As we recall, stocks are claims of ownership in the business (also called the Equity) that is publicly distributed. However, this ownership can come in many different nuances. Not all of these are exactly a variant of stock ownership, but we have included these here as we will come across these terms one time or other in our investing career.
The Two Basic Types of Stocks: Common Stock and Preferred Stock
Common Stock: When we discuss stock, we normally refer to the Common Stock in a company. This is a unit of equity in the company that is junior to most other claims. For example, all debt is senior to stock and in case of dissolution or liquidation of the company, the bond holders are paid first before the stock holders are. Common stock holders are last in line with their claims on the assets and earnings of a company.
Common stock is generally listed and traded on public stock exchange and can be easily bought and sold by retail investors through their brokers. Because the stock holders have the last claim on a company assets and earnings, this is one of the riskiest instruments. There can be no guarantee of a return of capital to the investors in the common stock.
In exchange for taking on this additional risk, the common stock holders expect and often get higher returns on their investment. The only thing that supports the value of a common stock is the ability of the company to continue to run the business profitably in the future and a general sense of confidence among the investors that the profitable business growth is sustainable. One of the ways that the company can demonstrate its ability to continue to grow shareholder wealth is by returning capital to the investors periodically in form of dividends. However, dividend payments are not normally required, and in many high growth companies, the management tends to prioritize investments in growth and new opportunities instead of making dividend payments. In such cases, the capital appreciation (increase in the value of the company and consequently its share price) becomes the primary means of generating returns for the shareholders.
Preferred Stock: Preferred Stock or as they are sometimes called, Preference Shares, are a hybrid between a debt issue (bonds) and a common stock. They earn a predefined dividend, just like a coupon on a bond, and the preferred stock comes with a defined par value or face value. Unlike bonds however, a preferred stock may not have a defined term (they can be perpetual, although in some cases the company may buy back the outstanding preferred stock at the par value). Also unlike a bond, the holders of the preferred stock take on most of the risk. If the company misses one of the dividend payments, it does not result in a default. In most cases, a missed dividend payment accrues and the company will eventually pay it back to the investors. The dividend on a preferred stock must be paid before any dividend is paid to the common stock holder. Preferred stock is however junior to debt.
Different Share Classes: A Shares vs B Shares
Common stock holders are the ultimate owners of the company. Which means that they have certain rights to determine the way in which the company operates. This includes management decisions, the ability to choose the board of directors, input on the future strategic direction of the company, etc. These rights are conveyed to the stock holders in form of voting rights, in the direct proportion to the shareholding. Typically, 1 share of a stock implies 1 vote.
In many instances though, the company may choose to decouple the voting rights from the shareholding by creating multiple classes of stock. Most common way this is done is via issuance of A and B classes of shares. A shares are normally sold to the public but they may carry very little voting right. Most of the voting rights may be concentrated in the B shares, which may primarily be held by the management or the founders/founding families of the company.
This is one way of allowing the public to finance and participate in the growth of the business while not giving up the ability to control the direction of the company. This may be desirable for the management or the founders of the company to continue to run the business in line with their original vision. However, this also creates various conflicts or issues such as,
a. The A shares are less desirable and will trade at a discount to the B shares due to the limited voting rights,
b. This discourages the shareholders or an activist investor to come in and make changes to the management or the business direction that may be sorely needed, and,
c. This encourages the management or the B share holders to run the company for their own benefit and not for the benefit of the public shareholders.
Some of the well know companies that have their shareholding organized this way include Ford Motor Company, Google Inc, and Alibaba.
Restricted Stock Units
Restricted stock units are generally used as part of the employee compensation as an alternative to Employee Stock Options. These are stock unites that are promised to the employees to be awarded in the future, upon meeting of certain predefined goals – such as employment time, achievement of certain growth metrics, etc. These stock do not exist until they are awarded (also called vesting), but just like stock options, they do have some value.
Stock Derivatives (Options, Warrants, etc)
Stock derivatives are synthetic instruments that derive their value from the underlying stock. Some examples include stock options and stock warrants. Stock options are generally not issued by the company at all and are created in the secondary market for hedging and speculation purposes. Stock warrants are similar to the stock options in many ways but can be issued by the company. Stock options do not result in issuance of additional stock upon the exercise of the option, whereas the exercise of the warrants will result in new stock being issued.
Sometimes a company will borrow funds (debt) from an investor or a group of investor with an intention of converting the debt to equity at a later date. This is normally done in the venture backed companies where the Venture Capitalists and/or Angel Investors may choose to make the initial capital infusion while taking lower risk. When the business potential is proved out, they may want to convert their debt to equity so they can can earn higher returns. The company may choose to issue convertible debt to attract investment at a time when its business model is not sufficiently proven in the market place.
As value investors, we are most likely to focus on the common stocks. We may occasionally come across different share classes, and we may want to be aware of the existing warrants and convertible debt so we can either take advantage of these instruments where we can, or we can worry appropriately about the future dilution potential.