After Hours is an editorial column more loosely covering our thoughts on a variety of topics in finance.
What is a stock?
A stock is a security (a tradable financial asset) representing a share of ownership in a business. A stock is sometimes also called a “share” or “equity”.
A person who buys shares of stock in a business is a “stockholder” of the business. Through his equity stake, the stockholder gains a say in a business’ operations and claims on its residual cashflows (essentially whatever money is left after expenses and debts have been paid).
Businesses need money to operate. Businesses need money to grow. Although, in theory, businesses can choose to get this money from their own operations, they can also choose to raise money through debt financing (by taking out loans or issuing bonds) or equity financing (by offering shares of stock).
What is debt financing?
Debt financing is when a business borrows money from banks (through a loan) or investors (through a bond issuance). The business promises to pay back the money he has borrowed plus interest. Sometimes, the business is also asked to put up some of its own assets as collateral in case it defaults. If a business is having trouble paying down a loan, lenders could potentially run after its assets to cover what they lent out. However, when a business takes out a loan, it sacrifices nothing in terms of ownership and it is only expected to pay back the principal on the loan plus interest.
What is equity financing?
Equity financing is when a business sells shares of its own stock to investors. A business is then able to raise money from the new capital put up by new investors. A business is not liable to pay back equity investors in the event of a collapse. However, what equity investors sacrifice in terms of safety of capital can be richly rewarded when a business does well. This is because equity investors gain a claim on a business’ residual cashflows in exchange for the capital they put up.
In raising money from equity investors, businesses can offer common stocks or preferred stocks.
What is a common stock?
A common stock is a stock in its most traditional sense. An investor who buys common stock gains ownership in a company and the possibility of dividends (when a business distributes a part of its profits to equity investors). In effect, common stocks allow for full participation in a business’ success but also full participation in the event it fails.
What is a preferred stock?
A preferred stock is a sort of cross between a common stock and a bond. An investor who buys preferred stock is paid a more secured and predictable dividend than one who buys common stock (assuming of course that the company has enough cash to do so). This is because a preferred stock investor is paid his cashflows before the common stock investor. (Although the company must, of course, pay lenders before preferred stock investors.) However, preferred stock investors do not gain any real control of a business and they usually don’t earn anything beyond the dividends promised to them. A business is also not necessarily required to redeem (buy back) its preferred stocks to cover the capital put up by preferred stock investors.