Stocks

Securities issued by a corporation are classified as debt, equity, or some hybrid of these two forms. Debt usually takes the form of a loan and must be repaid; equity usually takes the form of an ownership claim upon the corporation. The two main types of equity claims are common stock and preferred stock, although there are also related claims, such as rights, warrants, and convertible securities. Growing companies, which tend to lack the assets necessary to secure debt, often decide to issue equity securities. Although issuing common stock can be traumatic for a small business—because it can be costly, and because it causes a dramatic redistribution of ownership and control—it can also provide a solid foundation upon which to build a company. Preferred stock offers holders priority in receiving dividends and in claiming assets in the event of business liquidation, but it also lacks the voting rights afforded to common stockholders. Many venture capitalists require convertible preferred stock—which can be converted to common stock at some time in the future at a favorable price—as incentive to invest in start-up ventures.

COMMON STOCK

A share of common stock is quite literally a share in the business, a partial claim to ownership of the firm. Owning a share of common stock provides a number of rights and privileges. These include sharing in the income of the firm, exercising a voice in the management of the firm, and holding a claim on the assets of the firm.

Dividends

Sharing in the income of the firm is generally in the form of a cash dividend. The firm is not obligated to pay dividends, which must be declared by the board of directors. The size and timing of the dividends is uncertain. In a strictly rational economic environment, dividends would be considered as a "residual." In this view, the firm would weigh payment of dividends against other uses for the funds. Dividends would be paid only if the firm had no better use for the funds. In this case, declaring or increasing dividends would be a negative signal, since the firm would be admitting that it lacked possibilities for growth.

For widely held, publicly traded firms there are a number of indications that this is not the case, and that shareholders and investors like dividends and dividend increases. In these contexts, dividends are taken as a signal that the firm is financially healthy. A decrease in dividends would indicate inability to maintain the level of dividends, signaling a decline in prospects. An increase would signal an improvement in prospects. The signal from a dividend decrease is strong because management will wish to give only positive signals by at least maintaining the dividend, making cuts only when absolutely necessary. The signal from a dividend increase is also strong because management would be hesitant to increase dividends unless they could be maintained. The signaling nature of dividends is supported by cases in which the dividend is maintained in the face of declining earnings, sometimes even using borrowed funds. It is also supported by the occurrence of "extraordinary" or one-time-only dividends, a label by which management attempts to avoid increasing expectations.

This signaling approach is not applicable to closely held firms. In this situation, communication between management and shareholders is more direct and signals are not required. When owners are also the managers, sharing in earnings may take the indirect form of salaries and fringe benefits. In fact, shareholders in closely held firms may prefer that dividends be reinvested, even in relatively low return projects, as a form of tax protection. The investment is on a pretax (before personal tax) basis for the investor, avoiding immediate double taxation and converting the income to capital gains that will be paid at a later date.

Dividends are declared for stockholders at a particular date, called the date of record. Since stock transactions ordinarily take five business days for completion, the stock goes "ex-dividend" four days before the date of record, unless special arrangement is made for immediate delivery. Since the dividend removes funds from the firm, it can be expected that the per share price will decrease by the amount of the dividend on the ex-dividend date.

Stock dividends are quite different in form and nature from cash dividends. In a stock dividend, the investor is given more shares in proportion to the number already held. A stock split is similar, with a difference in accounting treatment and a greater increase in the number of shares. The use of the word "dividends" in stock dividends is actually a misuse of the word, since there is no flow of cash, and the proportional and absolute ownership of the investor is unchanged. The stockholder receives nothing more than a repackaging of ownership: the number of shares increases, but the price per share will drop. There are, however, some arguments in favor of stock dividends. One of these is the argument that investors will avoid stocks of unusually high price, possibly due to required size of investment and round lot (100 share) trading. On the other hand, stocks with unusually low price are also avoided, perhaps perceived as "cheap." The price drop accompanying stock dividends can be used to adjust price. Stock dividends have also been suggested as a way to make cash dividends elective while also providing tax-advantaged reinvestment.

With a cash dividend, an investor who wishes to reinvest must pay taxes and then reinvest the reduced amount. With a stock dividend, the entire amount is reinvested. Although taxes will ultimately be paid, in the interim a return is earned on the entire pretax amount. This is the same argument as that for low dividends in a closely held firm. Investors who wish cash dividends can simply sell the stock. Using stock dividends in this way faces restrictions from the Internal Revenue Service.

Control

The corporate form allows the separation of management and ownership, with the manager serving as the agent of the owner. Separation raises the problem of control, or what is termed the agency problem. Stockholders have only indirect control by voting for the directors. The directors in turn choose management and are responsible for monitoring and controlling management's conduct. In fact, the stockholders' ability to influence the conduct of the firm may be quite small, and management may have virtually total control within very broad limits.

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