types of stock

When buying a stock or share, most investors think that each is interchangeable, with no real differences between them. In fact, this is not the case and investors need to understand that stocks come in a variety of types, with different seniorities, voting rights and values. There are several different circumstances that lead to multiple competing stock types, including the structure of many IPOs, and varying stock classes is common with family-owned enterprises. Normally the differences have no impact on returns, but they may give clues about management strategy and overall direction of the business model.

What stock types exist?

Different types or classes of stock typically hide behind nondescript names such as A or B, and many investors simply ignore them – often to no real loss, as shares are primarily traded for their cash value. Some stock types do indeed have different prices, but generally the existence of different classes is a fix to ensure that control of a company stays with its founders, or to preserve seniority in case of restructuring. As a retail investor, it is normally correct to assume you get the least important class – and unless you insist on voting rights, this doesn’t matter much.

Voting rights can be common to all shares, can be reserved for a few senior classes, or can even be divided up unequally so Class A votes count twice as much (or more) than Class B. These shares are often included in IPOs where the existing stock holders fear their rivals or activist funds may be able to seize control of the company by buying up outstanding shares. To prevent this, the shares issued either have no voting rights or reduced vote weight, allowing the existing board to retain complete control of the company.

Normally the market is quite forgiving of this sort of trick, and they have become increasingly common in the wave of tech IPOs in the second part of the 2010s, but it is worth remembering in some cases these could be viewed quite negatively. Activist investors play a role in the markets where they are able to influence board decisions in struggling companies, and if an insulated firm is against this it may well allow them to be more decisive and stick to unpopular plans, but conversely, they may be harder to correct from the wrong course. This is a very salient issue in companies with a powerful single founder-investor.

Seniority

Unless you plan on becoming a retail-activist investor – not likely unless you are extremely wealthy – voting rights probably aren’t your top concern when it comes to share classes. So, what about debt seniority? In the case of bankruptcy, the owner of different client assets has differing claims to pick apart what is left of their assets, and senior stock holders are more likely to receive compensation than more junior holders.

However, compared to debt, equity investors tend to receive little or nothing in bankruptcy proceedings, so this is largely an irrelevancy for investors. Needless to say, you should not be investing in companies where you see any risk whatsoever of bankruptcy and holding more senior stock should the worst happen as it will likely provide only a very small cushion to losses that will surely be close to 100%.

Trading multiple stock types

Sometimes the various risk and seniority statuses of shares can result in different stock classes trading at different prices; this is unusual, and normally involves a fixed mark-up where the stock trades at X above the common shares but price action is identical. In this case, it normally makes sense to buy the cheaper stock, or whichever has the greatest liquidity and lowest spreads. In some cases, the prices can diverge more thoroughly, but the same principle should apply where you buy the most liquid option. 

Potential risks

In some cases, the existence of many different stock classes can be a warning sign to investors. Imagine a scenario where a non-profitable start-up acquires millions of users while remaining under the control of a powerful founder who owns 100% of the stock. He decides to float 50% of the outstanding stock, but fearing a hostile takeover by activist investors, issues stock without voting rights, leaving himself in complete control.

If the founder’s business model is correct, this may be helpful, but activist investors could also force the founder to profitability or correct problems in his leadership. You should only buy the stock of such a company if you have total confidence in the leadership, and you should be aware that a ‘normal’ publicly traded company will have greater oversight by investors. Depending on your views about single-person control, this may be good or bad, but investors can swiftly sour on unprofitable companies that try and side-line investors. Activist investors, rightly or wrongly, see themselves as an important part of overall market functioning, and are suspicious of attempts to freeze them out from the decision-making process.

Conclusion: what it means for retail investors

Hopefully after reading this article you are a little clearer about what Class A, B equities and similar means, as well as other synonyms like common and senior shares. In terms of price action, and percentage ownership of the company, or entitlement to dividends, stock type has little or no impact, and can safely be ignored. What ignoring means in practice is buying whichever stock type has the most volume and lowest spreads.

That said, it is worth thinking about why a company might want to issue divergent stock types, and whether this is a positive or negative sign for their overall direction. Some investors are more comfortable with highly centralised ownership structures, reasoning this allows the board to execute their strategy without distraction or interference, but others feel that activist investors play an important function safeguarding against common errors or unprofitable strategies. If you fall in the latter camp, large portions of outstanding equity without voting rights might be a cause for concern. However, in terms of capital appreciation, stock types show little real difference, and should not impact your overall return.

By Anurag Rathod

Anurag Rathod, as a blogger he used to spread all about app-based business, startup solution, on-demand business tips and ideas and so on.