Business owners and potential purchasers of businesses tend to have a number of questions about corporate stock and how it works. This post is a basic 101 tutorial, which answers some common questions about stock in a corporation and how it works.
What is stock?
A corporation’s capital stock represents ownership of the company and usually governance rights, although a corporation can issue stock that is non-voting.
A share of stock represents a percentage of ownership of the corporation. How much? It depends on how much stock is outstanding. To determine the percent ownership a shareholder has, divide the total number of shares the shareholder owns by the number of issued and outstanding shares. If, for example, a shareholder has five shares and there are 100 shares of issued and outstanding shares, the shareholder owns five percent of the company.
What are authorized shares?
The articles of incorporation of every corporation state how many shares of stock the company’s board of directors is authorized to issue. This is known as the corporation’s authorized shares. Since the articles of incorporation are filed with the secretary of state of the state in which the company is incorporated, and since this is a public document, the number of authorized shares tells the world something about the capitalization of the company.
The concept of authorized shares is a shareholder protection. When a corporation issues new shares, the ownership percentage of existing shareholders is diluted. In our example above, a shareholder who owns five out of 100 of a corporation’s shares owns five percent of the company. If the company were to issue another 100 shares, the shareholder’s ownership interest would be cut in half to 2.5%.
The concept of authorized shares puts constraints on the ability of insiders to dilute existing shareholders. In order to issue shares that have been authorized in the articles of incorporation, the company’s board of directors simply needs to adopt a resolution, usually by the majority vote of a quorum of directors. However, the articles of incorporation need to be amended in order for the board to issue shares in excess of the number of authorized shares. Since amendment of the articles usually requires a shareholder vote, shareholders are protected against having their ownership interest diluted without having a say in the matter.
What are issued and outstanding shares?
Issued shares are shares of stock that have been issued to one of the corporation’s shareholders. Outstanding shares are shares that are currently held by a shareholder. A corporation’s issued and outstanding shares represent the total ownership of the company. If a corporation repurchases some shares, those shares are no longer outstanding. If the corporation continues to hold the shares, they are issued but not outstanding, and they are known as treasury shares. Treasury shares do not have voting rights or rights to receive dividends. If treasury shares are cancelled by the corporation, the number of authorized shares is reduced by the number of cancelled shares. If the shares continue to be held as treasury shares, the corporation can reissue the shares.
What is common stock?
Basically, common stock is any stock that isn’t preferred stock. This post focuses on common stock. For information about preferred stock, see my post Angel Investing Basics. Although common stock usually has voting rights, corporations can also issue non-voting common stock.
How many shares should a new corporation authorize and issue?
Almost all of my clients are closely held, that is, they have only a few owners. If a corporation has only one owner, it would be sufficient for the corporation to issue a single share of stock to that shareholder. But it would be inconvenient if the shareholder wanted to bring on a business partner who would own five percent of the corporation. For that reason, corporations usually issue enough stock to make future stock issuances convenient. In the case of a single-owner corporation that wanted to issue stock to a new shareholder so that the ownership split would be 95% to 5%, the corporation would probably want to issue at least 10,000 shares to the original owner so it could issue 526 shares to the new shareholder.
An additional consideration is the effect of authorized shares on filing fees when incorporating, as well as on the corporation’s franchise taxes. In Missouri, for example, incorporation fees are $58 for the first $30,000 of authorized capital and $5 for each additional $10,000 of authorized capital. Authorized capital is the number of authorized shares multiplied by the par value of the shares. For this reason, closely-held Missouri corporations often authorize 30,000 shares in their articles of incorporation.
Until 2016 Missouri corporations were required to pay franchise taxes every year to the Department of Revenue. Franchise taxes were calculated based on the value of the corporation’s total assets or the par value of issued and outstanding capital stock, whichever was greater. For capital stock with no par value, the value was $5.00 per share or actual value, whichever is higher. Thus, par value could affect the amount of franchise tax a corporation owed.
What is par value?
Par value is an indicator of the minimum amount of capital a corporation has. It’s not a very useful concept these days, however. When a corporation issues stock, it is required to receive as consideration an amount at least as high as the stock’s par value. So if a corporation has 30,000 issued and outstanding shares of stock having a par value of $1, then the corporation has at least $30,000 of capital. Since corporations aren’t permitted to issue dividends or repurchase shares if their capital would fall below this number, par value can in theory tell you something about how solidly capitalized a corporation is. In practice, however, par value is usually set at a far lower value than the actual value of the shares (often at $0.001 or even zero), so it isn’t really that meaningful.