Equity securities in financing a corporation

Common stock is the most basic form of equity securities. Every corporation has common stock in its capital structure. All other types of securities are defined in relation to the common stock and its owners. All residual rights of the corporation, after all other corporate obligations have been resolved, belong to the common-stock owners. When only one class of stock exists (that is, common stock), the holders have equal pro-rata rights to any dividend distribution, to the assets of the company upon liquidation, and to vote on certain matters including the election of directors and designated major corporate transactions.

If more than one class of common stock exists, the rights and preferences of each class to participate in profits, dividends, assets, and governance must be defined in corporate documents. For example, one class of stock may have the right to elect more directors than its percentage ownership of the corporation would entitle it to have. On occasion, one class of common stock may be entitled to more dividends than another class. This device may be used when the controlling shareholders think dividends will help the company raise equity at a better price-earnings multiple (that is, less dilution) and the controlling shareholders do not need immediate cash returns from their ownership. In this instance, control considerations are likely to be more important than short-term income.

Preferred stock is equity security with preferences and certain superior rights over common stock. Classes of preferred stock can be structured in a variety of ways with preferences over both common stock and other classes of preferred stock. Preferences can relate to dividends, distributions on liquidation, covenants, anti dilution protection, redemption, and other characteristics. Preferred stock may be convertible into common stock. Convertible-preferred stock, often issued by a startup business, typically converts into common either at the option of the holder or automatically upon the occurrence of an event such as a public offering.

If preferred stock is sold in an investment transaction, the terms of the preferred stock will be defined in the company’s articles, certificate of incorporation, or Certificate of Designation. A Certificate of Designation is used when a company’s charter allows the board of directors, acting without the need for stockholder approval, to specify the terms of authorized but undesignated and unissued shares of preferred stock. Such a provision is called a blank check preferred provision It gives the board a significant amount of flexibility in negotiating issue terms when arranging a merger or venture-capital financing. If the charter of the company does not have a blank check preferred provision, any modification of preferred stock terms from those specified in the charter requires a charter amendment or a charter restatement.

Warrants are an option to buy a security (debt, preferred, or common stock) of a company at a specific price. A company will typically issue warrants to enhance the appeal of other securities or sell the warrants for a small amount of money. Warrants make an investment more attractive by allowing an investor to delay a purchase while maintaining a fixed purchase price. Warrants give an investor an upside (that is, if the stock appreciates, the investor can purchase it at the original lower price) with no downside (i.e., if the stock price falters, the investor will let the warrant expire unexercised and will not have put any additional funds into the company). Warrants are sometimes attached to subordinated debt and even to senior obligations to make them more attractive. Warrants sweeten the return to a lender without committing the borrower to a contractual cash payment.

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