Shawn has a masters of public administration, JD, and a BA in political science.
One method a business can use to raise funds is selling stock to potential investors. In this lesson, you'll learn about raising capital through the sale of stock, including its advantages and disadvantages.
Selling Stock to Raise Capital
Meet Stanley. He was a mechanical engineer for a heavy construction equipment company, who decided to start his own company designing and manufacturing high-tech construction equipment for the 21st century. The good news for Stanley is that he had sufficient funds to build the prototypes for each of his product lines; the bad news is that he's tapped out for cash.
He's shopped around for loans from different commercial bankers, but they don't want to lend him the millions he needs to get production going. After talking to his CPA, he was referred to a securities attorney about the possibility of selling stock of his company to raise capital.
The lawyer explains that stock is a type of security that represents an ownership interest in a company. Some stocks are publicly traded on a stock exchange, such as the New York Stock Exchange. You are probably most familiar with publicly traded stock. This type of stock is registered with the Securities and Exchange Commission, or SEC, and the sale and trade of stock is subject to rules and regulations. Some stocks are not publicly traded, although they are still regulated by the SEC and state security agencies.
There are two general types of stock: common stock and preferred stock. If Stanley decides to offer stock for sale, he'll have to decide if he wants to offer common stock, preferred stock or both.
Common stock is an ownership interest in a company and entitles its holder to a portion of the profits - called dividends - if distributed. Note that dividends are not guaranteed and vary in amount. Holders of common stock also have voting rights to elect the members of the board of directors.
Each share typically gets one vote. Most stock that is issued is common stock. If Stanley decides to offer common stock, he'll have to deal with shareholders that will be able to vote for directors. If he doesn't control a majority of the common stock shares, he may even lose control of his company.
His lawyer explains that it's possible to issue different classes of common stock that have different voting rights. For example, holders of Class A common stock may have ten votes per share, while holders of Class B common stock may only have one vote per share. Thus, Stanley could control all the Class A shares but sell the Class B shares to investors.
Just when Stanley thought he had a handle on stocks, his lawyer starts to talk about preferred stock. Preferred stock also represents an ownership interest in a company. However, preferred shares usually have very limited or no voting rights at all. On the other hand, holders of preferred shares do get some preferential treatment. Holders of preferred shares are usually guaranteed a fixed dividend, which will be paid before any dividends are distributed to holders of common stock.
Additionally, preferred shareholders will get paid before common shareholders if the company is liquidated. Preferred shares are often callable, which means the company can purchase the shares back, usually at a premium. Preferred stocks are sometimes convertible to common stock. Preferred shares may be a good option for Stanley to offer to investors because the added benefits may attract investors but also keep the company firmly in Stanley's control.
Public Offering v. Private Placement
Stanley's securities lawyer moves on to talk about the different ways to sell stock. He explains that the sale of stock is a highly complex and regulated transaction. This is especially the case if a company attempts to make an initial public offering, which requires complex public filings and registrations with the Securities and Exchange Commission. A prospectus will also have to be prepared, which is a long, complex disclosure document about the company and its directors and officers.
Investment banks are utilized to make an analysis of market demand and price. Investment banks also sell the stock at initial public offering. In fact, initial public offerings are so complicated and expensive few companies can do it. Publicly traded stocks that were sold at an initial public offering are stocks that you see traded on Wall Street.
Stanley was becoming discouraged until his lawyer started to discuss private placements. His lawyer explains that a private placement is an offering of securities, like stock, that is not offered to the general public but rather to a select group of private investors. These investors need to be accredited investors under the SEC regulations, which basically means they have either the income or net worth sufficient to withstand a complete loss of their investment. Private placements are still subject to the Securities Act of 1933 and the relevant SEC rules.
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Stanley will have to make some filings with the SEC and each state's securities agency where he plans to seek investors. However, the filings are easier and costs are much lower than those of an initial public offering. Additionally, his lawyer will prepare a private placement memorandum that will make certain disclosures about Stanley and his company to potential investors, which is similar to a prospectus.
Advantages and Disadvantages
After meeting with his lawyer, Stanley goes to his neighborhood bar to have a drink and think. He sees some important advantages and disadvantages with raising the money he needs by selling stock to investors. Advantages include being able to raise money without borrowing, which will help the financial health of his company.
In fact, since his bankers aren't willing to provide all the funding he needs, selling stock may be the only option. If he raises enough capital from selling stock, he may even be able to convince a bank to loan him money, since his company will have an infusion of cash.
Stanley has to weigh these advantages against some important disadvantages. As his lawyer explained, even a private placement is a complicated and expensive process. He'll have to hire his lawyer and his CPA to help prepare all the documents to make sure that he complies with federal and state law, and there's no guarantee that he can convince accredited investors to invest.
Of course, if he actually is able to sell the stock, he'll lose some profit, control or both to shareholders. If he doesn't maintain a majority share of the common stock, he could lose control of his company. If he issues preferred stock, the investors get profits before he does. It's not an easy decision.
Let's review what we've learned. Companies can raise money by selling stock to investors. Stock is an ownership interest in a company. There are different types of stock. Common stock provides for dividends and voting rights. Sometimes a company will issue different classes of common stock with different types of voting rights. Preferred stock provides a guaranteed amount of dividends, and holders are paid before holders of common stock. However, preferred stock has no voting rights or very limited voting rights.
Companies can sell stock through two general avenues. They can sell to the general public if they make the appropriate filings and registrations with the SEC. This is an extremely expensive and complicated process, and most companies don't have the resources to do it. On the other hand, some companies may try to sell their stock through a private placement to accredited investors. Filings will still be made to the SEC, and state securities agencies and disclosures will still be made to potential investors.
Raising capital through a stock offering has advantages and disadvantages. The biggest advantage is that it's a means to raise capital without the use of debt. In fact, it may be the only way to raise a large amount of capital if banks are unwilling to lend. On the other hand, disadvantages include having to answer to shareholders and the possibility of losing control over the company.
After viewing this lesson, you should be able to:
Define stock and differentiate between common stock and preferred stock
Explain what private placements are, and recall their advantages over initial public offerings
Describe the advantages and disadvantages of selling stock to raise capital for a business
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