A company’s equity capital is represented by common stock or preferred stock. A company can be capitalized with only common stock, but usually preferred stock is issued along with common stock. Both common and preferred stocks are entitled to receiving dividends, but where both of them are outstanding, preferred stock holders enjoy priority. Let’s understand the concept in detail.
Common stock is a type of equity security that represents an ownership in a company. It can be classified into voting shares and non-voting shares. The holder of a voting stock carries a voting right to elect Directors of the company and to vote company’s fundamental corporate activities (including M&A) and policies. A non-voting stock, on the other hand, has all the financial rights of the common stock, but is devoid of the power to choose directors or veto corporate transactions.
During liquidation, the common shareholders are entitled to receive residual claim on the company’s assets that is, they stand at the last behind all the corporate creditors and preferred shareholders for receiving the payment. When a company is forced into bankruptcy because of its inability to pay its obligations (debts), the common shareholders receive nothing. So, their returns are uncertain, contingent to earnings, company reinvestment, market efficiency and stock sale. Since their investment risk is high, common stockholders enjoy higher returns (with higher capital appreciation) compared to preferred stockholders when the company does well.
In case of a sale of a company that is capitalized with only common stock, the holders will receive a pro-rata portion of the sale proceeds. That is, they receive their share of the pie based on the number of common shares they own over the total number of shares owned by all the shareholders.
Common stock can be held closely or publicly. Publicly owned stocks have many owners and can be traded in stock exchanges and public markets. They can be readily sold. The company can also issue new shares once authorized by the board. On the flip side, closely-held stock (also known as private company) has few owners and cannot be traded in the market.
Common stock nomenclature
Although there is no standard definition of the lettered classes of shares, common shares can be segregated as Class A and Class B shares. Class A enjoys inferior voting powers than Class B shares.
Preferred stock can be assorted into (1) straight preferred, (2) convertible preferred and (3) participating preferred. Let’s discuss them in detail.
(1) Traditional Straight Preferred Stock
Traditional Straight Preferred Stock represents an ownership in the company without any voting rights. The stockholders receive (i) a fixed dividend and (ii) a right to receive the face value of their investment along with any dividends prior to its distribution to the common stockholders (but after all the corporate creditors are paid). Straight preferred stock is more like a debt in that they are paid prior to the common stockholders. They do not enjoy any capital appreciation and any unpaid cumulative dividends are paid in full and prior to the common stockholders.
(2) Convertible Preferred Stock
Convertible Preferred is a hybrid equity instrument that carries a voting right (in many cases) based on the fact that the convertible preferred stock can be converted into a predetermined number of common shares. Unlike straight preferred stockholders, convertible preferred is based on the fact that at any given point in time, a higher return is ascribed to either the face value of the preferred stock or the market value of the common stock into which it can be converted. So, the investor enjoys the privilege of waiting until the time of exit and then deciding the higher value of the two – face value of the preferred stock, plus any accrued unpaid dividends, or the earnings at the conversion. Also, read Hybrid Security: Convertible Bonds and Convertible Preferred here.
For example, if an investor owns $100,000 of convertibles that can be converted into 20% of the company (through common stock) and the company can be sold for $1 million, the holder enjoys making a decision between the higher value of the two – $200,000 at conversion into common stock or 20% of the sale proceeds.
(3) Participating Preferred Stock
Participating Preferred is the best investment of all the preferred stocks for an investor because the holder:
- gets a priority over the common stockholders in terms of payment from the sale or liquidation, plus
- receives the face value along with any accrued cumulative unpaid preferred dividends, and
- gets a pro-rata portion of the residual assets or proceeds. The pro-rata portion is determined by the number of common shares into which the convertible will convert divided by the total number of common shares.
An example will clarify this. Consider the same company as above (under “Convertible Preferred Stock”). If the investor holds $100,000 of convertible preferred which can be converted into 20% of the company, the holder will receive the face value ($100,000) prior to all the common shareholders, plus any unpaid dividends, plus 20% of the company’s residual assets.
$1,000,000 – $100,000 = $900,000
$900,000 x 20% = $180,000
$100,000 (face value) + $180,000 (residual claim) = $280,000
This makes participating preferred the best choice for all the sophisticated investors who evaluate early stage or growth companies for their investments.