Question #4Matthew HumphreyThe two most fundamental categories of stock in a new business arecommon stock and preferred stock, which differ in the rights that theyconfer upon their owners. But stocks can also be classified according to anumber of other criteria, including company size and company sector.
I willdescribe the different types of stocks that are available and the importantcharacteristics of each of them. Most shares of stock are called “common shares”. If you own a share ofcommon stock, then you are a partial owner of the company. You are alsoentitled to certain voting rights regarding company matters. Typically,common stock shareholders receive one vote per share to elect the company’sboard of directors. The board of directors is the group of individualsthat represents the owners of the corporation and oversees major decisionsfor the company.
Common stock shareholders also receive voting rightsregarding other company matters such as stock splits and companyobjectives. In addition to voting rights, common shareholders sometimes enjoy whatare called “preemptive rights. ” Preemptive rights allow common shareholdersto maintain their proportional ownership in the company in the event thatthe company issues another offering of stock. This means that commonshareholders with preemptive rights have the right but not the obligationto purchase as many new shares of the stock as it would take to maintaintheir proportional ownership in the company. But although common stock entitles its holders to a number ofdifferent rights and privileges, it does have one major drawback: commonstock shareholders are the last in line to receive the company’s assets. This means that common stock shareholders receive dividend payments onlyafter all preferred shareholders have received their dividend payments.
Italso means that if the company goes bankrupt, the common stock shareholdersreceive whatever assets are left over only after all creditors,bondholders, and preferred shareholders have been paid in full. The other fundamental category of stock is preferred stock. Likecommon stock, preferred stock represents partial ownership in a company,although preferred stock shareholders do not enjoy any of the voting rightsof common stockholders. Also unlike common stock, preferred stock pays afixed dividend that does not fluctuate, although the company does not haveto pay this dividend if it lacks the financial ability to do so. The mainbenefit to owning preferred stock is that you have a greater claim on thecompany’s assets than common stockholders. Preferred shareholders alwaysreceive their dividends first and, in the event the company goes bankrupt,preferred shareholders are paid off before common stockholders.
In general,there are four different types of preferred stock: . Cumulative: These shares give their owners the right to “accumulate”dividend payments that were skipped due to financial problems; if thecompany later resumes paying dividends, cumulative shareholdersreceive their missed payments first. . Non-Cumulative: These shares do not give their owners back paymentsfor skipped dividends.
. Participating: These shares may receive higher than normal dividendpayments if the company turns a larger than expected profit. . Convertible: These shares may be converted into a specified number ofshares of common stock. Since preferred shares carry fixed dividend payments, they tend tofluctuate in price far less than common shares. This means that theopportunity for both large capital gains and large capital losses islimited.
At the beginning stages of businesses it is better to issue stockoutright rather than to use stock options. Stock can be issued for littlecost and thereby provide the founders certain benefits of direct stockownership and avoid some of the drawbacks of stock options. One importantdifference between stocks and options is that stocks give you a small pieceof ownership in the company while options are just contracts that give youthe right to buy or sell the stock at a specific price by a specific date.