Every corporation must have at least one type of stock. This rule even applies to S corporations, but they are limited to 100 total shares and only one type of stock. The term “stock” is often used interchangeably with “shares” or “equity.” Those who own stock are called “shareholders” or “stockholders.”
Stocks play two primary roles for a corporation. Firstly, they set out who has an ownership stake in the company. The amount of stock that someone holds determines how much of the company he or she owns. Secondly, they raise funds for the corporation. Those who want to 'buy in' to the company will purchase stock, which gives the business capital for startup purposes or to raise funds at a later time.
Even small, closely held corporations will have stock, but it is often not publicly traded. Although many businesses can “go public,” they often choose not to because of the complicated nature of complying with regulatory laws. For some smaller companies, going public just does not make financial or practical sense. Nonetheless, stock still plays the two important roles mentioned above for small businesses as well.
Every stockholder owns a portion of the company. However, the type of stock that each owner holds will dictate their role in the enterprise. All of the various types of stock should be specifically described in the company’s articles of incorporation. How you will structure your stock (and therefore the ownership of your business) should be a big part of your considerations as you form and grow your business.
For example, some stock options will provide voting rights in the company while others are specifically designed so that the stockholder functions more as an investor instead of having a voice in the business. How you organize your stock will vary greatly depending on how your business is structured and how you want to attract investors.
Stocks are an alternative to getting a regular business loan from a bank or other lending institution. The other option would be to issue bonds, another form of debt financing. In contrast, issuing stock is referred to as equity financing because you are sharing a portion of the ownership of the business (or “equity”) with the shareholders.
Unlike getting a loan or issuing bonds, you do not have to pay back the money that you receive from those who purchase stock. You also do not have to worry about interest payments either. Depending on the type of stock, however, you may have to issue periodic dividend payments. For these reasons, issuing stock is sometimes a more appealing way to raise capital for your business.
Stock options can also be good incentives for your executives. Even private companies can devise ways to use stock as a means to reward employees or officers.
Companies like to use shares to attract investors because it is a liability-free way to invest in a company. Stockholders never risk more than what they originally invested in the stock when they became shareholders. When companies do not want to add a partner or co-manager, creating stock options is a good compromise. The shareholders usually technically have the power to vote at meetings, but they generally will not be able to dictate how a business runs its day-to-day operations.
There is a certain level of risk for your investors who purchase stock. They may not get their money back if the stock’s value drops and never rises. On the other hand, they may be able to increase their investment if the value of your business increases. That is the risk they take by purchasing your stock.
Some of your business formation documents, including corporate bylaws, LLC operating agreements, and the shareholders' agreement, will indicate the number of shares your company has, and even who holds these shares. The total number of shares that you indicate your business has in your corporate documents are referred to as the “authorized shares.” All of your authorized shares do not have to be issued, but medium and small businesses often issue all of the authorized shares in proportion to each owner’s stake in the company.
Your individual shareholders will also need some record that they hold a certain number of shares in your company. A stock certificate accomplishes this goal.
A stock certificate provides evidence that your company issued a specific number of shares to the holder of the stock certificate. While many publicly traded companies do not issue stock certificates in paper form, most small to mid-size businesses will. Larger companies often have electronic stock certificates, which makes them easier to trade. Regardless, you can usually ask for a stock certificate from the company if you would like one. Many smaller businesses do not want to make their stock easier to trade, so electronic stock certificates are less common.
It is important to note that some states demand that corporations issue stock certificates as part of their registration process. Be sure to comply with this requirement to avoid any legal issues with initial formation.
The possibilities are virtually endless when it comes to creating ownership options for your business. You can design a stock option that works for you and your investors. There are, however, specific types of corporate stocks already established that you can use in your business or as a model for creating stock options that work for you.
The common growth stock is likely the most well-known type of stock. Its value increases or decreases with the market. Stockholders can vote in shareholder elections and will benefit from any increase in the value of the stock. Dividends (an amount paid to shareholders from profits) are awarded to common growth stockholders at the discretion of the board of directors, and some common growth stocks will never issue dividends. The vast majority of publicly traded stocks found on NASDAQ or NYSE are common growth stocks.
Companies that are well established and mature generally have a stable stock value. As such, it can be difficult to sell stock to investors if there is little to no possibility that the stock will grow. Utility companies and very large, established corporations will often offer common income stock to entice investors.
The common income stock will reward its investors with higher dividends, but there is no contractual obligation to issue a dividend. Holders of this type of stock will have voting rights in shareholder elections as well.
Preferred stocks function differently from common stock. Instead of making money based on growth, preferred stockholders will make money off of required dividends. That is, the company must provide preferred shareholders with a certain amount of dividends on a regular basis, usually quarterly or annually. Preferred shareholders often do not have voting rights in a company, unlike common stockholders. Preferred stockholders also have less risk for their investment because if the company goes under, preferred shareholders must often have their investment returned to them as part of the winding up process.
Callable preferred stock allows the business to “call” the stock, which means that the investor must sell the stock back at a certain rate or by a specified date.
Convertible preferred stock has all of the traits of preferred stock, with one extra advantage. If the company suddenly increases in value, a convertible stockholder can transfer their preferred stock for common stock to benefit from the growth in value. Generally, this must be done by a specified date.
It is not uncommon for a business to issue unique stocks that have varying degrees of voting rights. If there is more than one type of stock, they are usually referred to as “Class A,” “Class B,” etc.
Some business owners make the mistake of failing to include specific rules and obligations related to their stock. Be sure to answer the following questions regarding the stock for your company:
Your shareholder agreement will include a lot of this information. It is important to answer these questions and others in the agreement.
For publicly traded companies, trading stocks is a fairly straightforward process. You can either put your stocks up for sale at a certain amount or buy stocks based on the value of the stock on the market at the time of purchase. For closely held companies or corporations that are not publicly traded, the process is generally the same, but buying and selling is not as easy.
When a closely held business sells its stock, that usually means that there is a significant ownership change occurring because just a few people own stock and have voting rights in the company. Buying and selling are still permitted, as long as the stock itself does not have any restrictions regarding transactions.
Valuation is challenging for some closely held business’s stock because there are few stock options with which to compare it. Valuing closely held stock may require the input of a professional in some situations because it will mean valuing the company as a whole.
A stock transfer ledger allows you to keep a record of every transaction that involves your stocks. It is not only a good practice to track stock transfers—particularly for small to mid-sized companies—but it may also be required to stay compliant with corporate requirements in your state. It should be maintained and kept with your regular corporate records.
Generally speaking, the stock transfer ledger will include the following information:
Your stock transfer ledger will be closely related to the information found on your stock certificates.
For many small and medium-sized businesses, attracting small investors is often the easiest way to sell stock. Small investors are often friends, family, and business associates. However, selling “common” stock is harder for small businesses because there is a very limited market for investors to sell their stock later. Selling stock with certain perks, such as dividends, may attract more investors.
You can also attempt to sell stock to larger, more sophisticated investors. This is often referred to as "venture capital financing." In these types of arrangements, you may have to provide the investor a role on the board of directors to secure the investment.
Issuing stock can be complicated. It will be helpful to have the forms you need at your fingertips that you know are compliant with both state and federal laws. LegalNature can help. Check out our business formation documents to get started.