Common and Preferred Stock Financing
by
Charles Lamson
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The ultimate ownership of the firm resides in common stock, whether it is in the form of all outstanding shares of a closely-held corporation or one share of IBM. In terms of legal distinctions, it is the common stockholder alone who directly controls the business. While control of the company is legally in the shareholders' hands, it is practically wielded by management on an everyday basis. It is also important to realize that a large creditor may exert tremendous pressure on a firm to meet certain standards of financial performance, even though the creditor has no voting power. In the next few posts we will also look closely at preferred stock. Preferred stock plays a secondary role in financing the corporate enterprise. It represents a hybrid security, combining some of the features of debt and common stock. Though preferred stockholders do not have an ownership interest in the firm, they do have a priority of claims to dividends that is superior to that of common stockholders.  To understand the rights and characteristics of the different means of financing we shall examine the powers accorded to shareholders under each arrangement. In the case of common stock, everything revolves around three key rights: the residual claim to income, the voting right, and the right to purchase new shares. We shall examine each of these in detail and then consider the rights of preferred stockholders.
Common Stockholders' Claim to Income All income that is not paid out to creditors or preferred stockholders automatically belongs to common stockholders. Thus we say they have a residual claim to income. This is true regardless of whether these residual funds are actually paid out in dividends or retained in the corporation. A firm that earns $10 million before capital costs and pays $1 million in interest to bondholders and a like amount in dividends to preferred stockholders will have $8 million available for common stockholders. Perhaps half of that will be paid out as common stock dividends and the balance will be reinvested in the business for the benefit of stockholders, with the hope of providing even greater income, dividends, and price appreciation in the future. Of course, it should be pointed out that the common stockholder does not have a legal or enforceable claim to dividends. Whereas a bondholder may force the corporation into bankruptcy for failure to make interest payments, the common stockholder must accept circumstances as they are or attempt to change management if a new dividend policy is desired. Occasionally a company will have several classes of common stock outstanding that carry different rights to dividends and income.  By some estimates, institutional investors (such as pension funds, mutual funds, or bank trust departments, rather than individual investors) account for 70 percent of stock trading volume. The percentage of corporate shares has increased dramatically in the last 60 years (Josephson, 2019, What is an Institutional Investor, Smartasset). As would be expected, management has become more sensitive to these large stockholders who may side with corporate raiders in voting their shares for or against merger offers or takeover attempts. The Voting Right Because common stockholders are the owners of a firm, they are accorded the right to vote in the election of the board of directors and on all other major issues. Common stockholders may cast their ballots as they see fit on a given issue, or assign a proxy, or power to cast their ballot, to management or some outside contesting group. As mentioned in the previous section, some corporations have different classes of common stock with unequal voting rights. While common stockholders and the different classes of common stock that they own may, at times, have different voting rights, they do have a vote. Bondholders and preferred stockholders may vote only when a violation of their corporate agreement exists and a subsequent acceleration of their rights takes place.  Cumulative Voting The most important voting matter is the election of the board of directors. The board has primary responsibility for the stewardship of the corporation. If illegal or imprudent decisions are made, the board can be held legally accountable. Furthermore, members of the board of directors normally serve on a number of important subcommittees of the corporation, such as the audit committee, the long-range financial planning committee, and the salary and compensation committee. The board may be elected through the familiar majority rule system or by cumulative voting. Under majority voting, any group of stockholders owning over 50 percent of the common stock may elect all of the directors. Under cumulative voting, it is possible for those who hold less than a 50 percent interest to elect some of the directors. The provision for some minority interests on the board is important to those who, at times, wish to challenge the prerogative of management. The issue of the type of voting has become more important to stockholders and management with the threat of takeovers, leveraged buyouts, and other challenges to management's control of the firm. In many cases large minority stockholders, seeking a voice in the operations and direction of the company, desire seats on the board of directors. To further their goals several have gotten stockholders to vote on the issue of cumulative voting at the annual meeting. How does this cumulative voting process work? A stockholder gets one vote for each share of stock he or she owns, times one vote for each director to be elected. The stockholder may then accumulate votes in favor of a specified number of directors. Assume there are 10,000 shares outstanding, you own 1,001, and nine directors are to be elected. Your total number of votes under a cumulative election system is:   Let us assume you cast all your votes for the one director of your choice. With nine directors to be elected, there is no way for the owners of the remaining shares to exclude you from electing a person to one of the top nine positions. If you own 1,001 shares, the majority majority interest could control a maximum of 8,999 shares. This would entitle them to 80,991 votes.  These 80,991 votes cannot be spread thinly enough over nine candidates to stop you from electing your one director. If they are spread evenly, each of the majority's nine choices will receive 8999 votes (80,991/9). Your choice is assured 9,009 votes as previously indicated. Because the nine top vote-getters win, you will claim one position. Note that candidates do not run head-on against each other (such as Place A or Place B on the ballot), but rather that the top nine candidates are accorded directorships. To determine the number of shares needed to elect a given number of directors under cumulative voting, the following formula is used:  The formula reaffirms that in the previous instances, 1000 shares would elect one director.   If the formula yields an uneven number of directors, such as 3.3 or 3.8, you always round down to the nearest whole number (i.e., 3) . It is not surprising that 22 of the 50 states of the U.S.A. require cumulative voting in preference to majority rule, that 18 consider it permissible as part of the corporate charter, and then only 10 make no provision for its use. Such consumer-oriented states such as California, Illinois, and Michigan require cumulative voting procedures.  *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 505-510* end |
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