What it means
When a company needs money to start up or grow, it can sell shares to investors. The people who buy common stock become part owners, and their stake is proportionate to the number of shares they hold compared with the total issued.
Common shareholders usually have the right to vote at shareholder meetings, for example to elect directors. They may receive dividends if the board declares them, but dividends are never guaranteed, and the amount can rise, fall or stop.
In a liquidation (when a company is closed and its assets are sold), common shareholders are paid last. Employees, tax authorities, lenders and preferred shareholders all come first, so there is often little or nothing left, which is the price of the upside that common stock offers.
On the balance sheet, common stock is recorded in equity. Many companies record the shares at a nominal par value, such as $1 per share, with any amount paid above par shown separately as additional paid-in capital (also called share premium).
The share price in the market is a different thing from the par value or the accounting value. The market price reflects what investors think the business is worth, based on its expected profit, growth and risk.
Founders and early investors should watch dilution. Each time a company issues new shares, existing holders own a smaller percentage unless they buy more, so the terms of new funding rounds matter a great deal.
In practice
Real-world examples
Example 1
A founder owns 800,000 of 1,000,000 shares and sells 250,000 new shares to an investor for $1,000,000. The investor ends up with 250,000 / 1,250,000 = 20% of the company, and the founder's stake falls from 80% to 64%. The founder still controls the board, but now needs the investor's support on major changes.
Example 2
A listed manufacturer declares a dividend of $0.50 per share. A shareholder with 10,000 shares receives $5,000, but if the board decides to cut the dividend in a poor year, that income falls with it. Many investors therefore look at the company's earnings and cash flow before counting on the dividend.
Example 3
A company is wound up with $600,000 of assets after sale, owing $750,000 to lenders and suppliers. Common shareholders receive nothing, because creditors are paid first and still have a shortfall. The shareholders lose their investment, though their liability is normally limited to the amount they paid for the shares.
Think of it
Common stock is regular ownership shares-you own part of the company with voting rights.
Formula
Calculation
Common stock account = Shares issued x Par value
Additional paid-in capital = Shares issued x (Issue price - Par value)
A company issues 100,000 shares with a par value of $1 at an issue price of $12. Common stock = 100,000 x $1 = $100,000. Additional paid-in capital = 100,000 x ($12 - $1) = $1,100,000, so total proceeds are $100,000 + $1,100,000 = $1,200,000, which equals 100,000 x $12.Case study
Seen in the real world
Larkfield Brewing is an illustrative, fictional craft brewer owned by two founders who each held 50% of 500,000 shares. To fund a new brewhouse they sold 125,000 new shares to a local investor at $8 each, raising $1,000,000.
After the sale there were 625,000 shares, so each founder owned 250,000 / 625,000 = 40% and the investor owned 20%. The founders accepted the dilution because the extra capacity was expected to double output.
In this illustrative scenario the company prospered, and three years later a buyer offered $18 a share. The investor's holding was worth $2,250,000, a rise of $1,250,000, and the founders concluded that owning 40% of a larger business was better than owning 50% of a stagnant one. They also noted that the investor's contacts had opened new distribution channels, an extra benefit that the cash alone could not have provided.
Watch out
Common mistakes
- Confusing par value with market value, when the first is an accounting label and the second reflects investor opinion.
- Assuming common stock always pays dividends, when payments depend on profit and board decisions.
- Ignoring dilution when planning new fundraising, which can leave founders with less control than they expected.
Questions
People also ask
What is the difference between common and preferred stock?
Preferred shareholders usually get a fixed dividend and priority in a wind-up but often no vote, whereas common shareholders get voting rights and the upside.
Are common stock and ordinary shares the same?
Yes, the terms mean the same in practice, with "ordinary shares" being the UK term and "common stock" the US one.
How do I find out how many shares are in issue?
Look at the equity note in the financial statements, or the cap table for a private company. The cap table lists every holder and how many shares each owns, including options still to be exercised.
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