A company is an independent legal entity that is generally formed for a commercial purpose with earning profits as a key objective. The ownership of a company is represented through its shareholding. Each individual share or stock represents a partial ownership of the company. Shareholding or stockholding of a company can be of different types like common stock, preferred stock and treasury stock.
This article looks at meaning of and differences between two types of company stock – common stock and treasury stock.
Definitions and meanings
Companies are authorized by their charter documents to raise both equity and preference share capital upto a specific level. This capital is divided into individual units known as shares or stocks. Each unit of common stock represents part ownership of the company. Out of this authorized share capital, companies may choose to issue all or part of the share capital depending on their need for funds.
The equity portion of a company’s shareholding is termed as common stock of the company.
ABC Inc is a listed company. It is authorized by its memorandum to raise capital of the face value of $5,00,000. This includes equity share capital of $4,00,000 and preference share capital of $1,00,000. 15% of its equity shareholding ($60,000) is held by the promoter group, the balance ($3,40,000) being fully subscribed to by the public.
Thus, the entire authorized equity share capital of $4,00,000 is issued, subscribed and fully paid up. This represents common stock of the company.
Holders of common stock have several rights including the following three key rights:
- To vote on several key matters such as electing directors, restructuring changes etc.
- Right to receive share of profit in the form of dividend if the company so decides to declare.
- Right to receive share of assets in proportion to their holding on liquidation of the company.
These rights are typically exercised by common stockholders in the general meetings convened by the company.
Treasury stock is the portion of the company’s shares that have been bought back from the shareholders but have not been retired or extinguished. Essentially, treasury stock represents those shares that are held by the company itself. They can be either equity shares or preference shares or a combination of both. These shares are no longer belong to shareholders and thus are not part of its outstanding share capital.
Shares held as treasury stock, unlike outstanding shares, do not have any rights. This means that treasury stock is not considered either for payment of dividends or for voting on any resolutions.
Continuing the above example, ABC Inc. is of the opinion that its capital is over-diluted, it thus decides to buyback shares of face value of $1,00,000 from the market to reduce its ownership dilution. The total issued equity share capital of ABC Inc would now stand at $3,00,000 – $60,000 being held by promoters and balance $2,40,000 being held by the public. Thus, the promoter shareholding percentage has increased from 15% to 20% after the buy back.
These shares which the company has reclaimed from the shareholders is termed as treasury stock.
Companies create treasury stock by buying back issued shares for various reasons, these include:
- To capitalize on under-valuation of its share price in the market.
- To reduce dilution and re-claim ownership.
- Improving financial performance ratios by reducing the number of outstanding shares.
Companies may choose to retain the treasury stock or offer them for investor subscription at a later stage when further funds are required. Also, these shares can be retired and eliminated from the books if the company does not see any use of them in future.
Difference between common stock and treasury stock
The seven key points of difference between common stock and treasury stock are detailed below:
- Common stock is the equity shareholding of the company that represents corporate ownership. The holders of such shares are regarded as common stockholders and are privileged as the real company owners.
- Treasury stock are the shares of the company that are held by the company itself i.e., these are the shares that have been bought back from investors by the company.
- Common stock, as the name suggests, refers only to equity shareholding. Preference shares would constitute preferred stock.
- Treasury stock can be equity share and/or preference shares so long as they have been bought back by the issuing company.
- Common stock can be held by promoters, managerial personnel, employees, investing institutions or even the general investing public.
- Treasury stock on the other hand can only be held by the issuing company.
4. Voting rights
- Common stock has several rights attached to it. These include right to share profits of the company, rights to receive share of assets on liquidation, right to vote in general meetings etc.
- Treasury stock does not have any such rights attached to it.
5. Disclosure in balance sheet
- Common stock is disclosed on the liabilities side of the balance sheet under share capital. It is comprised of authorized share capital and issued and paid-up share capital.
- Treasury capital is disclosed as a reduction from the total share capital of the company.
6. Part of financial ratios
- Value of common stock forms part of several financial ratios such as EPS, return on equity, return on assets etc.
- Value of treasury stock is essentially negative capital and thus does not form part of any financial ratios that consider the value of share capital.
- The purpose of issuing common stock is primarily for raising funds. These funds may be required at the startup phase, during any subsequent expansion phase of the company or for any other objective that requires funds.
- The purpose of treasury stock i.e., the purpose for buying back issued stock of the company is generally for reducing ownership dilution of the company. Companies may also look to take advantage of undervalued shares on the market by buying them back and strengthening promoter holding.
Conclusion – common stock vs treasury stock
Share capital is a large component of a company’s balance sheet. Appropriate structuring of the share capital is thus important for several reasons. It determines the quantum of funds that the company can raise as well as its ownership structure which has a significant bearing on the manner in which a company is run. Companies must thus assess their financial position and determine the suitable quantum of common stock that they must possess. Decisions on holding treasury stock must also be taken from time to time when the need or opportunity to exercise buy back of shares arises.