[Basic Finance] Overview of Equity Securities #1

Characteristics of types of equity securities

Common shares are the most common form of equity and represent an ownership interest. Common shareholders have residual claim (after the claims of debtholders and preferred stockholders) on form assets if the form is liquidated and govern the corporation through voting rights. Firms are under no obligation to pay dividends on common equity; the firm determines what dividend will be paid periodically. Common stockholders are able to vote for the board of directors, on merger decisions, and on the selection of auditors. If they are unable to attend the annual meeting, shareholders can vote by proxy (having someone else vote as they direct them, on their behalf).

In a statutory voting system, each share held is assigned one vote in the election of each member of the board of directors. Under cumulative voting, shareholders can allocate their votes to one or more candidates as they choose. For example, consider a situation where a shareholder has 100 shares and three directors will be elected. Under statutory voting, the shareholder can vote 100 shares for his director choice in each election. Under cumulative voting, the shareholder has 300 votes, which can be cast for a single candidate or spread across multiple candidates. The three receiving the greatest number of votes are elected. Cumulative voting makes it possible for a minority shareholder to have more proportional representation on the board. The way the math works, a holder of 30% of the firm’s shares could choose three of ten directors with cumulative voting but could elect no directors under statutory voting.

Callable common shares give the firm the right to repurchase the stock at a pre-specified call price. Investors receive a fixed amount when the firm calls the stock. The call feature benefits the firm because when the stock’s market price is greater that the call price, the firm can call the shares and reissue them later at a higher price. Calling the shares, similarly to the repurchase of shares, allows the firm to reduce its dividend payments without changing its per-share dividend.

Putable common shares give the shareholder the right to sell the shares back to the firm at a specific price. A put option on the shares benefits the shareholder because it effectively places a floor under the share value. Shareholders pay for the put option because other things equal, putable shares are sold for higher prices than non-putable shares and raise more capital for the firm when they are issued.

Preference shares (or preferred stock) have features of both common stock and debt. As with common stock, preferred stock dividends are not a contractual obligation, the shares usually do not mature, and the shares can have put or call features. Like debt, preferred shares typically make fixed periodic payments to investors and do not usually have voting rights.

Cumulative preference shares are usually promised fixed dividends, and any dividends that are not paid must be made up before common shareholders can receive dividends. The dividends of non-cumulative preference shares do not accumulate over time when they are not paid, but dividends for any period must be paid before common shareholders can receive dividends.

Preferred shares have a stated par value and pay a percentage dividend based on the par value of the shares. An $80 par value preferred with a 10% dividend pays a dividend of $8 per year. Investors in participating preference shares receive extra dividends it firm profits exceed a predetermined level and may receive a value greater than the par value of the preferred stock if the firm is liquidated. Non-participating preference shares have a claim equal to par value in the event of liquidation and do not share in firm profits. Smaller and riskier firms whose investors may be concerned about the firm’s future often issue participating preferred stock so investors can share in the upside potential of the firm.

Convertible preference shares can be exchanges for common stock at a conversion ratio determined when the shares are originally issued. It has the following advantages:

• The preferred dividend is higher that a common dividend.
• If the firm is profitable, the investor can share in the profits by converting his shares into common stock.
• The conversion option becomes more valuable when the common stock price increases.
• Preferred shares have less risk than common shares because the dividend is stable and they have priority over common stock in receiving dividends and in the event of liquidation of the firm.

Because of their upside potential, convertible preferred shares are often used to finance risky venture capital and private equity firms. The conversion feature compensates investors for the additional risk they take when investing in such firms.

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