As the owner of a private corporation, it’s important to understand your options when issuing stock. After all, not all stock is the same; the type you issue depends on your business structure and equity goals.
Classes of stock: Common stock versus preferred stock
There are two main classes of stock: common stock and preferred stock. Common stock generally goes to company founders and early employees, while preferred stock is usually reserved for investors. The two stocks differ in terms of their price, how they’re paid out, and what voting rights (if any) they come with.
Stockholders | Price | Payout method | Voting ability | |
Common stock | Company founders and early employees | Fair market value (FMV), aka how much a share of your private company’s stock would be worth on the open market) | Common stockholders get paid out after preferred stockholders; no fixed dividends | Common stockholders can vote on major company decisions (e.g., policies and executive hires) |
Preferred stock | Investors | Based on your company’s valuation (usually a higher rate than FMV) | Preferred stockholders get paid out first; they also collect fixed dividends on a monthly or quarterly basis | Usually don’t have rights to vote on company decisions |
Creating different share classes
A share class is a category of stock under the umbrella of common stock or preferred stock. You don’t have to create multiple share classes in your corporation, but it’s a helpful way to either extend or restrict your shareholders’ voting privileges.
Among common stockholders, for example, you could create three different share classes and give each one different voting rights. For Class A shares, you could give shareholders 50 votes per share, Class B shares 25 votes per share, and Class C shares 10 votes per share. You could also create a share class of non-voting common stockholders. Dividing your common stock into different classes allows you to control who has more influence over the direction of your company.
You can also create different classes of stock among your preferred shareholders. There are several options, depending on what types of benefits or rights you want to extend. You could:
Create a share class that gives stockholders a higher fixed dividend if you generate significant profits
Create a share class that lets stockholders take advantage of cumulative dividend payments in the event that you skip a regular dividend payment
Create a share class that gives stockholders preferred stock that can convert to a set amount of common stock shares if a specific amount of time has passed
Issuing stock as a C corp versus an S corp
C corporations and S corporations have different rules for issuing stock. As a C corp, you can issue both common and preferred stock. From there, you can create different share classes with different voting rights. You can also offer dividend payments to shareholders.
S corps, however, can only issue one type of stock. They also pay distributions (not dividends) to shareholders. Dividends and distributions are both a share of company profits, but C corp dividends are subject to double taxation (corporate taxes and individual taxes), while S corp distributions are taxed once.
If you own an S corp you have to abide by the following IRS rules:
You can only issue one class of stock.
You can’t give stock to more than 100 shareholders, which prevents S corps from being publicly traded.
Shareholders can be individuals (who are citizens or legal residents), estates, and certain trusts.
Corporations, partnerships, and non-resident shareholders are not allowed.
As an S corp, you can still create different share classes within your one class of stock. Depending on your growth and financial goals, you may want to give certain shareholders no voting rights, some shareholders all voting rights, and some the right to vote only on certain issues.
How to issue stock as a corporation
If you’re ready to issue stock, take the following steps to prepare:
1. Revisit your company’s articles of incorporation
Your company’s articles of incorporation—the formal documents you filed when creating your organization—should stipulate the maximum number of shares your company can issue, as well as whether or not you’re allowed to have multiple classes of shares.
2. Determine your goals for issuing stock
Think about why you want to issue stock. Would you like to reward your early employees for their loyalty and hard work? Do you need to bring on investors to raise money? If so, how much money do you need to raise to reach your immediate growth goals? What voting privileges do you want to offer stockholders?
The answers to these questions will help guide your decisions.
3. Figure out how many shares to issue
Next, consult your lawyer to help you figure out how many shares to issue. The exact amount depends on a number of factors, including:
Your articles of incorporation: There’s a maximum number of shares you can issue, but you may not want to hit the maximum right away. If you plan to fundraise in the future, it can be helpful to set aside a certain portion of shares for investors.
Your voting preferences: Consider how much influence you’re willing to give your shareholders. Keep in mind that the more shareholders there are, the less voting power each individual shareholder has.
Your company valuation: It’s important to get a company valuation to determine the price of your stock. Understanding the potential value of each share gives you a better idea of how many shares to issue and to whom.
FAQs
Can small businesses or startups have multiple classes of stock?
Yes, small businesses and startups can have multiple classes of stock—as long as they’re classified as C corporations. S corporations can only have one class of stock.
How do classes of stock affect company valuation and fundraising?
Classes of stock indirectly affect a company’s valuation and fundraising success. Offering preferred stock is a good way to attract individual investors, and lots of interested investors can ultimately bring in more funds. Preferred stock usually gets sold at a higher price than common stock, since it’s based on a company’s valuation.
What legal documents are required to create multiple classes of stock?
If you want to create multiple classes of stock in your corporation, you need to update your articles of incorporation and bylaws, get a formal written approval from your board (and potentially your existing shareholders), create a new shareholder agreement, and file the appropriate forms with your state. You also need to send an official written notice to your shareholders explaining the new stock system.
Can companies change or eliminate stock classes after issuing them?
Yes, companies can change or eliminate stock classes after issuing them, but they have to get approval from their board and from the existing shareholders.
How are classes of stock treated during mergers, acquisitions, or IPOs?
Different types of shares are treated differently during different liquidation events. During mergers and acquisitions, common stockholders usually receive cash payouts for their shares of stock, and preferred stockholders have the option to liquidate their shares or not. During IPOs, when private companies become public companies, preferred shares generally convert to common shares on a one-to-one basis. And all common stockholders will have the right to liquidate their shares on the public market in a stock exchange.
