Value Investing – Common Stock (Definition)
A document indicating ownership in a corporation is often referred to as common stock. It identifies an equity position in a business. The document or certificate is commonly referred to as a security and provides certain rights to the holder (owner). These rights include voting and residual value upon liquidation of the company.
There is a risk reward concept that is inherent in ownership. In general, the greatest risk in losses and potential are held by this group of owners known as the stockholders. Below are descriptions of the legal rights, the financial risks and methods of transfer pertaining to common stock.
Legal Rights
A corporation is owned by stockholders. The tool to indicate ownership rights is referred to as a stock certificate. When the corporation starts out, it issues (sells) a stock certificate in exchange for cash. In general, the corporation issues a lot of certificates and so the term used is ‘Common Stock’.
At the very start, the corporation seeks permission from the state to exist as a separate entity (to understand more, read Why Incorporate?). In the requesting process, the directors state the maximum number of shares it will issue. The state ‘authorizes’ the right of the corporation to sell stock to begin operations. In addition to identifying the number of shares authorized, the directors also state the respective legal rights to the shares. These are referred to as the ‘Shareholder Rights’. The most common rights issued with the certificate include the following:
Voting – the right to vote in accordance to your percentage of ownership of the number of shares issued, not authorized, but issued. If the corporation is authorized up to 50,000 shares and you purchased 100 shares of 7,000 issued, you have 100/7,000 or 1.429% of the voting rights for the corporation. In general the voting rights consist of the ability to elect directors (the greatest control mechanism for the common stock holder) and make changes to the by-laws (the legal status of the corporation submitted to the state). In addition, the voting privileges may include rights to vote for operational objectives, issuance of bonds and other forms of ownership securities.
Notification – whenever the company’s Board of Directors proposes a meeting or a change in the by-laws, you have a right to notice well in advance. This notification right also includes the ability to present a position notice relating to the issue at hand. Essentially, you have the right to go in front of the Board and present your case either for or against the proposed change.
Recall – not a common right, but in some smaller corporations that are regional in nature, shareholders with a minimum level of agreement with other shareholders or overall percentage of ownership, have a right to recall a board director or call to action to remove the entire board of directors. In effect, you may have the right to call a special meeting of the Board of Directors.
Preemptive Rights – in my example under voting, I illustrated the ownership percentage as 1.429. If the corporation decides to issue more stock, a preemptive right entitles you to maintain your position of ownership by allowing you to buy shares of the new issue in order to maintain your 1.429% ownership position.
However, the most sought after legal right of common stock is the right to the financial rewards the corporation is believed to potentially generate.
Financial Risks
In a simple corporate structure, there is no debt and no other types of stock sold. Therefore, any profits earned by the company are available for disbursement via dividends to the shareholders. The Board of Directors votes on a dividend distribution per share of stock. As an example: continuing with the 100 shares of the 7,000 shares issued in the example above; the board of directors decides that of the $23,000 profit earned $9,000 should be paid out to shareholders. Therefore, each share will get paid $1.2857. Since you own 100 shares, you will receive a check for $128.57 as your reward for the profits earned to date.
This may appear appealing to own stock; however, it is never this simple. Often corporations issue bonds to purchase equipment. Over time, the company borrows money to offset receivables or agrees to a mortgage for real estate. Often these bonds or notes have clauses in them stating that the company may not issue dividends until certain financial goals have been met. For the bond holders or banks, the key is to protect their investment. This reduces the financial reward for the shareholder.
In effect, by acts of law and via legal documents, shareholders get paid last and often receive zero if the company liquidates (most often due to bankruptcy). The key is good corporate performance to continue operations and meet the minimum requirements of the bonds or notes.
In addition to bonds or notes, sometimes corporations sell other forms of stock with a greater right to the financial rewards over the common shareholder. These higher forms of stock rights have various names and rights. The following are some examples:
Preferred Stock – a certificate with a preferred right to financial reward over common stock but has no voting rights.
Classes of Stock – sometimes corporations reorganize the stock into groups giving one class of stock more rights or more financial reward with less risk over the common stock. A company can issue something like ‘Class A’ stock with a greater right over common stock. This class of stock may be entitled to electing one or more of the Board of Directors giving them greater say in the operations of the company. In addition, they may receive preference over common stock shareholders in case of liquidation or financial distributions.
Convertible Stock – a security providing the right of the owner to convert from a reclusive position (no say and no financial reward) to a common stock or preferred stock position contingent upon certain goals achieved with the corporation. There may be a conversion if the company fails to meet certain goals too. This is a complex type of security and so its rights and privileges can be easily misunderstood. It is best to be a sophisticated investor if looking into buying this type of security.
Suffice it to say, the common shareholder has the greatest potential for reward if the company does well, however, if the company performs poorly or the economy affects the value of the assets of the company, the common stock holder will most likely lose the entire investment. The simplest way to state this is the common shareholder gets paid last.
Methods of Transfer
The common lay person often thinks of stock transfer as an image of the New York Stock Exchange floor where millions of shares of various corporations are bought and sold each day. This is referred to as the secondary market. The primary market is called the Initial Public Offering or IPO.
In the small business world, corporate stock is most commonly exchanged via the death of the holder of the certificate. When someone invests in a small business, they are usually the initial founder or company director of origin. Because the small business world is mostly family held operations, death is the trigger for transfer of the stock. The heirs receive the stock and they now own the business.
In some stock sells, the company sells certificates to family and friends or business associates. It is rare to go beyond the family boundaries as there are possibilities of accusations of deception or improper conduct. I don’t recommend this course of raising money for your company. Stay within the family environment. If you do go beyond the family circle, use contracts, agreement forms, letters of understanding and even security offering documentation to properly present the financial position, pro forma, and rights of the common stock to your company. Use must use discretion and seek legal counsel to sell stock to someone you do not know.
But in some cases, the company does grow and prosper. Using good financial advice and working with investment groups, a small business begins to diversify the ownership with others. In these situations, the corporation submits a request to the state to expand the number of shares authorized. Others begin to get involved. If the company goes beyond the boundaries of the state, it then must comply with the Securities and Exchange Commission requirements to sell shares of stock.
Once the company has achieved certain levels of financial success, the shareholders may decide to take the company public. This is a significant milestone in the company’s growth as there a new regulations and compliance requirements to go public. But if the company truly desires to expand, going through the steps of an Initial Public Offering (IPO) may be financially beneficial. More potential buyers are available and there are greater opportunities for all parties involved. This is a rare step for most businesses as only those that desire to expand beyond the scope of a family or small regional company are capable of achieving this level of ability to trade stock.
Summary – Common Stock
Common stock is a certificate providing the holder certain legal rights and financial rewards. Legally, the holder has the right to vote and participate to a certain extent in the election of the directors of the company. Financially, the holder can earn the greatest financial returns over other security holders but is also the last to get paid as creditors are paid first.
In the small business world, stock is rarely traded as there is a limited market and in addition most family owned operations desire to keep the business within the family. A company may seek out more sophisticated investors but must comply with many federal and state rules and regulations. It is rare for a company to reach the level of an Initial Public Offering (IPO). Act on Knowledge.