aspects of finance, including stock issuance, project risk management, and multinational operations, creating a framework for accountability and compliance.
Secondary Market: The secondary market is a platform where previously issued financial instruments, such as stocks and bonds, are bought and sold. It plays a crucial role in providing liquidity to investors, allowing them to easily trade assets after their initial issuance, thus influencing the pricing and valuation of securities in the broader financial ecosystem.
Securities Act of 1933: The Securities Act of 1933 was a landmark piece of legislation aimed at regulating the securities industry by requiring that investors receive significant information about securities being offered for public sale. It established a framework for the registration of securities and mandates disclosure to protect investors from fraud and misrepresentation in the sale of securities, playing a crucial role in ensuring transparency in the financial markets.
Shareholder: A shareholder is an individual or institution that owns shares in a corporation, representing a claim on part of the company’s assets and earnings. Shareholders are vital to a company's funding and have the potential to influence corporate governance through their voting rights, particularly regarding major decisions like mergers or acquisitions. They can hold common stock, which typically grants voting rights, or preferred stock, which usually does not but offers fixed dividends.
Stakeholder: A stakeholder is any individual or group that has an interest in the success and decisions of a business or organization. This includes parties such as employees, customers, investors, suppliers, and the community at large. Understanding who the stakeholders are is crucial for businesses, especially when making decisions that affect various aspects of their operations, including equity financing through common and preferred stock.
Systematic risk: Systematic risk refers to the inherent risk that affects the overall market or a particular segment of the market, which cannot be eliminated through diversification. This type of risk is influenced by factors such as economic changes, political events, and natural disasters, making it unavoidable and impacting all investments in the market. Understanding systematic risk is crucial for investors to gauge potential returns and manage their portfolios effectively.
Unsystematic Risk: Unsystematic risk refers to the risk associated with a specific company or industry, which can be reduced through diversification. It is the portion of total risk that is unique to an individual asset, as opposed to market-wide risk that affects all assets. Understanding unsystematic risk is essential when making investment decisions, as it helps investors determine how to allocate their resources across various securities to minimize potential losses.
Voting Rights: Voting rights refer to the legal rights that allow individuals to participate in the election of representatives and the decision-making processes of government. These rights are a crucial aspect of democracy, as they empower shareholders in a corporation to influence management decisions and corporate governance through their votes. Voting rights can vary based on the type of stock held, significantly impacting investors' power and control within a company.