Types of Equity Capital: Preferred, Common, and Treasury Stock
Corporations issue shares of stock equity to investors to secure capital financing. In exchange, shareholders are granted ownership rights over the underlying company. As ownership claims, equity capital positions and their valuations fluctuate with the earnings potential of the business. These equity share capital claims are further classified into preferred, common and treasury shares. Familiarize yourself with corporate finance alongside the importance of each type of equity share before making investment decisions. As always, the ultimate goal remains to maximize potential returns, while keeping risks to a minimum.
Preferred shares take their name from senior asset claims above common shares. In the event of bankruptcy, preferred shareholders receive cash from the proceeds of any asset liquidations prior to common shareholders. Preferred dividends must also be paid first, before common stock investments receive any dividends. Preferred dividends accumulate, and missed preferred dividend payments are totaled and paid out on their next payable date. Preferred shares, however, are junior to bondholder interest payments and asset claims. Creditors are first in line amid bankruptcy proceedings, before equity owners.
Conservative investors covet preferred shares for their regular, and relatively large dividend payments. Corporations may favor preferred shares over bonds, because the Internal Revenue Service offers tax breaks to U.S. corporations that receive dividend income from other domestic corporations.
Preferred shares do not carry voting power. Therefore, corporate management often issues preferred shares as means to access equity financing, without ceding control to outside investors. Convertible preferred shares are hybrid securities that may be integrated into poison pill plans to thwart hostile takeovers. Poison pills allow preferred shareholders to convert their positions into large amounts of common stock, when one investor owns a set percentage of the outstanding common stock. The conversions into new common stock significantly increase acquisition costs, because outside investors must buy more than 50 percent of the corporation’s common stock to control the company through its votes. One share of common stock outstanding equals one vote.
Investors purchase shares of common stock for capital gains potential. Capital gains refer to appreciation between purchase and sales prices for all assets. Common stock investments feature increased volatility and risks, because of subordinate asset claims to bonds. As compensation for taking on these risks, investors expect to earn higher rates of return. This risk-return tradeoff means that common shares are more so ideal for long-term financial goals and investment horizons. People may buy common stock investments as means to establish retirement funding, pay higher-education tuition and improve their overall standard of living. The Dow Jones Industrial Average is a key benchmark for U.S. common stock performance.
Treasury stock refers to outstanding common stock that the corporation has actually bought back. Stock buy backs reduce common stock outstanding, which translates into increased earnings per share available for common shareholders. These transactions are designed to support higher valuations for the common stock. Treasury shares are actually listed as negative shareholder equity on corporate balance sheets, as they pay no dividends and carry no voting rights. Established corporations such as Microsoft often return capital back to shareholders in the form of aggressive stock buy back programs.