Financing Going Concerns

Stock

If you decide to sell stock to finance your expansion, the proceeds from the sale will increase your stockholders' equity - the amount invested in the business by its owners (which is the same thing that we called owner's equity). In general, an increase in stockholders' equity is good. Your assets - specifically, your cash - will increase because you'll have more money with which to expand and operate your business (which is also good). But if you sell additional shares of stock, you'll have more stockholders - a situation that, as we'll see later, isn't always good.

The Risk/Reward Trade-Off

To issue additional shares of stock, you'll need to find buyers interested in purchasing them. You need to ask yourself this question: Why would anyone want to buy stock in your company? Stockholders, as we know, are part owners of the company and, as such, share in the risks and rewards associated with ownership. If your company does well, they may benefit through dividends - distributed earnings - or through appreciation in the value of their stock, or both. If your company does poorly, the value of their stock will probably decline. Because the risk/reward trade-off varies according to the type of stock - common or preferred - we need to know a little more about the difference between the two.

Common Stock

Holders of common stock bear the ultimate rewards and risks of ownership. Depending on the extent of their ownership, they could exercise some control over the corporation. They're generally entitled to vote on members of the board of directors and other important matters. If the company does well, they benefit more than holders of preferred stock; if it does poorly, they take a harder hit. If it goes out of business, they're the last to get any money from the sale of what's left and can in fact lose their investments entirely.

So who would buy common stock? It's a good option for individuals and institutions that are willing to take an investment roller-coaster ride: for a chance to share in the growth and profits of a company (the ups), they have to be willing to risk losing all or part of their investments (the downs).

Preferred Stock

Preferred stock is safer, but it doesn't have the upside potential. Unlike holders of common stock, whose return on investment depends on the company's performance, preferred shareholders receive a fixed dividend every year. As usual, there are disadvantages and advantages. They don't usually have voting rights, and unless the company does extremely well, their dividends are limited to the fixed amount. On the other hand, they're preferred as to dividends: the company can pay no dividends to common shareholders until it's paid all preferred dividends. If the company goes under, preferred stockholders also get their money back before common shareholders get any of theirs. In many ways, they're more like creditors than investors in equity: though they can usually count on a fixed, relatively safe income, they have little opportunity to share in a company's success.

Cumulative and Convertible Preferred Stock

There are a couple of ways to make preferred stock more attractive. With cumulative preferred stock, if a company fails to make a dividend payment to preferred shareholders in a given year, it can pay no common dividends until preferred shareholders have been paid in full for both current and missed dividends. Anyone holding convertible preferred stock may exchange it for common stock. Thus, preferred shareholders can convert to common stock when and if the company's performance is strong - when its common stock is likely to go up in value.