The Advantages of Common Stock Financing
Original post by Dana Griffin of Demand Media
Companies have two different types of financial instruments to facilitate growth: debt and equity. Debt instruments include loans and bonds similar to those available to private citizens; these entail a specific amount borrowed and paid back with interest. Equity instruments include all different types of stocks and ways to purchase partial ownership in a company. Shareholders are the most common type of equity investors. Unlike direct or angel investors, stockholders don’t have management input and instead gain control through special rights and privileges.
What is Common Stock?
Purchasing common stock refers to buying a set portion of a company. Your position on the food chain, however, lies below that of preferred stockholders and other investors. Common stockholders own a portion of the company and may receive dividend income based on the number of stocks they own. Companies divide common stocks into different classes, each with a different set of rights, including voting, dividends and a portion of assets if the company is dissolved.
Types of Common Stock
Different types of common stock come with different risks and income potential. Blue chip stocks belong to stable growing companies and come with regular dividend income and lower risk. Income stocks pay higher dividends and belong to mature companies; they don’t increase in value as much as blue chip stocks. Companies with high growth potential issue growth stocks; they do not receive dividends. Instead, you make income by selling your stock at a higher price. Value stocks refer to those bought at a lower price than their typical value due to a slow period of income for the company. Defensive stocks are very stable and resist the general downturn of the economy, while cyclical stocks move consistently with economic changes. New companies with good ideas but no profit history issue speculative stocks that carry both higher risks and returns than other stock types. Speculative stocks priced at $1 or less are penny stocks. As the name suggests, foreign stocks are those purchased from companies outside the United States.
The main advantage of common stock revolves around a company’s right to refrain from issuing dividends and instead reinvest all earnings back into the company. Faster and less expensive than specialty public offerings, issuing common stock requires only a subscription agreement and stockholders' agreement, and puts angel investors and founders on the same level. Disadvantages revolve around loss of control and profits. Each shareholder gets one vote per share to elect the board of directors and is entitled to a portion of company profits upon dissolution or if their elected board decides to issue dividends instead of reinvesting in the company.
Common stockholders have the greatest chance of both profits and loss. Unlimited dividend opportunity translates directly into unlimited profits, unless the company has no capital to pay out in dividends or goes out of business completely. Located at the bottom of the payout ladder, you only receive a portion of company profit or liquidation after all creditors and preferred shareholders are paid. However, you get plenty of rights to go along with your stock, such as one vote per share to elect the board of directors, who in turn decide the amount of dividends to pay out. Stockholders also receive direct consideration in any merger, acquisition or company sale. Finally, many stockholders sell stock to other buyers and make direct income.
- US Legal: Stocks Law & Legal Definition
- US Legal: Blue Chip Law & Legal Definition
- US Legal: Income Stock Law & Legal Definition
- Wake Forest University School of Law; Characteristics of Common Stock; Prof Alan R. Palmiter; April 2004
- Walker Corporate Law Group; Ask The Attorney -- Types of Angel Financing; Scott Edward Walker; February 2010
- Financial Times Lexicon: Common Stock
- Nolo’s Plain-English Law Dictionary: Common Stock
- HSBC; Types of Investments-Financial Instruments; 2011
About the Author
Dana Griffin has written for a number of guides, trade and travel periodicals since 1999. She has also been published in "The Branson Insider" newspaper. Griffin is a CPR/first-aid instructor trainer for the American Red Cross, owns a business and continues to write for publications. She received a Bachelor of Arts in English composition from Vanguard University.