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ANY COMPANY CAN ISSUE two types of stock – common stock and preferred stock. It may elect to issue common stock alone, but it can only issue preferred stock after or simultaneously with the issuance of the first tranche of common stock.
This is because the common stockholders of the company are the basic owners of the business. An incorporated business cannot exist without an owner or owners.
If the company is successful in making profits, the common shareholder may gain as a result of the payment of dividends as well as through the increase in the common stock prices on the open market. The common shareholder can realise this capital gain by selling his shares.
Alternately, the common shareholder can keep his holding of shares with the expectation that the company will continue to make profits and give rise to further capital gains. The profitable company can provide a very favourable prospect for the common shareholders.
However, the downside of being a common shareholder is that if the company fails, the common shareholder has the last claim on the assets of the company. When the business fails, it suffers losses, which tend to eventually erode the value of the company. In some cases, the business may be declared insolvent and be officially liquidated.
Whatever the circumstances, whenever a business that has failed or is failing is liquidated, the common shareholders are the last to be refunded.
The secured creditors, the unsecured creditors and the preferred stockholders are paid first and in that order. Sometimes, there is little or nothing available to pay to the common shareholders. Similarly, the preferred stockholders get the first share of dividends declared. They must be paid in full before any dividend is paid to the common stockholders.
It is also possible that only the preferred stockholders are paid and no dividend is paid to the common stockholders.
So, the preferred stockholders receive preferential treatment. Yet for all that, they must settle for a fixed dividend payment, no matter how profitable the company becomes.
You will always find that preferred stock is quoted with this limitation, usually as a percentage of the preferred stock original cost.
The common stockholders, on the other hand, may attract increasingly larger dividend payment as the company makes increased profits.
In addition, the preferred stockholder is entitled to a cumulative dividend. This means any unpaid dividend to the preferred shareholders for each past year must be paid in full before any dividend can be paid to the common shareholders for the current year.
On the other hand, dividends to the common shareholders are never cumulative. In any event, the amount of the common shareholders’ dividend only becomes apparent at the time of its declaration; it is not a fixed amount as is the case of the preferred shareholders’.
The directors of the company decide on the dividend and declare the amount to be paid per common share.
In order that the common shareholder can have a reasonable expectation of an attractive return, the directors may explicitly set out a dividend policy for the company.
Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. Email: LouiseFairsave@nationnews.com.
This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.