Share capital refers to the funds that a company raises in exchange for issuing an ownership interest in the company in the form of shares. There are two general types of share capital, which are common stock and preferred stock. The characteristics of common stock are defined by the state within which a company incorporates. These characteristics are relatively standardized, and include the right to vote on certain corporate decisions, such as the election of a board of directors and the adoption of poison pill provisions to fend off potential acquirers. In the event of a corporate liquidation, the common stockholders are paid their share of any remaining assets after all creditor claims have been fulfilled. If a company declares bankruptcy, this usually means that the holdings of all investors are either severely reduced or completely eliminated.
Preferred stock is shares in the equity of a company, and which entitle the holder to a fixed dividend amount by the issuing company. This dividend must be paid before the company can issue any dividends to its common shareholders. Also, if the company is dissolved, the owners of preference shares are paid back before the holders of common stock. However, the holders of preference shares do not usually have any voting control over the affairs of the company, as do the holders of common stock.
The types of preferred stock are:
- Callable. The issuing company has the right to buy back these shares at a certain price on a certain date. Since the call option tends to cap the maximum price to which a preferred share can appreciate (before the company buys it back), it tends to restrict stock price appreciation. Conversely, it gives a company's management additional flexibility to alter the capital structure of the business.
- Convertible. The owner of these preferred shares has the option, but not the obligation, to convert the shares to a company's common stock at some conversion ratio. This is a valuable feature when the market price of the common stock increases substantially, since the owners of preferred shares can realize substantial gains by converting their shares.
- Cumulative. If a company does not have the financial resources to pay a dividend to the owners of its preferred shares, then it still has the payment liability, and cannot pay dividends to its common shareholders for as long as that liability remains unpaid.
- Non-cumulative. If a company does not pay a scheduled dividend, it does not have the obligation to pay the dividend at a later date. This clause is rarely used, given the obvious negative impact on investors.
- Participating. The issuing company must pay an increased dividend to the owners of preferred shares if there is a participation clause in the share agreement. This clause states that a certain portion of earnings (or of the dividends issued to the owners of common stock) will be distributed to the owners of preferred shares in the form of dividends.
Share capital is also known as equity capital.