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2.3.3. Residual value

waterfall of claims on company in event of liquidation

Figure 1: waterfall of claims on company in event of liquidation

Ordinary shares only have a residual value, or residual claim status. This means that in the pecking order (or waterfall) of risk, creditors (providers of credit / loans) are favoured, followed by preference shareholders, in turn followed by ordinary shareholders, and this applies in the cases of claims on profits and claims on the assets of the company in the event of liquidation (see Figure 1).

It will be evident that bondholders are creditors of the issuing companies. They are not owners of the issuing companies, but they have a superior claim on the issuing companies' profits and assets, relative to the ordinary shareholders. This fact is depicted in Figure 2.

split of earnings between equity and bond owners of a company

Figure 2: split of earnings between equity and bond owners of a company

2.3.4. Voting rights

control and management of companies

Figure 3: control and management of companies

While ordinary shareholders are at the bottom of the waterfall of risk in terms of claims on profits and assets, they have the privilege of voting rights. Generally speaking (i.e. in the case of listed companies), ordinary shareholders do not control the daily activities of companies. This is left the managers of companies, who are appointed by the managing director, who in turn is appointed by the board of directors, who in turn are appointed by the ordinary shareholders. This may be depicted as in Figure 3.

Thus, ultimately, the ordinary shareholders are in control of the fortunes of the company. They appoint the board of directors to direct the company and they are selected for their skills and abilities that are fitting for the company. The board elects the managing director on behalf of the shareholders for his skills in the type of business the company is involved in.

Typically one share has one voting right. However, many company statutes allow for the existence of different classes of ordinary shares in terms of voting rights. There are different names for these shares such as:

• "N" shares and ordinary shares.

• Class A and Class B shares.

For example, Class A shares may carry one vote, while Class B shares may have one-tenth of a vote. An alternative to this arrangement is limiting the extent to which the "inferior" shares may elect the board of directors. For example, Class A shareholders may elect 90% of the board members, leaving only 10% to be elected by the Class B shareholders.6

Ordinary shareholders exercise their voting rights at the Annual General Meetings (AGMs) that companies are required to hold in terms of statute or General Meetings that may be called by the company or the shareholders. It is notable that ordinary shareholders may only call a General Meeting if they collectively hold 10% or more of the voting rights (this varies from country to country).

In the case of most listed companies, ordinary shareholders do not attend the AGM. They usually exercise their voting power by proxy voting. This is given effect by the company attaching a proxy form to the Notice of Annual General Meeting that is sent to each shareholder. Most shareholders do not even bother to complete the proxy. Clearly, in the case of a badly performing company, shareholders will either attend the AGM or appoint a proxy to represent them.

2.3.5. Elastic dividend payments

Although ordinary shareholders are the lowest head on the totem pole in terms of claims on the company's assets, they share in the net worth of the company, which may be substantial. The ordinary shareholders are the owners of this net worth, i.e. the assets of the company after allowing for all other claims (preference shareholders, creditors, tax owed). Clearly thus, while bondholders have a prior right in relation to ordinary shareholders, they only are entitled to a fixed interest payment (usually), while the latter share in the financial success of the company.

The profits of companies are paid to shareholders in the form of dividends (after tax), and the dividends received may, of course, be substantial if the company is highly profitable. However, there is no guarantee of a dividend. Thus, unlike bondholders, ordinary shareholders have no legal claim if a dividend is not paid.

The decision on whether a dividend should be paid and the magnitude of the dividend to be paid rests with the board of directors of the company. The decision is influenced by a number of factors, including:

• Whether the company will be more profitable in future by investing its profits in new equipment or new projects.

• The tax rate on dividends paid by the company (if this exists7).

• The tax rate on dividends paid by the shareholder (if this exists).

• The tax rate on capital gains (applicable in many countries).

2.3.6. Limited liability

risk-reward profile of ordinary shareholders

Figure 4: risk-reward profile of ordinary shareholders

A pertinent characteristic of ordinary shares is that shareholders have limited liability in terms of the debt of the company. Legally, ordinary shareholders are not responsible for the debt of the company; their liability ends with the loss of the share capital of the company, i.e. their investment in the ordinary shares of the company. But the potential for gain for ordinary shareholders is unlimited. The limit of their loss and their unlimited potential for gain may be depicted as in Figure 4 (it will be noted that this risk-reward profile is similar to that of a call option).

If the ordinary share capital of a company is equal to LCC100 million, this is the amount that the ordinary shareholders stand to lose if the debt of the company exceeds LCC100 million. It will be clear that if the debt is LCC50 million, then the net asset value (NAV) is LCC50 million, i.e. the ordinary shareholders lose lost LCC50 million in the event of liquidation. It will also be apparent that if the NAV increases to LCC200 million, the shareholders have gained LCC100 million in value (this assumes that the share price equals the NAV per share).

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