If you’re new to the investing or finance world, you may be wondering why companies issue common stock? As with most things in finance, there are numerous reasons why.
If you want to know what is the purpose of a company issuing stock, or how to issue stock, this article is perfect for you!
What Does Common Stock Mean?
Before diving into some of the reasons, let’s review exactly what does common stock mean? Common stock is often referred to as capital stock.
This is a representation of ownership in the company. If the company has 1,000 shares outstanding, and you own 100 of those shares, you own 10% of the company.
A company can have numerous classes of stock, but common stock is the most common and default class. Publicly traded companies may also have preferred stock, which gives those shareholders rights above and beyond what a shareholder of common stock would receive.
What Is the Purpose of Issuing Stock?
Understanding what is the purpose of stock issuing comes down to numerous variables. There is not a single reason why a company may issue stocks, but here are some of the most common:
A company may issue stock so they can raise capital, without debt financing. This capital/money can be used to fund operations, expand into new markets, create a new product, or make investments for the future needs of the business.
For instance, if a privately held car company needed to build a new manufacturing plant, that plant would cost them millions upon millions of dollars. Unless the company had this cash in the bank, they’d be faced with two choices.
They could either borrow money from a lender, or issue stock and use the money they received from issuing stock to fund their expansion. Without cash, a company can’t grow. Issuing stock is a great way of getting that cash quickly, without adding liabilities to the balance sheet.
Stocks are an incredible wealth building machine. Not only does the company receive money for the stocks they issued, the shareholder or investor can also receive money when they go to resell their shares on the open market.
Stocks can grow in perpetuity. That stock could be currently valued at $50/share, and in a year from now, the stock may increase to $75/share. This capital appreciation far exceeds the interest rate any bank is paying.
A privately held company may issue stock to it’s management team and employees. The company may choose to go public so they can sell their shares of stock on the open market.
Take Facebook as an example. When Facebook went public, plenty of internal employees of Facebook earned a significant amount of money from selling their shares.
Companies will always need capital as a way to expand their business. The private banking market, such as private equity or bank financing, is not always the most advantageous way to secure cash.
When you issue stock on the public market, you can attract investors from anywhere! You will not be tied to one specific private equity firm, or bank.
The larger investor pool you have can come with numerous advantages.
Advantages of Issuing Common Stock
The above covered what is the purpose of stock issuing, but what are the benefits of a company issuing stock?
First and foremost, issuing stock helps a company avoid debt. Debt must be repaid, which can put financial pressure on the company.
Through good times, it may be easy to pay the debt. Through bad financial times though, a company may struggle to pay debt.
Not only does the principal debt balance need to be paid, any lender is charging an interest rate to borrow their money. Interest rates in the private market vary quite a bit. Your company, the health of its financials, and the overall debt position will dictate what the terms and condition of the loan is.
When a company issues common stock, they are not taking on debt. They get to keep the money and use it however they want.
Of course, the shareholders will have opinions on how that money is being used, and if they believe the money is being used incorrectly, they’ll sell their shares. But, there is no debt obligation when issuing shares, and that provides a company with a great deal of breathing room.
Issuing stock also allows a company to have more liquidity, or cash in the bank that they can use. Liquidity is a foundational piece to running a successful business.
This cash will allow a company to make it through tough financial times. It will also allow a company to invest in its future, expand its operations as needed, and potentially acquire another company or competitor if possible.
All in all, liquidity gives the company options, and if the right options are acted on, the company can grow at a rapid rate.
Having new investors could also be in the company’s best interest. Investors will all have an opinion.
As the company reports quarterly earnings, investors will react by either buying more shares, or selling existing shares. This gives the company great insight, and can help the company understand how they need to adjust their business.
Instead of working with one or two large lenders, working with the public market opens your company up to more feedback, and that feedback can make the company more successful.
Disadvantages of Issuing Common Stock
Without question, issuing common stock comes with numerous disadvantages. These disadvantages include:
Giving Away Ownership
Common stock represents ownership in a company. When a company issues someone common stock, they are giving away ownership in the company to someone else.
This strikes a cord with some business owners. Perhaps the business is a family business, and if you issue shares, you are opening the business up to people besides family.
Ownership equals control, and that’s another pain point a business owner may need to navigate. If they like to be in charge at all times, having other owners may be difficult to deal with.
As mentioned above, ownership equals control. When more and more shareholders own the company, they’ll begin to have a voice in how the company is run.
The business may find itself managing the business to please the shareholders, and that is not always aligned with pleasing the customers. The more shares a company issues to the market, or to a specific investor, the less control or power the company will have to make its own decisions.
If a privately held company decides to go public and issue stock on the public market, their financials will be open to their competitors. Going public means your company earnings, and financials, need to be reported quarterly.
The company will also be required to give an earnings report/statement to shareholders. That report can give insight into what the company is dealing with currently, or what investments they plan on making.
Nonetheless, a competitor may find this information very useful, and can beat you to it if they act quickly.
How to Issue Stock
Issuing stock is not easy. There is an entire legal process a company must go through, in addition to meeting various SEC requirements if the company is issuing stock on the public market.
Going public can take some time, and there is often a cost associated with completing the various steps needed. Working with lawyers, accountants, and auditing firms will be part of the multi-month/year process.
In What Positions Would a Company Issue Common Stock?
As companies evolve, their position on needing to issue common stock changes. Some of the most common real world positions are as follows.
Research and Development
A company needs to constantly research and develop to stay relevant. Just think about how many times Apple created a new iPhone!
Research and development costs a lot of money, and if a company issues common stock, they can add liquidity back into the company to fund the r&d requirements.
Research and development is a very common reason why companies issue common stock.
Expand and Grow
Research and development is critical for growth, but it’s not the only growth factor. A company may need a new facility, upgrade existing infrastructures, or purchase expensive software and security measures.
These initiatives come with a hefty price tag, and having the cash to fund such expenses is key. Without cash, the company would need to take on debt to expand and grow, and that’s not ideal.
This is another very common reason why companies will issue common stock.
Preparing For a Merger or Acquisition
Mergers and acquisitions are also one of the reasons why a company may issue common stock. Issuing common stock can create a windfall of cash for a company, and that cash can be used to purchase another company.
This acquisition may give the company a competitive advantage, or more control over the market in which they serve.
Common Stock vs Preferred Stock
The main difference between common stock and preferred stock is the fact that preferred stockholders receive their dividend payments as a priority. If the company only has enough money to pay dividends to preferred shareholders, they will.
Whereas, a company is legally allowed to skip paying a dividend payment to common shareholders – although, skipping a dividend payment is viewed poorly in the eyes of any shareholder.
The Confusing World of Stocks
The world of stocks is certainly confusing. There are an endless amount of questions you can be asking yourself, such as; why companies issue common stock, or how do companies benefit from issuing stocks?
Unless you work in finance, this world may seem foreign. However, just because it is foreign doesn’t mean you shouldn’t get involved.
The confusing world of stocks can be simplified if you work with a financial advisor. Financial advisors not only exist to answer your questions, they will also help manage your money and help you make better investment decisions.
As discussed, stocks are a tremendous wealth building tool. The key is picking the right stocks, at the right time. Financial advisors can help you do just that.