Common stock financing represents the sale of ownership stakes within a corporation in exchange for cash or capital considerations. Investors and management must become familiar with the role of the corporation and the basic means with which to finance the business in order to appreciate shareholder rights and privileges. Common stock equity financing does carry distinct risks that are applicable to owners and management.
Corporations are organized under state law as legal entities--separate from owners and employees. Limited liability is the technical term for this separation. The limited liability status of the corporation allows the business to raise capital by taking on debt or issuing common stock with relative ease. Lenders and owners are more likely to invest when they know that the corporation has no claims to their personal assets outside of the business.
Corporate Financing and Common Stock
Corporate finance is related to the balance sheet. Assets are “balanced” by the sum total of liabilities and shareholder equity. Liabilities are comprised of debt to creditors that must be paid back with interest. Shareholder equity is made up of common stock and retained earnings that represent ownership claims over the firm.
Shareholder Rights and Corporate Structure
Common stock shareholders do carry voting rights. However, ownership claims to capital assets follow those of bondholders and preferred shareholders. Meaning, principal, interest and dividends upon bonds and preferred shares must be paid first in the event of bankruptcy.
In terms of operations, creditors simply want to be repaid with interest, while employees want to ensure that the company remains a going concern in order to keep their jobs. Of course, owners of common stock seek to maximize their returns on their investment. These distinct goals do not always match up perfectly.
Large corporations feature two tiers of equity investors and employees to separate ownership from management for the common good. Shareholders vote to elect a board of directors, led by a chairman. In turn, the board hires management, led by the chief executive officer.
Valuations pertaining to common stock fluctuate according to economic conditions and the strategic decisions made by management. One share of stock represents one claim to the assets and net income of the corporation. Common stock valuations increase when the pool of assets and retained earnings enlarges against shares outstanding, that is, the amount of shares held by investors. Further, share price values increase when total shareholder equity remains the same, and corporations buy back stock to reduce the amount of shares outstanding.
Publicly traded common stock prices are set per the auction method, where buyers and sellers meet at organized markets to agree upon valuations and transact business. Owners and prospects may also value a company by book value or intrinsic value before deciding to exchange shares at the market price.
Book value per share is defined as shareholder equity divided by shares outstanding. Intrinsic value is defined as the worth of future earnings in today’s dollars.
Financial managers may use strong common stock as “currency.” The corporation can sell additional shares of stock for high prices to fund acquisitions and capital equipment purchases.
Common stock equity holders risk losing their entire investment. Shares become worthless amidst business failure, or bankruptcy proceedings where bondholders arrive with superior claims related to the remaining assets.
Management is always at risk for ceding too much control over to a particular bloc of shareholders. Theoretically, any one entity or group of persons that purchase 50.1 percent of the shares outstanding will have the voting authority to run the business any way that they wish.