When starting a corporation, you must decide whether to authorize and issue stock to your shareholders. Many entrepreneurs are surprised to discover there is more than one type of stock and that different stock classes come with their own unique benefits and disadvantages.
In the broadest sense, stock breaks down into two classes: Common Stock and Preferred Stock.
Let's take a closer look at each class to better understand what makes each type unique.
Common Stock is aptly named. It is the most common type of stock. When you purchase stock on a public market—such as the New York Stock Exchange or Nasdaq—you are generally buying Common Stock.
Shares of Common Stock are standardized. Your share is the same as Sarah's share, which is the same as Mike's share, and on down the line. Unlike Preferred Stock, which can be customized to offer differing rights, Common Stock always vests the shareholder with the same rights and benefits.
There are two main benefits to owning Common Stock: voting rights and dividends.
Owning shares of a corporation's Common Stock makes you a partial owner of the company. You can exercise your voting rights at the annual shareholder meeting. Normally, one share equals one vote. If you own more shares, you have more votes.
Common Stock is eligible for dividends. Unlike with Preferred Stock, however, their distribution is not guaranteed. Your dividend distribution depends upon how much profit the company generates, as well as how much of the pie is left over after all other obligations have been met.
Two other benefits are worth considering. With a public company, Common Stock can be sold at any time. This is a distinct advantage. In many private companies, there are numerous restrictions on when stock can be sold and who it can be sold to, restrictions that greatly limit the value of those shares.
Usually, Common Stock also comes with preemptive rights. Preemptive rights allow you to maintain your ownership percentage if the company issues more stock. Say you own 10% of the current stock and the corporation decides to issue more shares. Preemptive rights guarantee that you may purchase enough of the new shares to maintain your 10% (although you are under no obligation to do so).
Certain drawbacks come with Common Stock. As mentioned before, Common Stock does not guarantee dividends. Even when the corporation generates plenty of profits, it is under no obligation to issue dividends to Common Stock shareholders. Berkshire Hathaway, for example, never issues dividends to shareholders.
In the case of liquidation, Common Stock shareholders are also at a disadvantage. Common Stock shareholders are the last to be paid during liquidation (unlike Preferred Stock shareholders). In fact, if the corporation closes and does not have the funds to meet all its debts, Common Stock shareholders will not receive compensation for their investment. Instead, they lose everything.
When determining how to issue corporate stock, not every company authorizes Preferred Stock. Corporations generally issue Preferred Stock to attract certain types of investors or to leverage control of the company.
Preferred Stock is different from Common Stock in that it offers distinct advantages that are not given to Common Stock shareholders. In addition, Preferred Stock is not standardized. You can issue different classes of Preferred Stock, each with their own unique benefits.
Preferred Stock offers two main privileges:
- Fixed dividends
- First in line during liquidation
Remember that Common Stock shareholders receive dividends in proportion to the amount of profit generated each year. Not so for Preferred Stock shareholders. Preferred Stock dividends never change. Dividends remain fixed regardless of how much profit the company makes.
An exception is made if there simply is not enough profit to cover dividend obligations. In that case, all dividend payments are deferred.
Should the corporation ever liquidate, Preferred Stock shareholders are guaranteed they will be paid first, a guarantee not extended to Common Stock shareholders. In this way, Preferred Stock is considered a safer investment.
There are four general types of Preferred Stock:
- Cumulative Shares: Offer the right to accumulate deferred dividend payments
- Non-Cumulative Shares: No back payment of deferred dividend payments
- Participating: Offer higher-than-normal dividends when profits are higher-than-normal
- Convertible: Option to convert shares into Common Stock if desired
A, B, and F
Common Stock and Preferred Stock are sometimes referred to as Class A and Class B Shares, respectively. But these are not the only classes.
A new breed of stock called Class F Shares (F for Founder) created by The Founder Institute is slowly becoming more common. Class F Shares are a particular breed of Preferred Stock issued only to founders.
The shares are bestowed with super-voting rights: each Class F Share is equal to 10 Class A Shares. Super-voting rights are used to retain control of a corporation by ensuring that company founders cannot be outvoted through a hostile takeover.
Class F Shareholders are often allowed to directly elect a member of the Board of Directors, and in some cases, this member will possess two votes instead of the usual one.
Every company divides up its stock how it sees fit, and when it comes to special classes of stock, label each group how it sees fit. Google, for example, has three share classes: A, B, and C. It is Google's B Class Shares that are granted special “founder's rights”.