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Understanding Stockholders’ Equity: Frequently Asked Questions
Stockholders’ equity represents all historical investment capital. It’s reported net of related fees after accounting for any distributions and dividend payouts to shareholders. Equity is often associated with the company’s overall net worth and represents the net balance of assets less liabilities. Here we will address common questions surrounding stockholders’ equity such as components of equity; stock option benefits; common stock vs. preferred stock; employee stock option vs. warrant and more.
1. What are the common components of stockholders’ equity?
Stockholders’ quity consists of:
- Capital contributed by investors. Often categorized as common stock, preferred stock and additional paid-in capital (APIC).
- Stock-based compensation (SBC)
- Retained earnings (if positive) or accumulated deficit (if negative): historical earnings from the company’s inception through the present net of any dividends/distributions to shareholders.
- Treasury stock: stock repurchases
- Direct costs incurred to raise capital (e.g., legal fees)
2. Common stock vs. preferred stock?
Preferred stock shareholders have:
- A higher priority to dividends and distributions as a result of earnings and a return of assets in the event of liquidation.
- Unlike common stock, preferred stock does not have voting rights.
3. What are par value and additional paid-in capital?
- Par value is the value of one share as determined by the company’s founding charter that will never change except in the case of a stock split.
- In the equity section, common stock and preferred stock are stated as the total shares issued to investors at par value.The amount investors pay for shares above par value is categorized as additional paid-in capital in excess of par (APIC).
- Direct costs to raise capital, such as legal fees, are recorded as direct reductions to APIC.
4. What are stock options?
- A stock option is the right to purchase (i.e., exercise) a set number of common shares at a specific price.Typically, this price is set at the fair market value (FMV) when granted as determined by an observable market or a third-party valuation known as a 409A report.
- The ability to exercise stock options typically vests overtime over the employee’s service period. The most common type of vesting is time-based vesting, which is based on a schedule. Other types of vesting are performance-based vesting, which is based on hitting specific quantitative benchmarks either individually or as a company.
- If stock options are forfeited prior to vesting, the options are returned to the company’s option pool.
- Some companies may allow for early exercises, which is when options are exercised prior to fully vesting.The unvested portion of early exercised options are treated as a liability and are adjusted to equity as they vest over time.
- When stock options are granted, the company must recognize stock-based compensation (SBC) expense which represents the fair market value of all the awards on the grant date. This expense is then recognized over the vesting period.
- SBC expense can be calculated by different complex option pricing models and consider different variables and assumptions. One of the simpler, more common models is the Black-Scholes model.
- SBC expense is recognized as an expense and increase to APIC.
5. What are the advantages of issuing stock options?
- Stock options can be advantageous, particularly for a start-up company that seeks to maximize cash. By offering stock options, companies can provide an alternative form of compensation to free up more cash in the short term.
- By issuing stock options, a company allows employees to receive a percentage of ownership in the company.
- Stock options can motivate employees to perform at a higher level, and because they vest over time, they can incentivize employees to stay with the company.
6. What is a 409A report?
- A 409A report is an independent appraisal of the fair market value (FMV) to purchase shares.
- The 409A report is a tax-related report.Its name references the Internal Revenue Code Section 409A and the IRS regulates reports.
- 409A reports should be issued before issuing common stock options and at least once per year. They should also be issued when a “material event” occurs.
- A “material event” is an event that can affect the price of common stock, like a new round of financing. Management and the legal team normally evaluate whether an event qualifies as a material event.
7. What are warrants?
- Warrants are the right to buy (call warrants) or sell (put warrants) a set number of shares at a specific price prior to an agreed-upon expiration date.
- Warrants are often issued as a form of consideration with debt and/or equity financings.
- Warrants represent future capital for the company when the investor exercises.
8. Employee stock option vs. warrant?
- Both stock options and warrants can be attractive for start-ups or other companies trying to maximize cash in the short-term.
- Unlike options, warrants don’t represent immediate ownership of the stocks but rather the right to purchase shares at a specified price in the future.
- Another key difference between a warrant and an option is that when warrants are exercised, the investor receives newly issued stock instead of already outstanding stock.As a result, warrants are dilutive while options are not.
- Warrants typically have much longer periods between issuance and expiration than options.As a result, warrants may be a better long-term investment while options are a better short-term investment.
- Options are generally used as a form of compensation to the company’s employees, while warrants are issued to outsiders and investors.
There are many questions that arise when running your business, especially around managing finances and accounting matters. For more information, read our Business Accounting FAQs.