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What are the many variations in characteristics of the “ownership structure” of the corporations?
At the time of formation, a corporation authorizes shares to issue to shareholders in exchange for capital.
- Promoters and Stock Subscription Agreements – Often the “promoters” of the corporation will seek promises from individuals to purchase stock in the corporation once it is fully formed. These “subscription agreements” provide certainty that the corporation will have operational capital post formation.
- Authorized & Issued Shares – The number of “authorized shares” of the corporation is stated in the articles of organization. This number generally far exceeds the number of shares actually issued to shareholders (“issued shares”). The corporation will retain the ability to issue more shares in the future.
- Treasury Stock – Sometimes the corporation will repurchase shares that have been issued. The repurchased shares are held by the corporation as “treasury stock”. There are a number of strategic reasons for repurchasing issued shares.
Equity Compensation – Corporations often award additional shares to current shareholders as a form of dividend. This has the effect of transferring the value of the stock dividend from the retained earnings to the corporation’s shareholder’s equity or capital account.
- Stock Split – If the corporation has a need for additional shares, it may authorize more shares or execute a “stock split”. A stock split effectively doubles the number of outstanding shares and reduces the share value by one half. This will double the amount of treasury stock on hand and the lower stock value generally serves to make the stock more liquid.
- Share Transfers – Unless there is an agreement otherwise, shareholders may generally transfer their stock to others. This may require the corporation to collect the seller’s shares and distribute new shares to the purchaser.
Stock can be divided into categories called “classes”, and these classes can be further divided into subcategories called “series”. Series simply indicate the time of issuance of a certain number of shares. Different classes of stock may have very different rights. For example, a class of preferred stock is different from a class of common stock. All series in a class are fundamentally the same, except for minor distinctions. Classes of stock ownership are generally categorized as follows:
- Common Stock – Common stock is the baseline corporate ownership interest. Common shareholders have general voting rights but hold the lowest priority for payment of dividends in the event of distribution or liquidation of the corporation.
- Preferred Stock – Corporations authorize and issue preferred stock for a specific purpose. Generally, this purpose is to provide special rights to certain shareholders, such as investors and corporate founders.
- Stock Options & Warrants – Options and warrants provide the right to purchase a given quantity of stock at a stated price. These are used to incentivize the holders to work to raise the value of corporation shares. Also, these instruments may provide tax incentives to the recipient. These rights can be very important when the value of the stock rises above the purchase price.
There can be an infinite number of classes of preferred shares — each with unique rights. The most commonly designated special rights associated with preferred shares are as follows:
- Dividends – Common shareholders may receive dividends as an entitlement of corporate ownership. Preferred shareholders often receive priority of payment of dividends above common shareholders. This type of right varies, but generally a preferred shareholder will receive full payment or distributions of dividends before common shareholders receive anything. For example, “cumulative dividend rights” means that the preferred shareholder will receive full payment of any current and past, unpaid dividends before common shareholders receive payment of current dividend distributions.
- Liquidation – Preferred shareholders generally receive a liquidation preference. This means that the preferred shareholder will be paid first from the proceeds of any sale or liquidation of the corporation or its assets. Often, preferred shareholders will receive some stated amount or multiple of their initial investment before other shareholders receive any distribution.
- Voting Rights – Preferred shareholders may have any form of modified voting rights. For example, the preferred shareholder may have the right to vote for specific corporate actions or to elect specific seats on the board of directors. In other situations the preferred shareholder may not have any voting rights.
Discussion: How do you feel about different classes of corporate ownership with different rights? What effect, if any, do you think it has in affording certain shareholders greater rights than other shareholders? Why?
Practice Question: Tom is an investor in ABC Corp. He wants to make certain that he receives a return on his investment and that other shareholders do not benefit from corporate profits ahead of him. What stock rights might Tom secure for himself when negotiating his investment?
- Tom should negotiate for preferred shares. Preferred shares receive a number of rights above those of common shareholders. These include preferred payment of dividends, cumulation of unpaid dividends, and liquidation preferences (first payment of interest in the even the company is sold).