Common and Preferred Stock Financing
|LO 17-1||Common stockholders are the owners of the corporation and therefore have a claim to undistributed income, the right to elect the board of directors, and other privileges.|
|LO 17-2||Cumulative voting provides minority stockholders with the potential for some representation on the board of directors.|
|LO 17-3||A rights offering gives current stockholders a first option to purchase new shares.|
|LO 17-4||Poison pills and other similar provisions may make it difficult for outsiders to take over a corporation against management’s wishes.|
|LO 17-5||Preferred stock is an intermediate type of security that falls somewhere between debt and common stock.|
The ultimate ownership of the firm resides in common stock, whether it is in the form of all outstanding shares of a closely held corporation or one share of IBM. In terms of legal distinctions, it is the common stockholder alone who directly controls the business. While control of the company is legally in the shareholders’ hands, it is practically wielded by management on an everyday basis. It is also important to realize that a large creditor may exert tremendous pressure on a firm to meet certain standards of financial performance, even though the creditor has no voting power.
Small, growing companies often operate at a loss until they reach critical mass. Start-up biotech firms frequently fall in this category along with small technology companies competing with the big guys like Intel and Qualcomm. TowerJazz is one such tech company. TowerJazz is headquartered in Israel with its subsidiary Jazz Semiconductor Inc. located in the United States and its wholly owned subsidiary, TowerJazz Japan, Ltd., in Japan. TowerJazz operates three fabrication facilities in Japan through a joint venture with Panasonic. These companies operate collectively under the brand name TowerJazz and trade on the NASDAQ stock exchange under the ticker symbol TSEM. The company fabricates integrated circuits for more than 200 customers worldwide in industries such as automotive, defense, medical, and aerospace. Their foundries fabricate semiconductors like radio frequency chips used in cell phones.
According to S&P Capital IQ, TSEM lost money from 2009 (−$10.65 per share) to 2013 (−$2.72 per share) and finally turned an aftertax profit of $0.07 per share in 2014. In fact 2014 was a breakout year for TowerJazz with record revenues of $828 million, a 64 percent increase over 2013. The ending cash balance on December 31, 2014, was $187 million.
TowerJazz would not have gotten to this point in its corporate life without the ability to sell common stock in public markets like NASDAQ. It is very expensive to operate and build foundries, and it takes a critical mass and high utilization rate within the foundries to make money. To get to this point TSEM had to continually sell new stock to finance its operations that were losing money. The company sold 35 million shares in 2008, 39 million shares in 2009, and 66.5 million shares in 2010.
By 2012 the stock was trading for less than $1. NASDAQ has a rule that a stock cannot stay listed if it continuously trades under $1. If a company can’t get its stock price above $1 within 180 days and keep it there for 30 days, the stock will be delisted; in other words, it can no longer be traded on NASDAQ.
By August 2012, shares of TSEM had ballooned from 125 million in 2008 to over 330 million, and the stock price was trading at $0.52. On August 2 TowerJazz had a 1 for 15 reverse split, reducing the number of shares to about 22 million. The share price closed at $9.01 on August 6, the day the reverse split became effective. By March 2015 the stock was trading at more than $16 per share and had hit a high of $18.20 on March 3. We should point out that during 2013, TSEM share count increased by another 25.4 million shares as the company converted some capital notes into stock and warrants and stock options were exercised.
Without investors willing to take a risk on companies like TowerJazz, these small companies would not have a chance to mature and become profitable. The ability to sell common stock to balance debt in the capital structure makes the stock markets important to corporations.
In this chapter, we will also look closely at preferred stock. Preferred stock plays a secondary role in financing the corporate enterprise. It represents a hybrid security, combining some of the features of debt and common stock. Though preferred stockholders do not have an ownership interest in the firm, they do have a priority of claims to dividends that is superior to that of common stockholders.
To understand the rights and characteristics of the different means of financing, we shall examine the powers accorded to shareholders under each arrangement. In the case of common stock, everything revolves around three key rights: the residual claim to income, the voting right, and the right to purchase new shares. We shall examine each of these in detail and then consider the rights of preferred stockholders.
Common Stockholders’ Claim to Income
All income that is not paid out to creditors or preferred stockholders automatically belongs to common stockholders. Thus we say they have a residual claim to income. This is true regardless of whether these residual funds are actually paid out in dividends or retained in the corporation. A firm that earns $10 million before capital costs and pays $1 million in interest to bondholders and an equal amount in dividends to preferred stockholders will have $8 million available for common stockholders.1 Perhaps half of that will be paid out as common stock dividends. The balance will be reinvested in the business for the benefit of stockholders, with the hope of providing even greater income, dividends, and price appreciation in the future.
Of course, it should be pointed out that the common stockholder does not have a legal or enforceable claim to dividends. Whereas a bondholder may force the corporation into bankruptcy for failure to make interest payments, the common stockholder must accept circumstances as they are or attempt to change management if a new dividend policy is desired.
Occasionally a company will have several classes of common stock outstanding that carry different rights to dividends and income. For example, Google, Facebook, and Ford Motor Company have two separate classes of common stock that differentiate the shares of the founders from other stockholders and grant preferential rights to founders’ shares.
Although there are over 90 million common stockholders in the United States, increasingly ownership is being held by large institutional interests, such as pension funds, mutual funds, or bank trust departments, rather than individual investors. As would be expected, management has become more sensitive to these large stockholders who may side with corporate raiders in voting their shares for or against merger offers or takeover attempts (these topics are covered in Chapter 20).
Table 17-1 presents a list of major companies with high percentages of common stock owned by institutional investors at the beginning of 2015. ExxonMobil is at the bottom of the list with a 58.99 percent institutional ownership while Motorola Solutions is now 94.33 percent owned by institutions. Large companies are institutional favorites, perhaps because the sheer size of the shares outstanding allows for large trades and a high level of liquidity.
Table 17-1 Institutional ownership of U.S. companies
|Company Name||Institutional Ownership (%)||Institutional Ownership in Shares|
|Motorola Solutions Inc.||94.33||227,076,675|
|Lockheed Martin Corp.||94.25||297,440,687|
|Walmart Stores Inc.||83.05||2,676,952,631|
|Bristol-Myers Squibb Co.||82.71||1,371,918,018|
|EI du Pont de Nemours & Co.||79.01||715,319,624|
|Johnson & Johnson||75.77||2,120,764,813|
|Walt Disney Co.||73.58||1,250,497,713|
|Procter & Gamble Co.||68.79||1,857,696,445|
|International Business Machines Corp.||66.00||653,174,614|
|General Electric Co.||62.46||6,272,679,212|
The Voting Right
Because common stockholders are the owners of a firm, they are accorded the right to vote in the election of the board of directors and on all other major issues. Common stockholders may cast their ballots as they see fit on a given issue, or assign a proxy, or “power to cast their ballot,” to management or some outside contesting group. As mentioned in the previous section, some corporations have different classes of common stock with unequal voting rights.
There is also the issue of “founders’ stock.” Perhaps the Ford Motor Company is the biggest and best example of such stock. Class B shares were used to differentiate between the original founders’ shares and those shares sold to the public. The founders wanted to preserve partial control of the company while at the same time raise new capital for expansion. The regular common stock (no specific class) has one vote per share and is entitled to elect 60 percent of the board of directors, and the Class B shares have one vote per share but are entitled, as a class of shareholders, to elect 40 percent of the board of directors. Class B stock is reserved solely for Ford family members or their descendants, trusts, or appointed interests. The Ford family has a very important position in Henry Ford’s company without owning more than about 3½ percent of the current outstanding stock. Both common and Class B stockowners share in dividends equally, and no stock dividends may be given unless to both common and Class B stockholders in proportion to their ownership.
While common stockholders and the different classes of common stock that they own may, at times, have different voting rights, they do have a vote. Bondholders and preferred stockholders may vote only when a violation of their corporate agreement exists and a subsequent acceleration of their rights takes place. For example, Continental Illinois Corporation was on the edge of bankruptcy in 1984, and failed to pay dividends on one series of preferred stock for five quarters from July 1, 1984, to September 30, 1985. The preferred stockholder agreement stated that failure to pay dividends for six consecutive quarters would result in the preferred stockholders being able to elect two directors to the board to represent their interests. Continental Illinois declared a preferred dividend in November 1985 and paid all current and past dividends on the preferred stock, thus avoiding the special voting privileges for preferred stockholders. In 1994, Continental was bought by Bank of America.