Common Stocks, Preferred Stocks: Basic Concepts

Stocks, which represent ownership in a corporation are, and have been, one of the best investments. The potential for profit greatly exceeds that for guaranteed investments or interest-paying investments. The main benefits of corporations over sole proprietorships and partnerships are that:

Disadvantages of a corporation include legal regulations, some of which require that it publish and distribute many reports to stockholders and various government agencies.

Corporations are business entities that operate under a charter from a state and raise capital by selling stocks and bonds, a form of capitalization. Stocks are equity capital, giving the owners of stock a part ownership in the corporation, and bonds are debt capital. Bondholders lend money to the corporation by buying their bonds. Total capitalization is the sum of equity and debt capitalization.

Capitalization = Equity + Debt

The net worth, or stockholders' equity, is the difference between total assets and total liabilities of the corporation.

Stockholders' Equity = Assets - Liabilities

Corporate Ownership — Stocks

Stocks, as a unit of ownership, can be broadly classified as common and preferred — all corporations issue common stock.

Legal Rights of Common Stockholders

Common stockholders have the following legal rights:

Voting Privileges

Common stockholders, unlike preferred stockholders, usually have the right to vote for the corporate board of directors, who, in turn, have complete control of the company. However, corporations, such as Google, Discovery Communications, and Comcast are increasingly issuing stock with no voting rights, which have a lesser value than voting shares, and many companies issue shares with greater voting rights, usually retained by the founders or executives of the company. Google, for instance, has Class A shares with 1 vote, Class B shares with 10 votes, and Class C shares with no voting rights.

Most stocks still give the stockholder 1 vote for each director position that is up for voting, but that vote may be apportioned in 2 different ways. Statutory voting allows using all votes for each of the vacancies for the board of directors; cumulative voting increases the number of votes that a stockholder can use for a particular candidate. For instance, if there are 4 different vacancies on the board and a stockholder owns 500 shares, then a statutory voting privilege allows the stockholder to cast 500 votes for each of 4 candidates for the 4 vacancies for a total of 2,000 votes, but no more than 500 can be cast for any candidate. Cumulative voting would give the shareholder 2000 votes (500 X 4) that could be apportioned in any way: all 2000 votes for one candidate, or 1,000 for one, 500 to each of two others, and none to the other, for instance.

If a stockholder cannot attend a meeting to vote, then he can cast his vote by proxy through the mail, or have someone else at the meeting cast his vote. However, the voting privilege is not as much as a privilege as the word may suggest:

Voting privileges are given to shareholders so that the controlling executives of the company serve the interest of the shareholders. However, voting does not solve the principal-agency problem, where the agents (board members and company executives) work for their own interest rather than for the interest of the principal (shareholders), much like politicians who serve themselves and special interests after they are elected rather than the voters who elected them. Since most shareholders own only a small portion of the company, they have little influence on the Board of Directors. Even major shareholders often do not have an interest in exercising their voting rights because they may have different objectives. For instance, high-frequency traders are only interested in taking advantage of price discrepancies on different trading systems or different related securities; mutual funds and exchange-traded funds tracking indexes buy stocks only because they compose an index and sell stocks removed from the index; even institutional investors do not bother trying to influence management because it is easier to simply sell the stock if they are dissatisfied with performance, although there have been a few instances of shareholder activism, where major institutional investors have pressured management and the board of directors to improve results.

Right to Information

In addition to the reports shareholders receive, including audited annual financial statements, they also have the right to the minutes of the meetings of the board of directors and to examine the list of stockholders, although these rights are not usually exercised.

Pre-emptive Rights

A pre-emptive right is an antidilution provision, giving current stockholders the right to purchase new issues of company stock before it is offered publicly, so they can maintain proportionate ownership of the company, if desired. Although most states have laws that give shareholders pre-emptive rights, the company may, depending on the law, pay stockholders a fee to waive their pre-emptive rights or the pre-emptive rights may exist only if so specified in the corporate charter. Pre-emptive rights were more prevalent in the past, but are rare today.

When the corporation does give its stockholders pre-emptive rights, it generally issues subscription rights showing how many shares the stockholder can buy and at what price. For instance, if shareholder John Doe owns 10% of the company, and the company issues 100,000 new shares of stock, then the company will allow John Doe to buy at least 10,000 shares of stock before the stock is presented to the public, so that he can maintain his proportionate ownership of the company. He can refuse to buy any new issues, or only some of them, but then his ownership percentage in the company will decline, and along with it, the number of pre-emptive rights received in any future rights offering.

Rights to Dividends

A corporation does not have to distribute profits to shareholders in the form of dividends, and indeed, many growth companies re-invest profits for greater growth rather than distribute them to shareholders, but if the company does declare a dividend, equal to a specific amount for each share, then common shareholders are entitled to the dividend amount times the number of shares owned. However, common shareholders rights to dividends are subordinate to the rights of preferred shareholders, if the company has preferred shareholders.

No Stock Rights for Beneficial Owners of Shares Held in Street Name

Most retail investors use brokers to buy and sell stock, and these stocks are usually held in the broker's name (aka street name ). This is done so that the securities are readily available for trading and it reduces the costs of transferring certificates. It also allows the broker to lend out the securities for a fee to others who want to sell the stock short. Because the stocks are actually in the name of the broker, the broker's customers who bought or borrowed the stock are considered the beneficial owners of the stock, and, hence, they have no stock rights — no right to vote, to receive information or dividends. In fact, the registrar of the stock does not even have the names of the beneficial owners, only the real owners who are the brokers for the stocks held in street name.

However, most brokers do pass the information and dividends received for the stock to the beneficial owners, and they will generally vote the way the beneficial owners request.

However, there could be a problem with voting if the stocks were lent to be sold short, because a broker does not have the voting rights for stock lent out or sold short; otherwise more votes could be cast than allowed by the number of outstanding stocks. However, a broker may still be able to vote the stocks according to the instructions of the beneficial owners if the broker has other shares of the same stock not lent out and if some of the beneficial owners have not sent instructions to vote a particular way. However, if the broker does not have enough shares to satisfy all requests to vote, then the votes may be apportioned according to the number of requests for voting and the number of shares held by each beneficial owner compared to the number of shares available for voting. For instance, suppose John is the beneficial owner of 300 shares of JXYZ stock and Jane is the beneficial owner of 500 shares of JXYZ stock, and both use the same brokerage, but their broker lent out 400 shares to be sold short. If John and Jane both issue voting instructions for different board candidates, then the broker can only vote half of the shares still retained, so the broker would vote 150 shares according to John's instructions and 250 shares according to Jane's.

There is no similar problem for dividends, because borrowers of stock are required to pay the dividend to the lenders of the stock.

Stocks in Margin Accounts Can Lead to Empty Voting and Payment in Lieu of Dividends

There are 2 disadvantages to holding stocks in a margin account, which are often lent out to short sellers:

  1. stock borrowers, but not the stockholders, can vote shares when the shares are lent out, which leads to what is being called empty voting;

  2. and if the stocks pay a dividend, the stockholders actually get — instead of a dividend that may qualify for the favorable tax rate of 0%, 15%, or 20% — a payment in lieu of dividends, taxed as ordinary income that may be as high as 37%. See Taxation of Dividends for more information.

Worse, the borrowers of the stock, often short-sellers, can vote against the corporation's interest to put downward pressure on the stock price, so as to increase short-selling profits — thus, voting against the interests of the true stock owners.

A possible scenario is for a hedge fund, which frequently profits from short-selling, to borrow the shares right before the record date — usually 30 days before the vote, and vote in its own interests. Delaware law, which governs most large companies because they are incorporated in that state, gives voting rights to whomever happens to have the stock on the record date. Often, the beneficial owners of the stock are unaware of the lending, and that their right to vote has been transferred to someone else.

Sometimes, because of inadequate accounting, both actual stockholders and the borrowers vote, leading to overvoting, which the New York Stock Exchange had found to be a frequent occurrence in some instances.

Classified Stock

Some companies issue different classes of stocks, and thus, are said to have a complex capital structure, or a multiple capital structure, generally differing by voting privileges. This is most often done so that the founders of a company can retain control of their company by retaining the class of stock with the greatest number of voting rights. Most often, these different classes are called Class A and Class B stock; however, which one has the greater voting rights may differ. For instance, Google has 2 classes of stock. Class B gives the holder 10 votes per share compared to the 1 vote for Class A. The 2 founders of Google and its CEO at the time of Google's IPO held the Class B shares while selling the Class A shares in a Dutch auction. Berkshire Hathaway issued a Class B stock that sold for far less than the Class A stock, so that smaller investors could buy shares.

The different stock classes may also differ in dividends or liquidation priority. The share classes are defined in the corporate charter and bylaws.

Classification of Common Stock

Authorized shares are shares authorized by the charter when the corporation was formed. Issued shares are authorized stock sold to investors. Issued shares and unissued shares make up all authorized stock. Outstanding stock is stock owned by investors. All outstanding stock has been issued, but sometimes a company will repurchase its own stock, which then becomes treasury stock, which reduces the number of outstanding shares.

Treasury stock is stock issued by the company, but later repurchased. Treasury stock has no voting rights, does not receive dividends, is not used in the computation of earnings per share, and is no longer outstanding stock. Companies repurchase their stock for any of the following reasons:

Par Value, Stated Value, Legal Capital

Par value is the value assigned to a share of stock when it is authorized, and is much less than its expected market value. Sometimes a stock will not have a par value, but will have a stated value in the corporation's financial records. Par and stated values set the minimum requirement for legal capital, which is the number of shares of outstanding stock multiplied by the par or stated value of each share. A corporation cannot pay dividends or repurchase its stock, if doing so reduces the amount of legal capital below the minimum required by state law. Par value is more relevant, however, for preferred stock, because they pay a fixed dividend that is a set percentage of the par value.

Why do Stocks have Par Value or Stated Value that is Less than the Market Price?

When a company first becomes incorporated, the state of incorporation must approve the number of shares of stock that the corporation is authorized to sell — authorized stock, or capital stock. Many states require that the stocks also have a par value, or nominal value, to provide a minimum of legal capital to pay creditors. The legal capital = the par value multiplied by the number of shares of outstanding stock, which is the number of shares currently held by investors. The corporation is not legally permitted to pay dividends or repurchase its own stock, if doing so reduces the amount of legal capital below the required minimum. The par value is printed on each stock certificate. The par value of each stock is also changed accordingly by stock splits. A 2-for-1 split, for instance, would halve the par value.

The par value is often $1 or less, which is much less than the market price or the expected market price of the stock. The par value is set low, because the stock cannot be issued for less than par value. If par value were higher and if the demand for the stock was less than anticipated, the corporation would be unable to sell the desired number of shares, since it would be unable to lower its price below par value to increase demand. Moreover, the cost of incorporation in some states is based on the total par value of the stocks being registered, so minimizing par value reduces the cost of incorporation in those states.

The issue price is the amount for which the stock is sold. The difference between the issue price and the par value is recorded in the company's books as the share premium:

Share Premium = Issue Price − Par Value

The par value of preferred stock is much higher than common stock because preferred stock pays a dividend fixed as a percentage of par value.

No-par stocks have no par value printed on its certificates. Instead of par value, some states allow no-par stocks to have a stated value, set by the board of directors of the corporation, which serves the same purpose as par value in setting the minimum legal capital the corporation must have after paying any dividends or buying back its stock.

If a corporation's stock has neither par value nor stated value, then the legal capital required = the amount received when the stock was issued.

Residual Claim

If a company liquidates, common stockholders have a claim to the residue — what is left after all creditors and all preferred stockholders have been paid. In most cases of liquidation, the common shareholder gets nothing.

Rights and Warrants

Rights and warrants are much like options. They give the owner the right, but not the obligation to buy new shares of stock at a specified price, and they expire at a specified date. Unlike options, where the money for options initially goes to the option writer, who probably has no association with the company other than possibly being a stockholder, the company issues rights and warrants to raise more money for the company. .

Stock Rights

If a corporation wants to raise more money, it will frequently do so by issuing more shares from the authorized, but unissued shares. However, as discussed above, existing shareholders may have the right to maintain their proportionate ownership of the company, so the company provides existing stockholders with subscription rights (aka rights certificates), giving stockholders the right, but not the obligation, to buy the new shares at a specified price — the subscription price — which is usually lower than the market price. A benefit for the company of selling to existing shareholders is reduced marketing costs over selling to the public. The rights offering is usually handled by investment bankers in a standby commitment, where the investment bank agrees to buy any shares not subscribed to by the holders of rights.

Stock Warrants

A warrant is a security that gives its owner the right, but not the obligation, to purchase a stipulated number of shares at a stipulated price anytime before the warrant expires. When the warrant is first issued, the stipulated price is always above the current market price, usually well above, because warrants have a much longer lifetime than stock rights. Warrants typically have a life of 5 years.

Warrants are frequently sold attached to bonds, to lower the interest that the corporation must pay, since the bondholder has the additional option of exercising the warrant for profit if the company does well. They may be attached to preferred stock as well. Sometimes the warrant is detachable — that is, after a certain time, it can be sold separately from the stock or bond; otherwise the warrant is nondetachable.

Stock Splits

When a stock appreciates considerably, the corporation will sometimes declare a stock split, which will lower the market price of the stock, and therefore, hopefully entice more investors to buy the stock. The split ratio is usually 2:1, that is, 2 shares of stock now replace every share of stock, but the ratio can be 3:1, 4:1, 5:3 or anything else. If an investor had 100 shares of stock selling at $80 per share, he will have 200 shares selling at $40 per share after a 2:1 split. All financial ratios with the share price as one of the terms and the par value of the stock will be adjusted accordingly. The number of outstanding stocks will also increase.

Whether the stock split entices more people to buy it is questionable, and necessarily limited. If this were not true, a corporation could continually split its stock to increase its value, even without increasing profits. However, some have argued that not splitting stocks tends to attract higher quality shareholders, who are more concerned about their long-term investment horizon rather than short-term goals of quick profits, thus providing some relief for company executives, allowing them to focus on long-term goals rather than short-term profits. Stocks with lower share prices tend to attract speculators rather than investors.

Reverse Stock Splits

When a company has financial difficulties, sometimes its stock falls to a low value. Often, this is seen as a sign of risk and bad performance, so the company will do a reverse split, where 2 or more shares of stock are exchanged for 1, thereby increasing the value of each share. The company itself is not worth more, but it may appear more valuable to inexperienced investors. Reverse stock splits may also prevent the stock from being delisted on an exchange, since most stock exchanges require a minimum stock price. Delisting often leads to substantial stock price declines.

Stock Dividend

Large companies that are profitable, but have little potential for growth, will start paying dividends, usually quarterly. Usually the dividend is paid in cash, but sometimes, to conserve cash, a company will declare a stock dividend instead of a cash dividend. The stock dividend is stated as a percentage of stock owned. Thus, with a 10% dividend, each stockholder will get 1 more share of stock for every 10 owned. The shareholders' proportionate interest in the company is unchanged, but each share will be worth less.

The dividend department of a broker collects and distributes cash dividends for stocks held in street name; it also distributes interest payments, stock dividends, stock splits, rights offerings, warrants, and any other distributions to stock- or bond-holders. The dividend dispersing agent (DDA) of a corporation distributes cash, property, or stock dividends to broker-dealers holdings the securities in street name. The broker-dealers then distribute the dividends to the appropriate account owners. The transfer agent distributes stock splits to the broker/dealer. For stockholders owning the shares directly, the DDA or the transfer agent contacts the stockholder directly. Normal stock dividends are treated the same as cash dividends, but if stock distributions are 25% or more of the outstanding shares or if stock splits increase the total shares outstanding by 25% or more, than the ex-date of the stock dividends and stock splits of 5 for 4 or better is the 1st business day following the payable date.

Preferred Stock

Preferred stock is much like common stock, but preferred stockholders usually have no voting privileges, but they do have priority for dividends and for the proceeds of any corporate liquidation should the company fail. Companies issue preferred stock to appeal to investors who want income and greater safety, but issuing preferred stock instead of bonds gives the company more flexibility. If the company is financially stressed, it can skip dividend payments to preferred stockholders, but not to bondholders. Oftentimes, preferred stock is issued when a company is having financially difficulties. It brings in more money at a time when the company needs it, but it doesn't obligate a company to future payments as bonds do.


Preferred stock is preferred because preferred shareholders have first claims to any dividends and company assets, if liquidation occurs, over the common stockholder. However, creditors still get paid before preferred shareholders. The dividend for the common stock may fluctuate from year to year, or even from quarter to quarter, but the preferred dividend is fixed. Preferred stockholders get their dividend at a fixed rate before any dividends are paid on common stock. However, dividends are not guaranteed even to preferred stockholders.

Unlike common stock, the par value of preferred stock is more significant to the stockholder because the dividend is expressed as a percentage of the par value, which doesn't vary with the market price. If the stock has no par value, then the dividend will be stated as a fixed sum per share.

Preferred stockholders also have no voting rights unless the company defaults on the dividend for a specific number of quarters, or if the company wants to issue a new class of preferred stock equal to or better than the existing preferred stock.

In addition, preferred stock may have the following features: adjustable rate, cumulative, convertible, callable, participating, and prior preferred.

Adjustable Rate

An adjustable-rate preferred stock pays a dividend that is pegged, usually quarterly, to a current interest rate bellwether, such as Treasury notes.


If preferred stock has a cumulative dividend right, then, if the company misses any payment of dividends to preferred shareholders, all dividends of all missed payments must be paid before any common stockholder. If the company liquidates, then the cumulative option gives preferred shareholders the right to all the missed payments before the common stockholders' residual interests.

Example: preferred stockholders get $40 per quarter for the preferred stock. The company has missed 3 quarterly payments in the past year, however. For the current quarter, the company must pay preferred stockholders $120 + the $40 due this quarter before anything can be paid to common stockholders.


The convertible feature allows the shareholder to convert their preferred stock to common stock at any time. Preferred stock is generally bought for its fixed dividend, but it is not as volatile as the common stock of the same company. If the common stock rises sharply, the convertible preferred stock will rise more than the preferred stock without the convertibility feature. Thus, the convertible feature allows the investor to enjoy a fixed income in a flat market, but also to profit from any significant rise in the market price of the common stock.


This feature benefits the company. It allows the company to call back, or to redeem, a callable preferred stock at a specific price, the call price, printed on the stock certificate. It can also repurchase the stock on the open market, and will do so if the current market price is below the call price.


This increasingly rare preferred stock not only receives its stated, fixed dividend, but it can also participate, or receive a portion, usually 50%, 75%, or 100%, of the common stocks' dividend.

Prior Preferred, First Claim Preferred, or Senior Preferred

These terms describe preferred stock having first claims on any dividend, and on assets if the corporation dissolves. Thus, prior preferred stock will have a superior claim over all preferred and common stock, but will still have an inferior status to creditors, including all holders of debt securities.

Tracking Stock

Many large companies are conglomerates consisting of different types of businesses, and, usually, 1 component is growing faster than the rest of the conglomerate. Some of these conglomerates will issue tracking stock in the fast-growing component, which is stock giving the stockholder a beneficial interest in that specific component, but not ownership interest. The tracking stock may be issued as an initial public offering or distributed to existing shareholders. This is like a spin-off, but the parent keeps ownership and control of the subsidiary, and gets more capital at a lower cost. Other benefits include:

The major disadvantage to tracking stock for investors is lesser voting rights compared to the parent stock, or even none at all.

Transfer Agent and Registrar

The transfer agent, which could be a bank, trust company, or the issuer, effects the actual transfer of securities from its former owner to its new owner. It certifies any required documents, issues new certificates to the new owner and cancels the certificates of the former owner. Since the transfer agent keeps track of owners of record, it usually is responsible for sending dividend payments, voting proxies, and notices of the annual stockholders' meeting. The transfer agent also handles problems relating to lost, stolen, or destroyed certificates. The transfer agent distributes additional shares when the stock is split or issues new certificates for a reverse split. When a stock dividend or stock split results in fractional shares, the transfer agent usually sends the beneficial owner a check for the value of the fractional shares.

The registrar is a state entity that usually employs the services of a bank or trust company to perform its functions and must be independent of the issuing corporation. The registration and issuance of new certificates must go through both the state registrar as well as the transfer agent. Although the registrar does not maintain the list of names of the owners of the company securities, the registrar does ensure that a corporation's outstanding shares do not exceed what has been authorized and also certifies that a bond represents a legal debt of the issuer. When securities are transferred, the registrar audits the work of the transfer agent, particularly ascertaining that the number of new certificates issued equals the number canceled.

By law, transfer and registration of stocks and stock certificates cannot be performed by a single person or department operating within the same institution. Issuers generally use commercial banks or trust companies.

Historical Notes