As previously referenced in this blog, stock allows a Corporation to do many different things. It is an effective way to raise capital, to transfer voting rights in a company, and it even can be a means to transfer presumptive rights to the heirs of the owners of a corporation. So quite literally – stock, if you can imagine it, you can do it.
Common stock is the stock that we all think of when we talk about owning stock. Common stock normally has some value and that value is related to the value of the company. Additionally, some common stocks have the ability to vote in certain instances, i.e. the shareholder meeting. However, common stock’s voting rights are normally limited versus other classes of stock. The other classes of stock can include preferred stock, investment-grade stock, and any other type of stock with its own specific rights and interests.
However, common stock is what we are most familiar with as individuals. It is the stock you own when you buy stock in a company like General Motors or General Electric. There are normally thousands or even millions of issued shares of that stock and the average person would not expect to nor actually attempt to go to a shareholder meeting and attempt to control the course of the company at that meeting. Generally, to own common stock only is a disinterested investment in very large corporations.
Now however if a corporation is small and closely held the common stock may have more power simply because there is less stock. If a corporation does not create different classes of stock the only type of stock that will be issued is common stock. If that is the case, both control over the corporation and interest in the profits of the corporation are embodied in that single type of stock. This can be a concern if you intend to issue stock to investors who you do not wish to have control of the company.
Additionally, common stock, as well as all classes of stock, provide for some options for shareholder derivative actions. Shareholder derivative actions are actions in which a shareholder can bring claims against the directors of the company if the shareholder believes that the directors of the company are decreasing the value of their stock, and making decisions that are inappropriate for the company. I will address derivative actions more in depth in later blog posts.
As I talk about different types of stock other than common stock, I’m going to give them certain names i.e. preferred stock, investment-grade stock and others as appropriate. These names are shorthand references to types of stock that can be changed to reflect the tastes of the corporation and its owners.
Traditionally when I think of preferred stock I think of stock in a company that has two major characteristics (one) more votes than common stock at a shareholder meeting and (two) an interest in the profits of the company, sometimes a greater interest than that held by common stock.
Preferred stock is normally the stock held by the owners or the founders of the company. The preferred stock ensures that regardless of how much common stock is issued the original owners of the company retain ownership interest in that company. An example, that most people from Michigan would recognize, is the Ford family retaining an interest in Ford Motor Company to ensure the families control over the corporation.
Preferred stock is very useful to retain control over the company that the owners founded. However, preferred stock that has too much control can make investors shy about investing any money in the corporation. In the calculation of the risks and benefits of investing in the company, the investor will say why should I give the corporation this amount of money when I know the preferred stockholder can do whatever he wishes with the company and the money and I have no control. Therefore, if your company only has preferred and common stock and you are offering only common stock to investors the powers of preferred stockholders must be considered carefully and tailored in such a way as to provide reciprocal protection to both the preferred stockholder and the common stockholder.
Investment Grade Stock
I often use the term investment-grade stock to define stock that is being offered to potential outside investors. Investment-grade stock has some hybrid characteristics that both preferred stock and common stock have. Normally I include greater ability to direct the company through the votes associated with investment-grade stock than the votes that would be associated with common stock. Additionally, investment-grade stock can call for the repayment of a note that is associated with the investment and therefore profits of the company may be directed to investment-grade stockholders before they are directed to both preferred and common stockholders.
Once again, the balance of the rights and interests of the stockholders of investment grade stock must be carefully balanced. Normally, this sort of stock is being issued to individuals who have a substantial interest in protecting their investment in this company, and are expecting to either profit greatly from the stock or in the alternative be paid back. If you are dealing with an investor who simply is looking to be paid back, it might be better to obtain financing through an alternate debt structure, i.e. loans, debentures, or other debt vehicle.
When I’m dealing with a corporation that wants to obtain investors, I do not normally create an investment grade class of stock upon the initial corporate set up. Instead, this class of stock is created once investors are found, and a discussion is held with those investors regarding what sorts of powers and payment expectations those investors have. It makes no sense to create a class a stock that says you have powers A,B, & C and then when you obtain an investor that investor says well I don’t want A,B, & C I want X, Y, & Z. Therefore, it is essential that you ensure that the powers associated with investment-grade stock are tailored to the investors themselves. This can even mean that there may be multiple classes of investment-grade stock. Sometimes this happens if there are multiple funding events.
Limitations and Requirements
Small corporations need to take care when issuing stock. Generally, corporations are required to register with the Securities and Exchange Commission if they are issuing stock to a large number of investors. The definition of a “large number of investors” is somewhat up in the air as regards the SEC rules. However, Michigan does have specific rules and limits the number to 50 shareholders. The rule of thumb as far as the SEC is concerned is 20 shareholders.
This is not to say you cannot go out and obtain registration from the SEC to be able to have your stock publicly traded. Normally the initial public offering (“IPO”) tends to make the original owners of the company seriously wealthy. However, getting to the point of being able to have an IPO requires a great deal of preparatory legal work in registering with the SEC and providing the appropriate reports. The SEC does have a less onerous registration for small businesses however; many small businesses that are just starting out and looking for investment capital would still have a hard time funding even that process. This blog post is not the arena to get deeply into the specific requirements and rules for SEC registration. We may address this at a later date in this blog in a series of articles, but at this time we will not delve very deeply into these registration requirements.
Therefore, I normally try to steer corporations away from multiple small investors and to have them focus on 1 to 5 large investors. Most small businesses do not require multimillion dollar investments to get them started. Normally, investment can be found from colleagues and acquaintances who are looking for an investment. Additionally, I am sometimes able to direct clients to colleagues of mine who specialize in finding investments for their clients, be they financial planners, private bankers, or other individuals involved in the financial services industry.
Stock provides a powerful tool for Corporations to raise money and retain control for the original founders. However, stock should not simply be considered something that you can do whatever you wish with. While stock allows for multiple different powers and rights, those powers and rights must be carefully considered and balanced to provide full and fair representation of all investors and owners.
As always, the corporate practice group and Timothy M. Kaufmann at Hewson & Van Hellemont, P.C. stand ready to assist you in all your corporate needs. We welcome you to contact our office at 248-968-5200 or contact Mr. Kaufman directly at firstname.lastname@example.org.