Financing with common stock serves as a reserve of borrowing capacity. Common stock financing represents the sale of ownership stakes within a corporation in exchange for cash or capital considerations. Stock financing is the sale of equity/ownership rights within a business in order to get money or capital considerations. The disadvantages of common stock as a source of long-term financing are as follows:
Disadvantages of Common Stock Financing to The Issuer
1. Common stock is an expensive source of long-term financing. Common stockholders expect a higher rate of return than other investors since the risk involved is also high. Moreover, flotation costs that include underwriting commission, brokerage fee, and other expenses usually are higher than those for debt and preferred stock.
2. The issuance/issue of new common shares may dilute the ownership and control of the existing shareholders. Dilution of ownership assumes greater significance in case of closely-held companies.
3. The sale of additional common stock dilutes the existing shareholders’ primary earning per share, particularly, if the assets acquired with the proceeds of the financing do not produce earnings immediately.
4. Common stock dividends are not tax deductible payments. The impact of this factor is reflected in the relatively higher cost of equity capital as compared with debt capital.
Disadvantages of Common Stock Financing to The Investors
1. A dividend on common stock is not certain. The company pays a dividend when it earns sufficient profit.
2. Common stockholders get last priority in the liquidation. In other words, common stockholders have a residual claim on the income and assets of the company.