In general, there are two kinds of stock in a corporation: common stock and preferred stock. Common stock is issued to founders, employees, consultants, and advisers. Preferred stock is issued to investors.
Read on to better understand common stock and its importance in equity management. You’ll also learn about the characteristics of common stock and how to issue them.
What is common stock?
Common stock is a type of equity security that represents an individual's ownership in a corporation when they purchase the corporation’s stock shares. It’s one of the most popular types of investments in the stock market. Issuing common stocks to shareholders allows them to benefit from the corporation’s growth and success. Common stockholders are the residual owners of a corporation, which means that they have a claim to the corporation’s assets and earnings after all of the corporation’s liabilities are paid off.
What are the advantages and disadvantages of common stocks?
It’s critical that founders and other startup leaders understand the advantages and disadvantages of common stocks before issuing them.
Advantages of common stocks
Issuing common stocks can offer a number of advantages to corporations like startups. Firstly, startups can have greater flexibility in managing their capital structure by issuing shares of common stocks to raise additional capital or by buying back shares to reduce the number of outstanding shares.
Common stockholders have a vested interest in the success of your startup and may be more likely to provide support and expertise to help your startup succeed. Moreover, a common stock offering can help establish a startup’s valuation, which can lead to higher investment offers.
Common stock issuance can also help provide tax benefits for a startup. Dividends paid to common stockholders are typically tax-deductible, which can reduce your startup’s overall tax burden.
Disadvantages of common stocks
It's important to note that there are also potential drawbacks to issuing common stock, such as dilution of ownership and control, as well as increased regulatory and compliance requirements. By issuing shares, you’re effectively dividing ownership and control of the startup with new shareholders, potentially reducing their influence on decision-making processes. Hence, you should carefully weigh the benefits and risks before issuing any shares of common stock.
Characteristics of common stocks
It is important to understand the rights that come with this type of security. Let's take a closer look at the key characteristics of common stock.
When buying shares of a publicly traded stock, one becomes a shareholder and owns a tiny portion of your startup. Common stockholders have ownership rights. They have the right to review the business's financial books and records and participate in shareholder meetings.
Common stockholders have the right to vote on important issues such as the board of director elections and major corporate actions such as mergers and acquisitions. Shareholders are granted a voting power that is directly proportional to the amount of stock they own. This means that the more shares of common stock a shareholder owns, the more voting power they have. Voting rights are important because they give shareholders a voice in important decisions that can affect your startup’s future.
Common stockholders have the right to receive dividends. Dividends are payments made to shareholders out of your startup’s earnings. The board of directors determines whether dividends will be paid and the payable amount. Dividends are typically paid in cash, but they can also be paid in the form of additional common stock shares. Investors usually view startups that pay dividends as being more stable and less risky.
Common stockholders have liquidation rights, which entitle them to your startup’s assets in the event of liquidation. If your startup declares bankruptcy or is liquidated, common stockholders have a claim to the company's assets after all of the debts and liabilities have been paid off. Since common stockholders are residual owners, they are paid last if your startup is liquidated. As a result, common stock is regarded as a riskier investment than debt securities or preferred stock.
How do you allocate stock?
To keep an incorporation process simple, founders should allocate common stock to both themselves and to an option pool. Founders also may choose to issue super-voting common stock or Series FF preferred stock, which is typically issued 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.
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.