|
|
||
is a class of common stock established by a company’s articles of incorporation and action of its board of directors that entitles its holders to lesser rights than the company’s regular common stock does. Typically, junior common stock is given much weaker voting, dividend, and liquidation rights than the company’s regular common stock, often equal to only one-tenth of those conferred by the latter. Usually, junior common stock becomes convertible share for share into regular common stock upon the company attaining certain predefined goals. Failure to reach those goals cancels the convertibility feature. Junior common stock is seldom used today. Several years ago, however, it was a common mechanism to grant additional share rights to management as an incentive for outstanding performance. The reduced rights of the junior common stock (or sometimes options to acquire junior common stock) allowed holders to contend that the shares were worth less than their regular common stock counterparts. This, arguably, allowed management to purchase these shares at prices considerably below the market value of the company’s regular common stock without having the IRS contend that they were purchasing the junior common stock at below its market value. As a consequence, the argument followed, the IRS would not require the holder to pay taxes on the differences. By making the junior common stock convertible share for share at a later date, management could eventually trade in its less valuable junior common stock for the company’s regular common stock. In order to create an incentive for management and to prevent the IRS from claiming that the convertibility of the junior stock was so certain that the shares should be valued at the higher regular common stock value when they were purchased (and the holder should pay taxes on the difference between what he paid and the fair market value of what he bought), the event that permitted management to convert its shares was usually a future performance goal that would be significant for the company and difficult for management to attain. It was a nice mechanism to reward management for outstanding performance. Unfortunately, accounting standards now require companies to include as compensation paid to the management shareholder who receives the junior common stock an amount equal to the difference between what he paid for his junior stock and the value of that stock at the time its conversion into common stock becomes reasonably certain. This creates an expense on the books of the company when it becomes apparent that it will meet the conversion goals. Even though this accounting treatment does not affect the underlying value of the company, by reducing earnings for accounting purposes it can have an adverse effect on the company’s valuation in the marketplace since these valuations are often premised, in part at least, on some multiple of the company’s earnings. This lower company valuation can, in turn, reduce the market price of the company’s shares and, consequently, make it more difficult for the company to raise money by selling its shares at full value. Consequently, junior stock is infrequently used these days as an incentive. See: Common Stock, Dilution, Earnups, Golden Handcuffs, ISOs (Incentive Stock Options). |
