Characterized by voting rights, like electing company directors, common stock is just what it is – the most basic form of stock issued by a company. Common stockholders do not receive a priority claim over dividends or distribution of company assets in the event of liquidation when compared to preferred shareholders.
What is Common Stock?
Common stock is one type of security that represents equity ownership in a company. It may also be referred to as common shares or voting shares. Common stockholders have the right to a share of the company’s profits and holds control rights like voting for board of directors and other corporate policies. Additionally, common stockholders may have the right to receive dividends after preferred stockholders, if the company chooses to pay out excess cash to shareholders.
Many early-stage startups choose to allocate common stock to the initial owners and founders of the company. And others choose to give stock options to the first few employees in addition to or in exchange of a salary.
Properties of Common Stock
There are a few key properties of common stock in the private market. These provisions include:
In general, common stock conveys voting rights to its holders. Investors receive a portion of votes based on how many shares they hold, most commonly one vote per share. When major company decisions need to be made, common stockholders can exercise their voting rights on decisions like corporate objectives, policies, and stock splits and participate in electing the board of directors.
Dividends can be paid out by the issuer of the stock when – or if – capital allows; this may be monthly, quarterly, or annually, but is dependent on availability of funds. If dividends are paid out, they are first distributed to preferred shareholders before they are paid to common shareholders. And if there is not sufficient capital to pay out all the preferred and common stockholders, preferred stockholders are paid dividends until the capital is fully allotted, and common stockholders do not receive a dividend. However, it is important to note than many private companies choose to not pay dividends and reinvest extra capital into the business.
Potential Benefits and Limitations
One potential benefit of common stock is the ability to hold an ownership percentage in a company. The value of the ownership percentage is dependent on many factors, like equity dilution following subsequent funding rounds. But holding an ownership percentage, also has the potential of benefits, like increasing the value of principal amount invested, which can make it an appealing option.
Common stock is susceptible to dilution risks in the event of additional equity raises, which are generally in the form of preferred stock or instruments that convert to preferred stock. In the event of an Initial Public Offering (IPO), outstanding preferred stock may convert to common stock immediately before the IPO, diluting the common stock. However, dilution is common with additional funding. To learn more about dilution, check out our recent blog Equity Dilution in Startups.
Common stockholders receive full voting rights, while preferred stockholders receiving voting rights in uncommon. The ability to cast a vote on major company decisions is one potential benefit of common stock.
While common stockholders receive the right to be paid dividends from excess profits, it is not guaranteed that dividends will be paid out at all. And even if dividends are paid out, common shareholders are not guaranteed to receive dividends as preferred stockholders are required to be paid in full before common stockholders receive anything. This right to dividends can be seen as a potential benefit, but the lack of guarantee can be seen as a potential limitation.
Additionally, in the event of liquidation of company assets, common stockholders may or may not receive a distribution of assets, and if they do, it is after creditors, debtholders, and preferred stockholders have received their distribution.
Putting it All Together
Common stock is a common equity structure that allows an investor to own a percentage in the company. Common stockholders are entitled, but not guaranteed, to receive dividends or a distribution of company assets upon a liquidation event. The most basic form of equity, it can be important to understand common stock and how it works.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.