Management 410-500 Midterm

Question #4
Matthew Humphrey
The two most fundamental categories of stock in a new business are
common stock and preferred stock, which differ in the rights that they
confer upon their owners. But stocks can also be classified according to a
number of other criteria, including company size and company sector. I will
describe the different types of stocks that are available and the important
characteristics of each of them.

Most shares of stock are called “common shares”. If you own a share of
common stock, then you are a partial owner of the company. You are also
entitled to certain voting rights regarding company matters. Typically,
common stock shareholders receive one vote per share to elect the company’s
board of directors. The board of directors is the group of individuals
that represents the owners of the corporation and oversees major decisions
for the company. Common stock shareholders also receive voting rights
regarding other company matters such as stock splits and company
objectives.

In addition to voting rights, common shareholders sometimes enjoy what
are called “preemptive rights.” Preemptive rights allow common shareholders
to maintain their proportional ownership in the company in the event that
the company issues another offering of stock. This means that common
shareholders with preemptive rights have the right but not the obligation
to purchase as many new shares of the stock as it would take to maintain
their proportional ownership in the company.

But although common stock entitles its holders to a number of
different rights and privileges, it does have one major drawback: common
stock shareholders are the last in line to receive the company’s assets.

This means that common stock shareholders receive dividend payments only
after all preferred shareholders have received their dividend payments. It
also means that if the company goes bankrupt, the common stock shareholders
receive whatever assets are left over only after all creditors,
bondholders, and preferred shareholders have been paid in full.

The other fundamental category of stock is preferred stock. Like
common stock, preferred stock represents partial ownership in a company,
although preferred stock shareholders do not enjoy any of the voting rights
of common stockholders. Also unlike common stock, preferred stock pays a
fixed dividend that does not fluctuate, although the company does not have
to pay this dividend if it lacks the financial ability to do so. The main
benefit to owning preferred stock is that you have a greater claim on the
company’s assets than common stockholders. Preferred shareholders always
receive their dividends first and, in the event the company goes bankrupt,
preferred shareholders are paid off before common stockholders. In general,
there are four different types of preferred stock:
. Cumulative: These shares give their owners the right to “accumulate”
dividend payments that were skipped due to financial problems; if the
company later resumes paying dividends, cumulative shareholders
receive their missed payments first.

. Non-Cumulative: These shares do not give their owners back payments
for skipped dividends.

. Participating: These shares may receive higher than normal dividend
payments if the company turns a larger than expected profit.

. Convertible: These shares may be converted into a specified number of
shares of common stock.

Since preferred shares carry fixed dividend payments, they tend to
fluctuate in price far less than common shares. This means that the
opportunity for both large capital gains and large capital losses is
limited.

At the beginning stages of businesses it is better to issue stock
outright rather than to use stock options. Stock can be issued for little
cost and thereby provide the founders certain benefits of direct stock
ownership and avoid some of the drawbacks of stock options. One important
difference between stocks and options is that stocks give you a small piece
of ownership in the company while options are just contracts that give you
the right to buy or sell the stock at a specific price by a specific date.