Common and Preferred Shares - Explained
What are Common and Preferred Stock of a Company?
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Table of ContentsWhat is Common Stock or Common Shares?What are Preferred Stock or Preferred Shares?Options to Purchase Shares
What is Common Stock or Common Shares?
Common shares of stock are the basic unit of ownership for every corporation. Every corporation must have a class of common stock. A common share represents one unit of all of the authorized units (authorized shares) of ownership of the corporation. It entitles the holder to one vote in any election in which shareholders participate. Further, the default rules state that the common share holder has equal rights as to all other common shareholders. Founders generally receive common stock at the time of founding the corporation.
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What are Preferred Stock or Preferred Shares?
Preferred shares constitute an alternative class of stock authorized in the articles. As the name implies, preferred shares give certain rights to holders that are preferential in comparison to the rights of common shareholders. Companies generally use the preferential provisions of preferred shares to attract equity investors.
Investors generally received preferred shares with any number of preferred rights. For example, preferred shareholders may have priority with regard to dividends (defined rights to receive dividends or cumulative rights over time).
Further, preferred shares may receive a liquidation preference if the business is sold. In the same vein, the preferred share may protect against dilution in the event of authorization of additional common shares.This is normally done through a conversion ratio that allows preferred shares to be converted to common shares.
The preferred shareholder may have superior voting rights (such as multiple votes per share, the right to vote for certain director seats or for certain corporate actions).
- Note: The common characteristics of preferred shares issued to equity investors are covered in greater detail in subsequent lectures.
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Options to Purchase Shares
Often companies, instead of issuing stock to an employee, will issue options to that employee. Options allow the employee to purchase stock at some point in the future at a pre-determined exercise price. The real benefit of using options to purchase stock is for tax benefits.
An option to purchase stock at the current value of the stock is not taxable. The recipient has not received a monetary gain from the grant. (Note: If the option allows the recipient to purchase stock at a price less than the current value, then the difference between the strike price and the current value is immediately taxable to the recipient of the option).