What is common stock?
Common stock (ordinary, voting, or common shares) is a vital concept for business owners and investors looking for viable investments. Understanding common stock – its meaning, definition, viability, benefits, and risks – will steer you towards making informed financial decisions.
Common stock represents your residual ownership in a business entity. It gets you the capital appreciation of a company’s securities alongside voting rights on the company's critical decisions such as policies and board of directors. However, some companies, such as Google, offer common stock without eligibility for voting rights – voting and non-voting. But since the latter is still a tradeable asset, holders can make lots of money by selling the shares from the company's growth and success.
Averagely, common shares provide a higher relative than bonds or preferred stock. But you should note that the higher returns come with higher risks associated with such securities.
Read on to understand everything you should know about this concept.
Who can invest in common stocks?
Since they are publicly traded, anyone can invest in common stocks. Investment bankers, among other corporate finance professionals, can use common stock prices on the exchange to determine the company's performance. investment banking also publicizes private entities through the initial public offering (IPO). Once the company is publicly traded, it can issue common stocks.
Most positions in the investment world are likely to interact with common stocks in one way or another. Financial advisors and personal finance advisors offer guidance on buying and selling different types of common stocks. Stockbrokers also specialize in the same area – facilitation and guidance of their clients on buying and selling common stocks.
Classification of common stock
There is no unified classification of common stock. But as mentioned above, some companies, such as Google, issue two types of common stock – voting and non-voting categories. Others offer less voting power in place of the latter. The goal is to preserve control of the company even though both classes enjoy equal rights in organizational profits and dividends.
What are the features of common stock?
Common stock shares were initially issued as actual paper documents. The industry has since evolved and digitalized, explaining why the shares are mostly traded virtually today, thanks to reputable online digital brokers. Common stock is characterized by several features as follows:
- Ownership: Common stock represents the shareholder's partial ownership of the company. If the company is dissolved and the assets liquidated, these shareholders are entitled to a portion of the proceeds paying off bondholders, creditors, and preferred shareholders. Since common stockholders are partial company owners, they also have a right to review the entity's financial books and records and attend shareholder meetings.
- Voting rights: Common stockholders have a right to vote in critical corporate matters and decisions such as the board of directors, mergers, and acquisitions. Each shareholder enjoys a voting power directly proportional to the amount of stock they own, meaning more stock results in higher voting rights. These voting rights give the stockholders a voice in deciding the company's leadership, operations, and future.
- Fungibility: Stock shares are fungible, meaning they all are worth the same amount at any given time. Besides, each share represents ownership of the said company in the same amount. For this reason, one common stock share can be replaced by another without changing value or rights.
- Volatility: Common stock, a type of equity security, is more volatile than preferred stock(corporate bonds, hybrid security, or debt security). For this reason, it is likely to encounter immense price changes over time. Plus, a common stock share has no minimum or maximum market value.
- Dividend rights: Common stockholders have a right to receive dividends – payments made to shareholders from the company's earnings. The board of directors is responsible for deciding whether the dividends should be paid and the payable amount. While the dividends are usually paid in cash, the shareholder can receive them as additional common stock shares. Investors find companies that pay dividends to be more stable, thus, less risky.
- Liquidation rights: Common stockholders have liquidation rights that allow them access to the company's assets in case of liquidation. If the company is liquidated or becomes bankrupt, these stockholders have a right to claim organizational assets after all debts and liabilities are cleared.
Since they are residual owners, these shareholders are paid last in the event of liquidation. For this reason, common stock is considered a riskier investment than preferred stock or debt securities.
Why do companies issue common stock?
Companies issue common stock for various reasons. Firstly, it is to raise capital for different purposes, including
- Business expansion
- To pay off outstanding debts
- To acquire promising companies
- To create a future cash reserve
- Product development
- Research
- Recruitment
By issuing stock, a company increases its equity, thereby reducing its reliance on debt.
A company issues its first stock during the initial public offering, IPO, which indicates that it is growing and is ready for investor capital. Issuing stock dilutes the power of its old and existing shareholders. For this reason, some companies give stocks to dissolve existing power by injecting fresh blood.
What are the advantages and disadvantages of common stocks?
Like other investments, common stock has its pros and cons. Here are the advantages of common stock that you should know.
Advantages of issuing common stock:
Performance
Common stocks have been proven to perform better than bonds and deposit certificates. This investment brings higher returns through capital gains and dividends anytime the company's stock valuation rises. On the other hand, dividends arise when the company remains with substantial revenue after clearing its commitments.
Voting rights
Investing in common stock allows you voting rights – one voting right per stock held – in the company's crucial matters. This way, you can participate in business decisions, policy formation, and leadership elections.
Liquidity
Common stocks are highly liquid – easy to buy or sell – depending on your preference and choice. This feature allows great flexibility in modifying the investment at any time stress-free.
Limited liability
Common stockholders are passive investors. Therefore, their responsibilities are limited as they can easily dissociate themselves from any events in the company beyond financial investment.
For this reason, they can enjoy a safe financial future as long as the returns are great, which comes with a steady company growth rate. Besides, investors have no risk of losing more money than the original investment.
Disadvantages of issuing common stock:
Market risks
Market risk arises for common stockholders when the company consistently underperforms. A significant decline in an organization's performance undermines its profits and, eventually, the shareholder's earnings and dividends.
Anyone investing in the common stock should understand that being residual owners means they have no right to priority payouts even when the company is doing quite well.
Uncertainty
While you may consider common stockholding a fixed-income option, there is no guarantee for returns. The common stockholders only receive their payout after the bondholders and preferred shareholders get their full pay. For this reason, this investment carries lots of uncertainty which worsens with a lack of control in the investment class.
Why do investors buy common stocks?
Investors invest in common stocks for various reasons, such as:
- To increase their income through dividends, their shares may pay off.
- To resale the shares and make profits.
- To participate in the company's growth and become part of its success.
How do you allocate stock?
To keep an incorporation process simple, founders should allocate common stock to themselves and an option pool. Founders may also choose to issue super-voting common stock or Series FF preferred stock, typically given to founders.
Note that the issuance of supervoting or Series FF preferred can add complexity to the incorporation and ongoing management of the corporation. That highlights the importance of obtaining legal and tax advice in deciding whether these and other types of shares are worth the time and cost of establishing them.
Why is common stock referred to as equity?
Common stock represents your residual ownership stake in a business entity. Every company maintains a balance sheet that comprises assets and liabilities. The assets include everything the company owns or is entitled to, such as equipment, property, cash reserves, and accounts receivable.
A healthy company has larger assets than total liabilities. The difference – what is left over – is the residual amount belonging to the owners – shareholders' equity – and it is what represents the company's shares. On the other hand, liabilities comprise everything the company owes, from debts to payables, among other obligations.
What is the difference between common stock and preferred stock?
Common stock and preferred stock both represent company equity. However, they behave differently, characterized by different features. While the common stock may (mostly) or may not come with voting rights, preferred stock doesn't typically carry voting rights but a fixed and regular dividend amount.
Unlike common shareholders – who are also eligible for dividends – preferred shareholders have a guaranteed dividend of a fixed amount payable at regular intervals. Besides, the latter takes precedence regarding dividend distribution.
Preferred stock is less volatile than common stock as its dividend payments are typically regular, similar to corporate bondholders. Being a preferred stockholder allows you access to regular and fixed income – its market value is less likely to fluctuate dramatically like common stock.
Preferred shareholders also have priority in asset distribution over common shareholders. They receive an earlier payout in the event of company liquidation after bondholders. Only then can the common stockholders receive their pay.
Moreover, preferred stock is often callable – after a given date, it can be exchanged (reassigned to the issuing company) for its par face value.
How can I use common stock to vote at company meetings?
On days you can't attend, you can vote by proxy – a third party can vote on your behalf, along with others who can't participate. Some issues you can vote on include leadership, approval of stock splits and dividends, mergers, and acquisitions. Common shares typically come with one vote per share held, granting you the right to vote on company decisions during shareholders' meetings.
Common stock: Key takeaways
As a startup founder, it is your obligation to raise capital for company expenses such as product development, expansion, recruitment, research, and payment of debts. Issuing common stock is one of the most effective ways of creating such capital. Besides, it makes you outstanding among potential investors during the initial public hearing, and IPO by portraying you as a viable investment, especially if you pay dividends. With adequate capital at hand, you can make informed financial decisions for your business entity, as you steer towards growth and success.
Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.
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