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Although most firms have only one type of common stock, in some instances classified stock is used to meet the special needs of the company. Generally, when special classifications are used, one type is designated Class A, another Class B, and so on. Small, new companies seeking funds from outside sources frequently use different types of common stock. For example, when Genetic Concepts went public recently, its Class A stock was sold to the public and paid a dividend, but this stock had no voting rights for five years. Its Class B stock, which was retained by the organizers of the ompany, had full voting rights for five years, but the legal terms stated that dividends could not be paid on the Class B stock until the company had established its earning power by building up retained earnings to a designated level. The use of classified stock thus enabled the public to take a position in a conservatively financed growth company without sacrificing income, while the founders retained absolute control during the crucial early stages of the firm’s development. At the same time, outside investors were protected against excessive withdrawals of funds by the original owners. As is often the case in such situations, the Class B stock was called founders’ shares.

Note that “Class A,” “Class B,” and so on, have no standard meanings. Most firms have no classified shares, but a firm that does could designate its Class B shares as founders’ shares and its Class A shares as those sold to the public, while another could reverse these designations. Still other firms could use stock classifications for entirely different purposes. For example, when General Motors acquired Hughes Aircraft for $5 billion, it paid in part with a new Class H common, GMH, which had limited voting rights and whose dividends were tied to Hughes’s performance as a GM subsidiary. The reasons for the new stock were reported to be (1) that GM wanted to limit voting privileges on the new classified stock because of management’s concern about a possible takeover and (2) that Hughes employees wanted to be rewarded more directly on Hughes’s own performance than would have been possible through regular GM stock.

GM’s deal posed a problem for the NYSE, which had a rule against listing a company’s common stock if the company had any nonvoting common stock outstanding. GM made it clear that it was willing to delist if the NYSE did not change its rules. The NYSE concluded that such arrangements as GM had made were logical and were likely to be made by other companies in the future, so it changed its rules to accommodate GM. In reality, though, the NYSE had little choice. In recent years, the Nasdaq market has proven that it can provide a deep, liquid market for common stocks, and the defection of GM would have hurt the NYSE much more than GM.

Taken From : Five-Minute MBA – Corporate Finance

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