Typical Types Of Securities
Why Issue Common Stock
There are three primary reasons companies issue common stock. The most common reason is to raise money to finance the company if debt is unavailable, insufficient, or offered on poor terms.
Another reason is to incentivize employees and consultants. For example, employees and consultants sometimes agree to work for less money, or in some cases no money, when the company gives them common stock.
Lastly, companies sometimes use common stock in exchange for acquiring assets or another company.
The Benefits Of Buying And Holding Common Stock
Most people buy common stock for three reasons. First, to later sell at a higher price (or so they hope!). Next, to hold for the passive income a dividend may generate for them. Lastly, they are interested in participating in the governance of a company.
Issuing Common Stock
Only the company can issue common stock. Within the company, all common stock issuances must be done with the board of directors’ authority. In some cases, the board of directors can authorize others to issue common stock, such as in connection with an equity incentive plan or stock option plan. Such a plan has several restrictions on people who are granted authority to issue a company’s common stock, and a majority of the company stockholders must also authorize incentive or option plans.
The Advantages Of Owning Common Stock
Owning common stock means the owner can profit from selling it, assuming it increases in value or if the company pays shareholders dividends.
Further, holding stock allows holders to vote in matters regarding things like the composition of the board of directors, selling the company to another, or dissolving the company outright.
Common Stock Versus Preferred Stock – The Differences
These two securities are generally the typical types of securities that come to mind when people think of investing or securities.
Common stock is a unit of ownership of a company, is generally characteristically the same across all companies, and is almost universally set out in the corporate law of all 50 states.
Preferred stock is more of a creature of contract, if you will. Company boards of directors have the authority to “designate” it with nearly any characteristic they desire, including:
- Special voting rights;
- Special dividend rights;
- Liquidation rights that put preferred stockholders in front of common holders upon liquidation of the company and often entitle the holder to receive many times the amount of their investment if the company sells to a third party;
- Conversion rights into common shares;
- Redemption rights that allow the holder to exchange their preferred stock for cash.
Why Issue Preferred Stock
Companies tend to issue preferred shares to attract investors. Most investors who insist on preferred shares want the special characteristics they have and the advantages they bring. Perhaps the clearest advantage is a more votes per share than those cast by shareholders of the common stock. Beyond this is the ability to make greater profits per share than common shareholders if the company sells with their liquidation rights. Similar to this, preferred shareholders may receive prioritized dividend payments, both in terms of the time they receive the payment and the amount.
The Appeal Of Preferred Stock
Those who buy preferred shares are typically interested in decreasing the risk of an equity investment while increasing the reward. These types mitigate these risks by having more influence over the company’s decisions via their concentrated voting power, as well as having the right to recover their investment before the common stockholders if the company is sold or liquidated.
Issuing Preferred Stock
Like with common stock, only the company can issue preferred stock. More specifically, this can only happen when it has been both authorized and designated either in the articles of incorporation or certificate of designation. These documents must be filed with the Secretary of State or Department of Commerce of the state where the company is domiciled.
Within the company, preferred stock can only be issued with the consent of the board of directors. Subject to the company’s articles of incorporation and bylaws, the board of directors must usually get the majority of the shareholders’ consent to designate the characteristics of a preferred stock. During the designation phase, the specific characteristics of the preferred stock are defined.
Preferred Stock – Advantages And Disadvantages
The advantage of owning preferred stock is that the holder is usually entitled to superior rights relative to the common stockholders.
However, this is not necessarily always the case. In many cases, preferred stock actually has no voting rights. Another drawback to holding preferred shares is if the company is public and the common shares are publicly traded, preferred shares must go through the extra step of being converted. This assumes they are even convertible, which is not always the case. Having to go through this process can greatly slow down liquidity, or the ability to sell shares.
Stock Options and Warrants
Options are a bit more complicated than the typical types of securities such as common and preferred stocks.
An option is a contract between the company and a potential shareholder that allows the potential shareholder to purchase stock at a set price at some point in the future. In some cases, stock options are not immediately exercisable by the holder. This means that even if the holder wanted to buy the common shares of the contract, certain things must occur before they are eligible to do so. These criteria, whether the passing of time or the occurrence of events, are referred to as “vesting.”
Stock Purchase Warrants
Stock options and stock purchase warrants are generally synonymous terms, both describing contracts between the company and potential shareholders that gives the holder the right to purchase shares at a fixed price at some point in the future.
“Stock option” is used in the Internal Revenue Code, corporate law, and in the context of company employees. “Stock purchase warrants” is more commonly used in the context of third-party investors who do not work for the company. While the terms could technically be interchanged, and a significant portion of the respective agreements lies in terms of the agreement, the term “warrants” is generally used in connection with investors and “options” with employees.
Stock Option Plans
To improve efficiency and consistency in issuing stock options and other equity to employees and consultants, companies will often create formal agreements called “stock option plans” or “equity incentive plans.” These plans must be approved by both the board of directors and the majority of the common shareholders. The plans usually lay out the parameters and conditions under which stock options can be issued. Some of these parameters include:
- The total number of shares that may be issued under the plan;
- The period of time in which the plan is in effect;
- How to treat options issued under the plan where the employee relationship is terminated or if the company is sold.
Equity incentive plans also include a special committee empowered by the board to make stock issuances per the plan. So long as that special committee empowered under the equity incentive plan issues shares within the parameters and conditions of the plan, they are generally entitled to issue shares to employees and consultants to the company without further permission from the board of directors.
Stock Options – Advantages And Disadvantages
The primary advantage of options for a company is that it can require that employees stay employed with the company before they are in a position to profit from the stock issued to them. This incentivizes the employee to stay in good standing with the organization. For employees, the primary advantage is that they can lock in a stock price that may be much less than the company stock price on the date of exercise in the future.
A drawback of stock options for a company is that the option exercise price for the shares may be at a very steep discount to the value of the shares on the date the employee ultimately purchases them. The result is that the company is selling shares of stock for far less than they are worth. Additionally, accounting for stock options in the company’s financial statements is much more complex than merely accounting for outstanding common stock. For employees, options contracts are designed to require that the employee purchase the shares rather than receiving the shares as a grant. Also, where there is a cash exercise component, which is usually the case, the holding period does not commence until the employee has exercised their options and paid for their shares. This has significant tax implications, likely causing the employee to pay more in taxes. On top of this, there is always the risk that the option’s exercise price at the date of issuance may be lower than the share price. Internal Revenue Code Section 409A severely penalizes shareholders who received options with an exercise price below the shares’ actual value on the date the option was issued.