Before you invest in stock shares, you should ascertain whether the corporation has issued just one class of stock shares. A class is one group, or type, of stock shares all having identical rights; every share is the same as every other share.
A corporation can issue two or more different classes of stock shares. For example, a business may offer Class A and Class B stock shares, where Class A stockholders are given the vote in elections for the board of directors, but Class B stockholders do not get a vote.
State laws generally are liberal when it comes to allowing corporations to issue different classes of stock shares. Differences between classes of stock shares can be significant and affect the value of the shares of each class of stock.
Comparing common stock and preferred stock
Two classes of corporate stock shares are fundamentally different: common stock and preferred stock. Here are two basic differences:
Preferred stockholders are promised (but not guaranteed) a certain amount of cash dividends each year, but the corporation makes no such promises to its common stockholders. Each year, the board of directors must decide how much, if any, cash dividends to distribute to its common stockholders.
Common stockholders have the most risk. A business that ends up in deep financial trouble is obligated to pay off its liabilities first, and then its preferred stockholders. By the time the common stockholders get their turn, the business may have no money left to pay them.
Neither of these points makes common stock seem too attractive. But consider the following points:
Preferred stock shares usually are promised a fixed (limited) dividend per year and typically don’t have a claim to any profit beyond the stated amount of dividends. (Some corporations issue participating preferred stock, which gives the preferred stockholders a contingent right to more than just their basic amount of dividends.)
Preferred stockholders generally don’t have voting rights, unless they don’t receive dividends for one period or more. In other words, preferred stock shareholders usually do not participate in electing the corporation’s board of directors or vote on other critical issues facing the corporation.
The main advantages of common stock, therefore, are the ability to vote in corporation elections and the unlimited upside potential: After a corporation’s obligations to its preferred stock are satisfied, the rest of the profit it has earned accrues to the benefit of its common stock.
Taking a closer look at common stock
Here are some important things to understand about common stock shares:
Each stock share is equal to every other stock share in its class. This way, ownership rights are standardized, and the main difference between two stockholders is how many shares each owns.
The only time a business must return stockholders’ capital to them is when the majority of stockholders vote to liquidate the business (in part or in total). Other than this, the business’s managers don’t have to worry about losing the stockholders’ capital.
A stockholder can sell his or her shares at any time, without the approval of the other stockholders. However, the stockholders of a privately owned business may agree to certain restrictions on this right when they first became stockholders in the business.
Stockholders can put themselves in key management positions, or they may delegate the task of selecting top managers and officers to the board of directors, a small group of persons selected by stockholders to set the business’s policies and represent stockholders’ interests.
The all-stocks-are-created-equal aspect of corporations is a practical and simple way to divide ownership, but its inflexibility can be a hindrance, too. Suppose the stockholders want to delegate to one individual extraordinary power, or to give one person a share of profit out of proportion to his or her stock ownership. The business can make special compensation arrangements for key executives and ask a lawyer for advice on the best way to implement the stockholders’ intentions.
Nevertheless, state corporation laws require that certain voting matters be settled by a majority vote of stockholders. If enough stockholders oppose a certain arrangement, the other stockholders may have to buy them out to gain a controlling interest in the business. The limited liability company legal structure permits more flexibility in these matters.