There is a lot of important terminology when referring to stock and stock transactions. Therefore, I felt that it needed its own post. Here is a breakdown of the important terms you should know in regards to stock.
Common stock is the most basic form of capital that a corporation can have. All corporations will have common stock. One unit of stock is called a share. Common shareholders have certain rights of ownership.
- Voting rights – Common shareholders have the right to vote at annual meetings, either in person or by proxy, on matters such as electing the board of directors, mergers, and liquidation.
- Dividend rights – A dividend is a payment of company profits to the shareholders. Companies are not required to pay dividends but only shareholders can receive dividends. According to a 2013 New York Times article, 54% of companies worth more than $100 million pay dividends.
- Liquidation rights – When a company liquidates, common shareholders have the right to any remaining assets after all debts are paid. Typically, a company liquidates because of poor performance or bankruptcy and the shareholders rarely recover any of their investment in those cases. While the right exists, it is not a very useful one.
- Preemptive rights – If a company issues new shares, those additional shares dilute or lessen the percentage of ownership of the current shareholders. Preemptive rights give the current shareholders the right to purchase enough shares to maintain their current percentage of ownership. For example, if a company plans to issue 100,000 new shares of stock and Bob owns 5% of the current shares of stock, the company must offer 5% of the new shares to Bob before offering them on the open market. Bob must have the cash to purchase the additional shares.
Preferred stock is often called a hybrid investment because it has some characteristics of stock and some characteristics of bonds. Like common shareholders, preferred shareholders have liquidation and dividend rights. Preferred shareholders actually have preferential rights over common shareholders. That means that preferred shareholders would be paid before common shareholders in both circumstances.
Unlike common shareholders, preferred shareholders typically do not get voting rights.
Preferred stock is similar to bonds because it offers a fixed dividend rate. For example, a $1000 preferred share might have a face rate of 7%. That means that for each share owned, the shareholder would get a dividend of $70. This rate is fixed as long as the preferred share is in circulation. Preferred stock can also be called, meaning that after a certain period of time, the company has the right to redeem the preferred shares. Preferred stock can be convertible, which means that the shares can be converted to common stock.
Less than 10% of companies have preferred stock. Click here for a list of companies that have preferred shares.
Treasury stock is stock that has been repurchased by the company. Treasury stock is a contra-equity account and therefore, has a debit balance. Shares of common stock lose all of the rights the shares would traditionally have once they have been repurchased by the company. Treasury shares can serve a number of purposes. Companies will repurchase shares to use for stock options, bonuses, or employee programs (retirement matching or employee stock purchase plans). Companies will also repurchase shares to help strengthen the remaining shares on the market.
Number of Shares Authorized
Authorized shares are the total number of shares the company is allowed to sell. The number of shares authorized is designated in the corporate charter (organizational document). Companies must be sure to authorize enough shares to allow for growth in the company because in most states, it is rather difficult to change the corporate charter.
Number of Shares Issued
Issued shares are the shares the company has elected to sell. This number cannot be greater than the number of shares authorized.
Number of Shares Outstanding
Outstanding shares are the shares that have been issued that are currently not owned by the company as treasury stock. These shares are the shares that are owned by the general public. Outstanding shares include all parties that are not the company, including current and former employees. Only company owned shares are excluded from this total.
When you see the term stockholders’ equity, you should instantly think of a corporation. That is because corporations are the only type of entity that have stockholders. Partnerships have partners. Sole proprietorships have a proprietor. Corporations have shareholders.
A corporation is an entity structure that offers a number of characteristics that make it unique. Some of these characteristics are advantages and some are disadvantages. The important characteristics of a corporation are:
When you create a corporation, it is like giving birth to a child. The corporation is a being separate from the owner. It has many of the rights and privileges that a person would have, things like free speech and the ability to establish credit. It is because of this principle that a number of the other characteristics exist.
Unlimited Life and Continuous Existence
Because a corporation is an entity separate from the owner, even if shareholder were to pass away, the corporation still exists. A corporation can continue to exist until it is dissolved, either because the owners agree to do so or because it is forced into bankruptcy and forcibly dissolved.
Easy Transfer of Ownership
If you watch the stock market, you know how easy it is to buy and sell stock. Every time a stock transaction takes place, partial ownership of the company changes hands. Due to the fact that a corporation is a separate entity from its owners, owners can easily dispose of their ownership stake by simply selling their stock. As long as there is a willing buyer, ownership transfers can take place.
Limited Liability for Shareholders
A corporation can establish credit and enter into business transactions with third-parties. Shareholders are not liable for the actions of the corporation unless a shareholder personally guarantees a debt (which is often required when small corporations are establishing credit). Therefore, shareholders have limited liability against personal losses.
If a corporation gets sued, the shareholders cannot be sued with it. If a corporation goes bankrupt, the shareholders cannot be held liable for the debt (unless personally guaranteed). A shareholder’s liability is limited to the amount of the investment made by the shareholder. For example, if you invest $10,000 in a corporation and that corporation does bankrupt, you will most likely lose your $10,000 investment because the stock will become worthless. You cannot lose more than the investment in the company.
Separation of Ownership and Management
Corporations allow for the separation of ownership and management. That means that owners do not need to be managers and managers do not need to be owners. It is often the case that someone is both, like the case of Mark Zuckerberg at Facebook. In most small corporations, the owners typically manage the company but it is not necessary that owners run the company or are even involved in the day-to-day operations of the company.
In some cases, this is considered an advantage, but if you are a shareholder/manager, you could also lose control of the company you started.
Corporate Taxation and Double Taxation
Unlike sole proprietorships and partnerships, corporations pay taxes at the entity level. According to KPMG (one of the Big 4 Accounting Firms), the U.S. corporate tax rate is approximately 40%. This applies to the profit that the corporation makes. If the company decides to pay out dividends to its shareholders, those dividends are also taxed. The tax on the dividends is collected from the shareholders. The maximum dividend tax rate is 23.9%.
Imagine a corporation has a profit of $1 million and decides to pay out all of the after-tax profit to the shareholders. How much money would the shareholders have after taxes?
One million dollars of corporate profit could be taxed as high as 54.34% leaving $456,600 to the shareholders after all taxes are paid. This is certainly a disadvantage for U.S. corporations.
It is important to be aware of the characteristics of corporations in order to decide how to form a new business venture. It is also important to know these characteristics when working with corporations.