Capital-Formation Strategies and Trends 15 Equity Securities Equity securities include common stock, preferred stock, and warrants and op- tions. Each type provides a different set of rights, preferences, and potential rates of return in exchange for the capital contributed to the company. The typi- cal growing company (whose value to an investor usually depends on intangi- ble assets, such as patents, trade secrets, goodwill, and projected earnings) will issue equity securities before incurring additional debt. This is because it lacks the assets necessary to secure the debt, and because additional debt is likely to increase the company's failure risk to unacceptable levels. Common Stock. An offering of common stock and the related dilution of interest in the company is often traumatic for owners of growing companies that operate as closely held corporations. The need for additional capital to al- low for growth, combined with the lack of readily available personal savings or corporate retained earnings, leads to a realignment of the capital structure and a redistribution of ownership and control. Although an offering of common stock is generally costly and entails a surrender of some ownership and control, it does provide you with an increased equity base and a more secure foundation on which to grow, and it increases your chances of getting loans in the future. Preferred Stock. Broadly speaking, preferred stock is an equity security that shares some characteristics with debt securities. Holders of preferred stock are entitled to receive dividends at a fixed or adjustable rate of return (like holders of a debt instrument) before dividends are distributed to holders of the common stock. Owners of preferred shares also participate in the distribution of assets in the event of liquidation ahead of the holders of common stock. The preferred stock may carry certain rights regarding voting and convertibility to common stock. The shares may also have antidilution or preemptive rights, or redemption privileges that may be exercised by either the company or the shareholder. Although your fixed dividend payments are not tax-deductible (as interest payments would be) and company ownership is still diluted, preferred stock offers a balance between risk and reward because you need not return the principal invested (unless there are provisions for redemption). In addition, preferred stock's return on investment is limited to a fixed rate of return (unless there are provisions for convertibility into common stock), and their holders' claims are subordinated to the claims of creditors and bondholders in the event of the liquidation of the company. The use of convertible preferred stock is especially popular with venture capitalists. American Management Association www.amanet.org