Remember when Facebook was on the brink of going public in 2012? A pivotal factor contributing to their success was the power of common stock. Facebook's employees, initially compensated with common shares, turned from ordinary tech workers into multimillionaires overnight. With this wealth, the company was able to attract and retain the brightest minds in Silicon Valley.
That is the power of common stock. As an employer or startup founder, leveraging this form of equity compensation could be a game-changing strategy for your business. Read on to navigate through key concepts and how common stock benefits both you and your employees.
What is Common Stock?
Common stock, a type of security that represents ownership in a corporation, is the most prevalent form of investing in public and private companies. Each share of common stock constitutes a contract between the shareholder and the company. These contracts, or shares, signify a claim on the part of the company's assets and earnings.
As a common stockholder, you essentially become a part-owner of the company. This means that you acquire a fractional claim on the company's profits, or earnings, and you have a right to vote on significant company matters. This ownership is proportional to the number of shares you hold compared to the total number of shares outstanding.
Furthermore, common stock is categorized into 'authorized,' 'issued,' and 'outstanding' shares. Authorized shares are the total shares that a company can legally issue. Issued shares are those that the company has sold or given out, while outstanding shares are the issued shares currently held by all its shareholders, including both institutional investors and retail investors.
While each company has one type of common stock, there may be different classes, typically class A and class B, each carrying different voting rights and dividend payments. This structure is often used when founders or key individuals want to retain a majority of the voting rights while still raising capital.
Moreover, you need to understand that common stock is subordinate to all other types of financial liabilities and securities in the case of bankruptcy or liquidation. This means that if a company were to go bankrupt, the common shareholders would be the last to receive any remaining assets, only after all debts, bonds, and preferred stock dividends have been paid.
Why Do Companies Offer Common Stock?
Offering common stock can provide a multitude of strategic benefits for a company. Some are listed below:
1. Capital Raising
The fundamental reason companies offer common stock is to raise capital. The funds procured can be used for various purposes such as starting a new project, investing in research and development, expanding into new markets, or even paying off existing debts. This process of raising capital by issuing common stock to the public is known as an Initial Public Offering (IPO). What makes this attractive is that, unlike loans, the money raised doesn't need to be repaid, providing more flexibility in managing finances.
2. Attracting and Retaining Talent
In the highly competitive business landscape, attracting and retaining talent is critical for success. By offering common stock as a part of the compensation package, companies can incentivize employees by aligning their interests with the company's performance. When employees own a piece of the company they work for, they tend to be more motivated and committed, knowing that their efforts can directly influence the company's value.
3. Corporate Control and Acquisition Strategy
Sometimes, companies issue common stock to maintain control within the organization or in acquisition strategies. For example, a company might issue shares to a friendly third party to prevent a hostile takeover. In acquisitions, companies often use their own common stock as currency to purchase other companies, preventing the need for large amounts of cash.
4. Improving Public Image
A company that has gone public often gains increased visibility and credibility in the market. This can improve the company's public image and lead to increased customer trust, potentially driving more business.
5. Creating an Employee Stock Ownership Plan (ESOP)
Some companies offer common stock as part of an ESOP. This allows employees to become shareholders, fostering a sense of ownership and loyalty. ESOPs can also provide tax benefits to the company and its employees.
6. Spreading Risk
When a company issues common stock, it essentially spreads the risk among a larger group of investors. This can provide a buffer against financial downturns and increase financial stability.
As you can see, offering common stock can be a powerful strategic move. However, it's essential to carefully consider your company's specific circumstances, needs, and long-term goals before deciding to issue common stock.
Who Are Eligible for Common Stock?
Common stock can be offered to a wide range of individuals and entities, but here are the typically eligible people who can own it and under what circumstances:
- Public Investors: In a public company, anyone who can afford to buy shares on the open market is eligible to own common stock. This includes individual retail investors, institutional investors such as mutual funds, hedge funds, pension funds, and even other corporations.
- Private Investors: In a private company, common stock is typically offered to private investors such as venture capitalists and angel investors. These investors provide capital funding in exchange for ownership of the company. The specific terms of their ownership, including the price per share and the number of shares they receive, are usually determined through negotiations.
- Employees: In both public and private companies, common stock can be offered to employees as a part of their compensation package. This is usually done through mechanisms like Employee Stock Ownership Plans (ESOPs) or Employee Stock Purchase Plans (ESPPs). Often, the stock is used as a form of incentive compensation, enabling employees to share in the company's success. It's worth noting that eligibility can vary based on factors such as position, length of service, and performance.
- Founders and Early Stage Employees: Founders and early employees are often granted a substantial portion of common stock. This aligns with the significant risks they take on and their integral role in building the company from the ground up. The initial division of stock among founders can be a critical decision and is typically based on their respective contributions and roles.
- Board Members and Advisors: Companies often grant common stock to board members and advisors in recognition of their contributions. This ensures that these key individuals have a vested interest in the company's success.
Gentle reminder: the decision of who is eligible for common stock is highly strategic and should align with your company's long-term goals. It's important to carefully consider how the distribution of common stock could impact the company's control, finances, and culture.
What are the Features of a Common Stock?
Common stock, as the name suggests, is the most common form of ownership in a corporation. It carries several features that differentiate it from other forms of investment and corporate securities.
1. Ownership Stake
The most defining feature of common stock is that it provides an ownership stake in a corporation. When you buy a common stock, you're essentially buying a piece of the company. This ownership is proportional to the number of shares you own relative to the total number of outstanding shares.
2. Voting Rights
Another significant feature of common stock is that it usually comes with voting rights. For every share of common stock owned, a shareholder typically gets one vote. These votes can be used in corporate meetings to decide on key issues like electing members to the board of directors or approving a proposed merger. It's important to note that not all common stock is created equal. Some companies offer multiple classes of common stock, with each class carrying different voting rights.
3. Dividends
Common shareholders may also receive dividends, which are a portion of the company's profits distributed among shareholders. While dividends are not guaranteed and the amount can vary from year to year, they can provide an ongoing income stream for shareholders. It's important to note that common shareholders are last in line to receive dividends. They are only paid out after obligations to creditors, bondholders, and preferred shareholders have been met.
4. Capital Appreciation
When a company performs well and its profits rise, investors may be willing to pay more for its stock, causing the price to increase. This increase in stock price, known as capital appreciation, is another potential benefit for common shareholders. However, the opposite is also true. If the company performs poorly, the stock price may decrease.
5. Limited Liability
A valuable feature of common stock (and stock ownership in general) is the provision of limited liability. This means that a shareholder's liability is limited to the amount they invested in the company. In other words, if a company goes bankrupt and has to pay its creditors, the shareholders would not be personally responsible for the company's debt.
6. Residual Claimant
Common stockholders have the last claim on the assets and income of a corporation. In the case of liquidation, all of the company's obligations must be met first (e.g., debts to creditors, payments to bondholders, and preferred shareholders). Only then, if anything is left, it is distributed among the common stockholders.
Risks and Challenges Associated with Common Stock and How to Solve Them
While offering common stock can offer significant advantages, it's not without risks and challenges. Still, understanding these can help you mitigate potential problems and make the most of your equity strategy.
One potential risk is that Issuing more common stock can dilute the ownership of existing shareholders, including the company's founders. While this can help raise significant capital, it could also mean losing control over the company's direction. To mitigate this risk, carefully plan the number of shares you're willing to issue, and consider implementing a dual-class stock structure, which can allow founders and key executives to retain control.
Moreover, the price of common stock can fluctuate significantly due to factors such as economic conditions, investor sentiment, and company performance. This can lead to potential losses for shareholders. Simply create a strong business plan and financial model that can demonstrate potential profitability and attract long-term investors rather than short-term speculators.
Also, it might take time for a company to become profitable enough to pay dividends to its common shareholders. Moreover, if the company is liquidated, common shareholders are the last to be paid. To solve this issue, focus on delivering consistent performance and growth, which can lead to stock price appreciation, an alternative form of return to dividends.
Publicly listed companies face regulatory requirements such as disclosure of financial information and adhering to securities laws, which can be complex and costly. Private companies offering common stock to employees must also comply with certain regulations. Consulting with legal and financial experts can help ensure compliance with these requirements.
Differences in opinion among shareholders, especially those with significant ownership, can also lead to disputes and potentially disrupt operations. Establish clear and comprehensive shareholder agreements that outline decision-making processes, dispute-resolution mechanisms, and other governance matters.
Additionally, if the stock price declines or the company underperforms, employees who received common stock as part of their compensation might feel that they're not being adequately rewarded. To handle this, maintain clear and regular communication with your employees about the company's performance and the long-term value potential of their equity compensation.
Common Stock vs. Bonds
Although both securities, bonds represent a debt that the company promises to repay with interest, while common stock signifies ownership in the company. Offering common stock over bonds can be beneficial as it doesn't create a repayment obligation.
Common Stock vs. Preferred Stock
Common stockholders have voting rights, while preferred stockholders usually do not. However, preferred stockholders have a higher claim on dividends and assets if the company liquidates. Choosing to offer common stock or preferred stock depends on your goals and the rights you want to extend to the shareholders.
Common Stock vs. RSUs
Restricted Stock Units (RSUs) are another form of equity compensation that you can grant to employees. Unlike common stock, RSUs don't confer ownership until vesting occurs. Thus, employees with RSUs don't have voting rights or dividend entitlement until vesting. If your goal is to retain employees and keep them motivated over a more extended period, RSUs can be a better option.
‘Common’ Yet A Unique Ownership Opportunity
Offering common stock as a form of equity compensation can be a game-changing strategy for businesses looking to attract and retain the best talent, raise capital, and grow their company. As a business leader, it's essential to understand the key features, benefits, and potential risks associated with common stock. Whether you're running a fast-growing startup or an established business, the decision to offer common stock should not be taken lightly.
Common stock can motivate your team, create a sense of ownership, and align everyone’s interests with the long-term success of the company. But at the same time, it’s critical to consider the implications on company control, market volatility, and the regulatory landscape.
While common stock has its merits, it may not always be the best fit for every company or every situation. Alternative forms of equity compensation, like Restricted Stock Units (RSUs), can sometimes offer a more streamlined, less risky way of offering company ownership to employees. RSUs can often provide similar benefits of alignment and motivation, with potentially fewer complications around dilution and market volatility. To know more about RSU plans and how they fare against other equity types, book a demo with Upstock today.
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