Different Classes of Stock Shares - dummies

Different Classes of Stock Shares

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

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 classes of stock shares.

For example, a business may offer Class A and Class B stock shares, giving Class A stockholders a vote in elections for the board of directors but not granting voting rights to Class B stockholders.

State laws generally are liberal in allowing corporations to issue different classes of stock shares. A whimsical example is that holders of one class of stock shares could get the best seats at the annual meetings of the stockholders. But whimsy aside, differences between classes of stock shares are significant and affect the value of the shares of each class of stock.

Common stock and preferred stock are two classes of corporate stock shares that are fundamentally different. Here are two basic differences:

  • Fixed dividend amount: Preferred stockholders are promised (though not guaranteed) a certain amount of cash dividends each year, but the corporation makes no such promises to its common stockholders. (The company must generate earnings to pay any type of dividend, including dividends on preferred stock.) Each year, the board of directors must decide how much, if any, cash dividends to distribute to its common stockholders.

  • Claims on assets: 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 to collect, the business may have no money left to pay them. In other words, the common shareholders are last in line to make a claim on assets.

Neither of these points makes common stock seem very attractive. But consider the following points:

  • Preferred stock shares 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. This topic is too technical to explore further in this book.)

  • Preferred stockholders may not have voting rights. They may not get to participate in electing the corporation’s board of directors or vote on other critical issues facing the corporation.

The 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. Although a corporation may keep some earnings as retained earnings, a common stock shareholder may receive a much larger dividend than a preferred shareholder receives.

Here are some important points 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. Otherwise, the business’s managers don’t have to worry about stockholders withdrawing capital. If one investor sells common stock to another shareholder, the company’s capital balance is unchanged.

  • A stockholder can sell his or her shares at any time, without the approval of the other stockholders. The stockholders of a privately owned business, however, may agree to certain restrictions on this right when they first become 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, which is a small group of people selected by the stockholders to set policies and represent stockholders’ interests.

    Now don’t get the impression that if you buy 100 shares of IBM you can get yourself elected to its board of directors. On the other hand, if you have the funds to buy 100 million shares of IBM, you could very well get yourself on the board.

    The relative size of your ownership interest is key. If you put up more than half the money in a business, you can put yourself on the board and elect yourself president of the business. That may not be the most savvy business decision, but it’s possible. The stockholders who own 50 percent plus one share constitute the controlling group that decides who’s on the board of directors.

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. 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.)