Study Notes for Overview of Equity Securities

Overview of Equity Securities

Equity refers to the ownership interest or residual claim in the assets of a firm after all the liabilities of the firm have been paid. While referring to a firm’s <a href="https://financetrain.com/elements-of-balance-sheet/">balance sheet</a>, equity refers to the capital contributed by the owners (also known as shareholders) plus any retained earnings or losses.

A firm can issue various types of equity securities to raise capital. Different securities have different ownership claim on the company’s net asset.

Common shares are the most common type of equity securities issued by a company.
<ul>
	<li>If the firm is liquidated, the common shareholders will have the residual claim over the assets of the firm after all debt and preferred stock has been paid.</li>
	<li>Common shares provide voting rights to the shareholders which provide the shareholders the ability to participate in major corporate decisions such as election of directors, mergers and acquisitions, selection of auditors, etc.</li>
	<li>The company is not obligated to pay dividends to the common shareholders every year. It may choose to pay some or all of its net income as cash dividend to common shareholders.</li>
	<li>Shareholders may attend the annual general meeting in person and use their vote. If they are not able to attend, they can also vote by proxy (i.e., have someone else vote on their behalf).</li>
</ul>
<img class="aligncenter size-full wp-image-15553" alt="Common Share Certificate" src="https://financetrain.com/wp-content/uploads/common-shares.jpg" width="464" height="355" />

Callable and Puttable Common Shares

The common shares may also be callable or puttable. A call option gives the issuer of the common shares the right, but not the obligation to call the shares back at a pre-specified call price which is set at the time the common shares are issued. These shares are also called redeemable common shares. The issuer will generally call the shares when the current market price is higher than the call price. In such a case, the issuer can buy back the shares at the call price and sell them in the market at the market price. Note that it’s a right of the company and the investors holding the shares are obligated to sell if the issuer decides to call back the shares. Calling the shares helps the companies in reducing their dividend payments.

A put option gives the investor the right but not the obligation to sell the common shares back to the issuer at a prespecified price set at the time the shares were issued. Investors will be interested in selling the shares back if the current market price is less than the put price. This helps the investors in lowering their loss potential. Put options are beneficial for issuers as they make their issue more attractive to investors.

Common Equity Shares - Meaning and Features

Preference shares are another type of equity securities issued by firms that combine the features of <a title="Common Equity Shares – Meaning and Features" href="https://financetrain.com/common-equity-shares/">common shares</a> as well as debt securities. Just like common shares, they do not mature, and can have features such as call and put options. However, like interest payments in debt securities, holders of preferred shares receive fixed payments in the form of dividends at a pre-set rate. Dividends are also generally higher than the dividends paid to common shareholders. Preference shares do not have voting rights.

The dividend payments to preference shares can be cumulative, non-cumulative, participating, or non-participating.

<img class="aligncenter size-full wp-image-15559" alt="Preferred Shares" src="https://financetrain.com/wp-content/uploads/preferred-share.jpg" width="500" height="346" />
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td valign="top" width="187">Preference Shares</td>
<td valign="top" width="429">Description</td>
</tr>
<tr>
<td valign="top" width="187">Cumulative Preference Shares</td>
<td valign="top" width="429">Dividend accrues. If the company doesn’t pay dividend in one year it must be paid in the future period before paying dividends to common shareholders.</td>
</tr>
<tr>
<td valign="top" width="187">Non-cumulative Preference Shares</td>
<td valign="top" width="429">Dividends do not accumulate over time if not paid. However, if a company decides to pay dividends to common shareholders in a particular year, it can do so only after paying dividends to preference shares.</td>
</tr>
<tr>
<td valign="top" width="187">Participating Preference Shares</td>
<td valign="top" width="429">Shareholders receive standard preference dividend plus additional dividends if the company’s profits are above a pre-specified level.They may also have provisions under which if the company is liquidated, they will receive value greater than the par value.</td>
</tr>
<tr>
<td valign="top" width="187">Non-participating Preference Shares</td>
<td valign="top" width="429">The shareholders receive only the standard preference dividend. They do not participate in the company’s profits.They receive only par value on liquidation.</td>
</tr>
</tbody>
</table>

Preference Shares - Meaning, Types and Features

Convertible preference shares give the preference shareholders the right to convert their shares into a specified number of common shares. The ratio of how many <a title="Common Equity Shares – Meaning and Features" href="https://financetrain.com/common-equity-shares/">common shares</a> an investor will get for each <a title="Preference Shares – Meaning, Types and Features" href="https://financetrain.com/preference-shares-meaning-types-features/">preference share</a> is called conversion ratio. An investor has many advantages in buying convertible preference shares instead of directly buying common shares.
<ul>
	<li>Preference shares earn higher dividend compared to common shares and also allow them to participate in company’s profits.</li>
	<li>As the common shares’ price increases, the option to convert becomes valuable.</li>
	<li>Preference shares are less risky than common shares and have priority claim over firm’s assets than common shares.</li>
</ul>

Convertible Preference Shares

<a title="Common Equity Shares – Meaning and Features" href="https://financetrain.com/common-equity-shares/">Common shares</a> provide voting rights to the shareholders which provide the shareholders the ability to participate in major corporate decisions such as election of directors, mergers and acquisitions, selection of auditors, etc. When electing the members of the board of directors, there are two commonly used methods of voting: Statutory Voting and Cumulative Voting.

Under the statutory voting system, directors are elected one at a time. Each director is voted on one at a time. Therefore, a shareholder may give any one candidate, as a maximum, only a number of votes equal to the number of shares owned. Statutory voting favors majority shareholders.

Under cumulative voting system, total number of votes each shareholder may cast = (# of shares owned) x (# of directors to be elected). With cumulative voting, a shareholder may give all the votes he/she holds to a single candidate. Cumulative voting favors minority shareholders.

<img class="aligncenter size-medium wp-image-15565" alt="vote" src="https://financetrain.com/wp-content/uploads/vote-300x175.gif" width="300" height="175" />

Example
<ul>
	<li>A company has two shareholders: “A” (owns 50 shares); “B” (owns 249 shares). There are 5 directors to be elected and 7 candidates running (T, U, V, W, X, Y, Z). “A” wants candidate Z to be on the board. B wants candidates T, U, V, W, and Y.</li>
	<li>Using statutory voting: “A” has 50 votes and “B” has 249 votes. Since each director is voted on one at a time “B” will be able to vote in all his candidates and “A” will not be able to vote in his candidate.</li>
	<li>Using cumulative voting:</li>
</ul>
“A” has 50 x 5 = 250 votes (all for Z)

“B” has 249 x 5 = 1,245 votes (÷ 5 = 249 for T, U, V, W, and Y)
<ul>
	<li>Therefore, Z wins the most votes. “B” cannot arrange votes to block Z.</li>
</ul>

Voting Systems: Statutory Voting and Cumulative Voting

A company can also issue various classes of common stock, such as Class A and Class B, with each class having different features. One class may have higher voting power, while the other may have higher dividends. For example, Class A shares may have 1 vote per share and 100% of dividends. Class B shares may have 10 votes per share and zero dividends (usually not publicly traded).

The following is a description of Class A and Class B shares issued by Berkshire Hathaway.
<blockquote>Each Class A common share is entitled to one vote per share. Class B common stock possesses dividend and distribution rights equal to one-fifteen-hundredth (1/1,500) of such rights of Class A common stock. Each Class B common share possesses voting rights equivalent to one-ten-thousandth (1/10,000) of the voting rights of a Class A share. Unless otherwise required under Delaware General Corporation Law, Class A and Class B common shares vote as a single class. Each share of Class A common stock is convertible, at the option of the holder, into 1,500 shares of Class B common stock. Class B common stock is not convertible into Class A common stock.</blockquote>

Overview of Equity Securities

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