Issuance of Common Stock

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What is common stock, and why does a company issue them?

Common stocks are shares issued by a company to raise money instead of selling debt or issuing preferred stock. Common stocks are essentially ordinary shares. When the company issues common stock for the first time, they do so via an initial public offering or an IPO. Subsequently, common stock is offered through secondary offering pricing. Here, they raise the total number of outstanding shares in the markets for the public to buy and sell. Issuing common stock enables the company to grow and achieve specific goals such as expanding the business offerings, acquiring another company, paying off debt, or raising more capital for general business reasons. When issuing common stock, a company needs to be mindful that they are essentially diluting the holdings of the existing shareholders, implying a reduction in their ownership of the company. If a company goes bankrupt, investors who have bought the common stock will receive money only after all the creditors, bondholders, preferred shareholders receive their share.

What are the benefits of issuing common stock?

Issuing common stock can prove highly beneficial to a company. The benefits are manifold, varying from company to company, whether a publicly held company or a private one. The advantages common to both are as follows:

Reduces Debt: When a company issues common stock, they ask people to buy a part of the company. Owning stocks of the company implies that the investor owns a particular share of the company. This does not need to be repaid by the company itself, and therefore there is no interest expense attached to it. In fact, if a company has a high debt load, it can use the money raised by issuing common stock to pay off part of the debt. The company considerably reduces its fixed costs by paying it off, as interest payments have been reduced or removed entirely, to increase profitability at the same or lower sales levels.
Increases Liquidity: When a company needs to increase its cash flow in the upcoming quarters or need to mitigate certain constraints regarding its cash flow, issuing common stock is an option they explore.

The advantages for a publicly held company are as follows:

Easier to acquire: A company can issue common stock targeting the shareholders of companies they want to acquire, post which they can sell it for cash, thus making the acquisition easier to take on.
Better the credit rating: A company may have a credit rating agency assign a credit rating to its securities. When issuing common stock, the company’s cash reserves go up considerably, making it look like it is more financially conservative. This ensures a better credit rating from the agency.
Enhancing the float: A company can attract more investors if it has a large reserve of registered shares available to be bought or sold. When issuing common stock, the company will need to get the stock registered with the Securities and Exchange Commission (SEC), thereby increasing the company’s float. If the company issues stock but does not get it registered, the float does not increase.

What are the disadvantages of issuing common stock?

While issuing common stocks does have numerous benefits or maybe the need of the hour, a company needs to be mindful of certain disadvantages of issuing common stock. They are as follows:

Diluting ownership: When a company issues stock, a company is essentially increasing the number of outstanding shares in the market. When the new shares make their way to the market, the value of the shares held by existing shareholders is diluted.
Diminishing voting influence: As a shareholder of a company, investors get to vote on important company developments and decisions. When a company issues additional common stock, they dilute the ownership of the existing shareholders and the influence they have over essential company developments.

Is common stock equity?

Common stock is equity. It is a type of security that gives the investor ownership rights of the company. If a company issues 100 shares and an investor buys 10 shares, the investor owns 10% of the company. This implies that if all the company’s assets were converted to cash and subsequently all the liabilities were paid off, the investor would get 10% of the remaining money.

How is the value of common stock calculated?

When analyzing the value of a common stock, people focus on its market value and price. However, it is the book value that is taken into account. The book value is the claim stockholders have on the company’s assets. This is calculated based on the accounting information on the company balance sheet. As the balance sheet consists of historical data, the book value of the common stock is usually different from the stock’s market price. The book value per share is calculated using the equity ratio available to the common stockholders against the number of outstanding shares.

The comparison between book value and the stock market price gives great insights into investor sentiments and how the company is valued in the market. If the book value is more than the market price, the company is undervalued. If the book value is more than the market price, the company is considered overvalued.

What are the different classes of common stock?

When they issue common stock, most companies issue only one class of common stock, where each share provides equal value and rights to every other share. Sometimes companies issue two or more classes of common stock, usually denoted by a letter. The reason for issuing two or more classes of common stock could be many, such as they want to create a class of stock just for the top management and senior-level executives, assigning greater per-share voting multiple than the other class of stock. By doing this, the top management and senior executives maintain control over the company and its day-to-day running. This class of stocks, though, would not be traded publicly.

A company may issue the following classes of common stock:

Class A shares are available to individual investors and can be traded publicly. Each share has one vote. Companies issuing one class of common stock usually issue Class A type of shares.
Class B shares are exclusive to the founders and top management of a company. These shares cannot be publicly traded, and the voting power is in multiples of Class A shares. For example, Class B has a multiple of 10 Class A shares. This implies that for every one vote of Class A, Class B stockholders get 10 votes.
Class C is similar to Class A shares, i.e., they are available to individual investors and can be traded publicly. However, they do not have any voting rights.
Class F Stock is a class of stock that has been gaining momentum in the recent past. This class of stock is available only to the founders of the company. The features are typically super-voting rights with certain restrictions on public trading.

The company needs to clearly define the types and features of different classes as there are no provisions specific to the different classes.

How to issue common stock?

As a company set to issue common stock, these are the steps that need to be followed:

Step 1: When issuing common stock, the company has first to determine how much capital it needs based on why it needs to issue the stock in the first place. When this is determined, only then can the company determine how many shares need to be issued and at what price they will be issued.

Step 2: Check the company’s Articles of Incorporation, stating the maximum number of shares that the company can issue. The company doesn’t need to issue the maximum number, but issuing more than the maximum number mentioned in the Articles of Incorporation requires formal modification of the articles.

Step 3: Now that the amount of capital needed and the number of shares that can be issued has been determined, the next step is to set the stock value that will be issued.

Step 4: The company then needs to determine the class of stock it will issue. It will need to clearly define the terms and provisions of the stock in terms of voting rights and other factors that will influence the trade-ability of the stock.

Step 5: With everything in place, the company needs to determine how many shares it will issue. This is a simple calculation of dividing the capital required by the price of the share. Ensure that the number of shares issued is less than the maximum number stated in the Articles of Incorporation.

Step 6: Compliance with the law is mandatory, and a legal time should guide the company to ensure that issuing the stock is in line with the law. This includes registering with the SEC.

Step 7: Once all the details have been fine-tuned and agreed upon, the company needs to draft the Stock Subscription Agreement, detailing the transaction and issuing stock certificates to all the shareholders. This legal document will state the stockholder’s name, the number of shares held, the value of the shares when purchased, and any special terms and conditions applicable.

Step 8: The last step is to issue the stock and complete the transaction. The company receives the money in exchange for the share certificates.

How to calculate the average issue price of the common stock?

When calculating the average issue price of the common stock, the following information is required:

The number of shares that have been issued
The net earnings from the issue of the common stock
The costs incurred in issuing the stock such as legal fees and commissions

With this information, the gross earnings can be calculated using this formula:

Gross Earnings = Net Earnings + Costs

The gross earnings, in turn, are used to calculate the average issue price of the common stock, as depicted below:

How to record the issuance of common stock in the books?

The accounting of the issuance of common stock depends on whether it has been issued at par value or not. To record the issue, the following break up is used:

Issuing common stock is a long process necessary when taking on an expansion or growing the business. Consulting with the right legal team and financial team is vital throughout the entire process. This enables the company to benefit from issuing the common stock and raise the capital they need.

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