What is capital stock?
What are the advantages and disadvantages?
What is the capital stock definition and capital stock vs common stock?
In this article, we will break down the notion of “capital stock” so you know all there is to know about it
We will define a capital stock, look at common stock vs capital stock, the difference between capital stock and treasury stock, how it’s recorded on the balance sheet and look at concrete examples of a fictional company’s capital stocks.
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What is capital stock
Put very simply, capital stock or stock of capital represents the shares of stock that a company can issue to its shareholders.
Capital stocks do not represent the total outstanding shares but rather the maximum number of shares that can ever be issued by the company based on its charter.
A company is not authorized to issue more shares than what it is authorized to issue in its capital stock.
Corporation A is authorized to issue an unlimited number of common shares.
The company’s capital stock is therefore an unlimited number of common shares that can ever issue to shareholders.
Those who own shares in the capital stock of the corporation own a percentage of the company.
You can consider a capital stock to be linked to corporate ownership.
The capital stock can represent either common shares (also referred to as common stock) or preferred shares (or preferred stock).
Corporation A has the ability to issue an unlimited number of common shares or preferred shares.
Corporation A’s capital stock includes both the common and preferred stock.
An incorporated legal entity is legally authorized to issue shares of stock to different shareholders.
For example, a sole proprietorship does not have the authorization to issue shares whereas a registered corporation can.
When a company initially issues shares of capital stock to a shareholder, the amount it receives will be recorded as paid-in capital in the corporation’s balance sheet.
When a company receives money in exchange for the shares in its capital stock, we refer to that as a capital contribution and that is reported as the “paid-in capital” on the balance sheet.
Typically, a company’s common stock will be given an arbitrary nominal value (par value) for the purpose of recording the transaction on its balance sheet.
Corporation A issues 1,000 shares to Suzy at a nominal value of $1.00 per share.
Corporation A reports a pain-in capital of $1,000 on the stockholder’s equity section of its balance sheet.
Value of capital stock
A company’s capital stock is given an arbitrary value.
Typically, each share of stock is assigned a par value of $1.00 or even a few pennies.
The par value or nominal value is not related to the fair market value of the stock but it is an accounting value that is reported on the company’s balance sheet.
The value of a company’s capital stock can be derived using the following capital stock formula:
Total value of capital stock = (Nominal value per share) X (Total number of shares issued)
Definition capital stock
According to Investopedia, the capital stock definition is as follows:
Capital stock is the amount of common and preferred shares that a company is authorized to issue, according to its corporate charter
What is notable with this definition is that capital stock represents the number of shares a company can issue based on its articles of incorporation.
Advantages of capital stock
There are several key advantages in a company’s ability to issue shares from its capital stock.
Let’s look at the main ones.
An important advantage of a company’s capital stock is its ability to issue shares to raise capital and fund its growth.
A company can issue shares from its capital stock to:
- Fund operations
- Buy land
- Buy equipment
- Purchase real estate
- Hire employees
- Invest in R&D
The company will be free to use the capital raised in the best way it believes it can fund the growth of the business.
If the company runs out of money, it will have the option to raise additional funds by issuing more shares.
Raising capital by selling shares (equity investment) is interesting for corporations as they are able to access the capital needed by the business without having debt (debt financing).
Unlike debt financing where a borrower must pay back the borrowed money with interest, equity financing imposes no obligation on the company to pay back the investment or interest on the investment.
The investor purchases the shares in the capital stock of a company as an “investment” hoping that the company’s valuation will increase over time and may even be in a position to pay dividends to shareholders.
Another advantage in the issuance of capital stock is a company’s ability to sell shares (or ownership) to individuals with skills and expertise that can help scale the business.
These individuals can be investors, key personnel or experts in the field who can support the growth of the business.
When a person buys shares in a company, they own a percentage of the company’s ownership.
This aligns the interests of the investor and that of the company where they both have a common interest to grow the business and increase the company valuation.
This will lead the investors in supporting the company and providing it with the expertise and support it needs to grow.
Over time, a corporation may have the ability to buy back shares it has issued from its capital stock and return them into its treasury.
Corporation A has issued 100,000 common shares to several shareholders.
Provided it has the right to do so, it can buy back 10,000 shares and reduce its total outstanding shares by 10%.
In that case, the company will have 90,000 outstanding shares and 10,000 shares in its treasury.
This can be an interesting option if the company is considering paying dividends or is looking to take advantage of a lower market valuation of the company stock.
Disadvantages of capital stock
Issuing too many shares in a company’s capital stock may also have some drawbacks.
Loss of ownership
When a company issues common shares to a shareholder, the company is giving up “ownership of the business” in favour of the new shareholder.
The result is that the percentage ownership of the current shareholders will be diluted or diminished.
The more a company issues shares from its capital stock, the more the share value will be diluted as well.
In some cases, a project may be less costly to fund using debt financing than equity financing
Loss of majority control
Company founders and majority shareholders need to pay close attention to the number of shares issued from the company’s capital stock to maintain control of the business.
By issuing shares, the majority shareholders may get diluted to a point where they no longer control the majority of the company’s issued and outstanding shares.
Companies may need to give up some level of ownership to entice someone to invest in buying the shares of the corporation.
On the other hand, some shareholders may not want to give up the company’s control by issuing shares from their capital stock.
Is capital stock an asset
Capital stock represents the maximum cap of shares that a corporation may issue to shareholders.
A capital stock, in of itself, is not an asset
It represents the pool of different shares of stock a company can issue and for how many in total.
However, when a corporation issues shares from its capital stock, such as common shares, the company produces an asset as it will typically get money in exchange for the shares.
The money the company will get in exchange for the shares will be recorded in the company’s balance sheet representing an asset.
Also, for the shareholder, the shares represent an asset or an investment as they have value, can appreciate in value over time, grants the shareholder rights to get dividends and so on.
Capital stock vs outstanding shares
Capital stock represents the total number of shares a company is authorized to issue (authorized shares) whereas outstanding shares represent the actual number of shares issued to shareholders.
The total outstanding shares must be within the limits authorized by the company’s capital stock as defined in its charter or articles of incorporation.
Corporation A is authorized to issue an unlimited number of common shares (capital stock).
Corporation A has issued 100,000 common shares to John (outstanding shares).
Capital stock vs treasury stock
Capital stock is the total number of shares a company is legally authorized to issue to shareholders whereas treasury stock is the total number of shares available to the company to issue to shareholders or the shares it bought back in the market.
Unlike outstanding shares issued to shareholders, treasury shares or treasury stock do not grant voting rights or right to dividends.
Corporation A issues 100,000 common shares but can only sell 60,000 shares in the market.
As a result, the 40,000 issued shares it was not able to sell will remain in its treasury and be considered as treasury stock.
Treasury stock may be issued to shareholders and at that moment will no longer be considered treasury shares but shares outstanding giving its stockholder the right to vote or get dividends.
The total number of shares issued less the total number of outstanding shares represents a company’s treasury stock.
Capital stock vs common stock
The capital stock is the total number of shares a company is legally authorized to issue in shares while common stock is a type of share issued by the company forming its capital stock.
A company’s capital stock is composed of common stock and preferred stock.
Corporation A is authorized to issue 100,000 common shares in its capital stock.
Corporation A issues 1,000 common shares to John and 500 to Suzy.
John is now a shareholder of the company and has 1,000 common shares and Suzy has 500 common shares.
Together, they own 1,500 shares out of the company’s 100,000 capital stock.
Capital stock example
Let’s look at a concrete example of a fictional company’s capital stock.
Corporation ABC’s articles of incorporation allow the issuance of Class A Common Stock, Class B Common Stock, Class C Common Stock and Preferred Stock as follows:
- Maximum of 5,000,000 Class A Common Stock
- Maximum of 5,000,000 Class B Common Stock
- Maximum of 2,000,000 Class C Common Stock
- Maximum of 1,000,000 Preferred Stock
The company’s capital stock is 13,000,000 shares.
Corporation ABC has already issued 500,000 Class A Common Stock and 50,000 Preferred Stock.
The issued and outstanding shares in the company’s capital stock are:
- 500,000 Class A Common Stock
- 50,000 Preferred Stock
Here is an example of how a company’s capital stock can be drafted in its charter:
Capital stock FAQ
How to calculate capital stock?
The value of a company’s capital stock can be calculated as follows:
Capital stock = Number of shares issued X Par value
Corporation A has issued 10,000 common shares at a price of $1.00 per share.
The value of its capital stock is $10,000 (10,000 common shares X $1.00 per share).
The par value per share is an arbitrary number assigned to the shares and will be recorded as paid-in capital on the company’s balance sheet.
Any value paid by an investor above the par value will be considered as “additional paid-in capital” and will also be recorded on the company’s balance sheet.
Is capital stock the same as common stock?
Capital stock is not the same thing as common stock.
The capital stock is what a corporation is authorized to issue in shares while a common stock is a type of share.
A corporation is authorized to issue 1,000,000 common shares and 500,000 preferred shares (company’s capital stock).
Since the company is authorized to issue common shares and preferred shares, these are the type of shares that the company can issue from its capital stock.
What increases capital stock?
A company’s capital stock is the maximum number of shares a company can issue.
A corporation is not authorized to issue more than what its capital stock authorizes it to issue.
However, a company can choose to amend its articles of incorporation or charter allowing it to increase its capital stock.
Corporation ABC has a capital stock of 1,000,000 common stocks.
If it wants to issue 2,000,000 common stocks, it must modify or amend its charter increasing the number of shares it will be authorized to issue in its capital stock.
The company may amend its incorporation papers to increase its capital stock to 10,000,000 common stocks so it can issue 2,000,000 to a shareholder.
What does capital stock mean in economics?
In economics, capital stock means an economy’s ability to produce assets, goods and services.
For economists, capital stock is the source of economic output (such as produced goods or assets used in the production of goods or services) allowing an economy or nation to produce income.