Comprehensive Notes: Equity, Valuation, Dividends, and Treasury Stock
Cap Table, Convertible Notes, and Financing Stages
Topic: stock allocation, valuation, and how ownership evolves in startups; includes discussion of options, cap tables, and how financing rounds dilute existing holders.
Employee stock options: given out by companies; pricing and predicting how many will be exercised is a specialized task; requires expertise in price and forecasting who will accept the options.
Subject matter expert role: price options, forecast exercise, and determine total dilution.
Real-world takeaway: being valuable often requires combining disciplines (e.g., tech + business) to anticipate market needs and roles (as illustrated by the speaker’s anecdotes about his kids).
Cap table basics (not a public company):
A cap table tracks ownership, types of equity, and how financing rounds affect ownership.
The example startup raised close to $14,000,000 via convertible notes before a Series A; this is a common path for early-stage companies that start with friends/family financing and progress to formal rounds.
Convertible notes: issued to early investors; notes convert into equity later (typically at the next round) rather than being repaid in cash.
Post-conversion cap table snapshot in the example:
Common stock: 11,700,000+ shares (after conversion of notes)
Notes converted: 524,000 shares converted from convertible notes
Series A rounds introduced preferred stock (Series A1 and Series A2): a few more shares issued as new money comes in.
Cap table evolution example: as more money comes in, more preferred shares are issued; this dilutes existing common holders.
The cap table is maintained by a system in most companies, and it records all investors and share classes (common, preferred, etc.).
Why it matters for exams/real life:
Understanding how ownership shifts with each financing event helps explain dilution, voting rights, and liquidation preferences.
The cap table concept ties to valuation, control, and planning for future rounds or exit strategies.
Present Value Concepts: Lump Sum vs Ordinary Annuity
Core idea: sometimes you receive a one-time payment (lump sum) and a stream of payments (annuity) over time; you must discount both to present value to compare alternatives.
Two streams, two PV calculations:
Present value of a lump sum (face value):
PV_{ ext{lump}} = rac{FV}{(1+r)^n} = FV imes (1+r)^{-n}
Present value of an ordinary annuity (regular payments C for n periods):
PV_{ ext{annuity}} = C imes rac{1 - (1+r)^{-n}}{r}
Total present value:
PV{ ext{total}} = PV{ ext{lump}} + PV_{ ext{annuity}}
Calculator notes:
When using a financial calculator, you typically compute the present value of the face value and the present value of the payment stream separately.
If there are two payments per year, you must adjust the interest rate accordingly (e.g., use r/2 for a semiannual rate).
In practice, you’ll set the calculator to reflect the timing of payments (n periods, payment amount C, rate r) and sum the two PVs to get the overall present value.
Practical nuance:
The two streams approach helps explain why debt securities or employee compensation with options must be evaluated using both a lump-sum payoff and ongoing cash flows (e.g., interest or dividend streams).
Cumulative vs Noncumulative Dividends
Key distinction:
Cumulative preferred stock: if the company does not pay dividends in a given year, the unpaid dividends (arrears) accumulate and must be paid before any dividends can be paid to common shareholders.
Noncumulative preferred stock: if a dividend is skipped in a year, no arrears accumulate; the company merely pays the current year’s dividend if it can.
Example from the lecture:
Suppose a company plans to pay $10,000 in dividends this year and has cumulative preferred shares.
If dividends are skipped in 2022 and 2023, arrears accumulate; the example used: arrears total of $4,800 ($2,400 per year for two years).
2024 dividend: current year preferred is $2,400; arrears remain $4,800 to be paid first, plus the current year $2,400. After paying arrears and current year, only the remaining amount can go to common shareholders. In this example, after settling arrears ($4,800) and current year ($2,400), only $2,800 would be left for common shareholders.
Practical takeaway:
With cumulative stock, the order of payment when declaring a dividend is: first arrears, then the current year’s preferred, then common equity receives any leftover.
With noncumulative stock, you pay the current year’s preferred dividend first, and any leftover goes to common if the company can pay.
Treasury Stock: Buybacks, Reissuance, and APIC Allocation
What is treasury stock?
Treasury stock refers to a company’s own shares that it has repurchased and keeps in its treasury; these shares are not outstanding.
Reasons for buybacks: potentially raise the stock price (fewer shares outstanding increases earnings per share and stock price), to preserve shares for employee compensation, or to optimize capital structure when there is excess cash.
Accounting basics:
Treasury stock is a contra equity account (debit balance), which reduces total shareholders’ equity.
It is recorded at cost (not par value) when purchased.
Journal entries:
Purchase (example: 100 shares at $30):
Debit Treasury Stock $3,000; Credit Cash $3,000
Effect: equity is reduced by $3,000; cash is reduced by $3,000.
Paying options out of treasury stock (as Coca-Cola does in the example):
Treasury shares are used to satisfy employee stock options, reducing the need to issue new shares or cash outflows.
Reissuing treasury stock:
If treasury stock is sold for more than its cost: Cash received is greater than cost; you credit Treasury Stock for its cost and credit Additional Paid-In Capital (APIC) for the excess; no gain or loss is recognized in net income (per FASB rules on treasury stock).
Example: buy 100 shares at $30 ($3,000 cost) and later sell for $35 ($3,500 cash):
Debit Cash $3,500; Credit Treasury Stock $3,000; Credit APIC $500
If treasury stock is sold for less than its cost:
You still record the difference in APIC (no realized gain/loss in net income).
Example: sell 100 shares at $25 ($2,500 cash):
Debit Cash $2,500; Credit Treasury Stock $3,000; Debit/APIC adjustment of $500 to APIC as described in the material (no loss recognized in the income statement).
Effects on equity after treasury stock transactions:
Buying back stock reduces equity by the cost of the shares purchased.
Selling treasury stock increases cash and adjusts treasury stock to cost, with any difference routed to APIC and not to net income.
The overall equity position may improve or deteriorate depending on APIC adjustments and the cost basis of the treasury stock.
Important note from the lecture:
One practical consequence: treasury stock accounting reduces equity, even if the shares are later reissued at a gain; the APIC route preserves the equity accounting without impacting reported earnings.
Retained Earnings, Net Income, and Dividends
Retained earnings (RE) overview:
RE is the cumulative total of net income (or loss) over time, minus any dividends paid to shareholders.
It is a running balance that gets updated each period.
How it changes:
Net income increases RE at year-end (via closing entries from the income statement).
Net loss decreases RE.
Dividends are always subtracted from RE.
A prior period adjustment (if needed due to errors) can adjust RE; such adjustments are rare and typically indicate material misstatements.
The balance in retained earnings is the result of adding the annual net income (or subtracting the net loss) and subtracting dividends paid.
Practical note:
Investors care about retained earnings as a measure of reinvested earnings that could support future growth or be paid out as future dividends.
Dividends, Declaration, Record, and Payment Dates
Dividend policy and governance:
Dividends are determined by the board, typically through a declared dividend policy.
The board meeting authorizes how much to pay and when.
The three key dates:
Declaration date: The board declares a dividend; creates a legal liability for the company to pay the stated amount. In accounting, this is recorded as a dividend liability (Dividends payable).
Record date: The date on which ownership is determined to receive the dividend; only shareholders on this date (or on the record) receive the dividend because shares may trade hands up to the record date.
Payment date: The actual date on which cash is paid to shareholders; the liability is settled (Dividends payable is debited; Cash is credited).
Practical example (from the lecture):
Canadian Falcon declares a $0.25 per share dividend on 2,000 outstanding shares on March 15.
Amount of cash to be paid = 2,000 × $0.25 = $500.
On declaration date, entry recorded:
Debit Dividends $500; Credit Dividends Payable $500
This creates a liability for the company; later, on payment date, the dividend payable is settled with cash.
Stock dividends and related concepts:
A stock dividend is a dividend paid in additional shares rather than cash.
Stock splits are not dividends but corporate actions that adjust the number of shares outstanding and par value without changing the overall equity.
Stock Dividends and Stock Splits: Mechanics and Impacts
Stock dividends (issued as shares of stock):
Small stock dividends (typically up to around 25% of outstanding shares, the transcript uses 25% as a reference):
Issued at market value; journal entry typically debits Stock Dividends and credits Common Stock at par, with the remainder credited to APIC (Additional Paid-In Capital).
Large stock dividends (exceeding the small-percent threshold):
Issued at par value; journal entry debits Stock Dividends and credits Common Stock for the par value of the new shares issued; the effect is to reduce retained earnings.
In both cases, the total number of shares outstanding increases, and the par value per share may change (particularly for large stock dividends, where par value is typically increased proportionally to the new shares).
Example concept: a 25% dividend can reduce retained earnings by the par value of the issued shares and increase the common stock account by the same amount (par value × new shares).
Stock splits (e.g., 1-for-1, 4-for-1, etc.):
A stock split increases the number of shares outstanding and reduces the par value per share accordingly, with no overall change in total equity.
Price per share adjusts inversely to the split ratio (e.g., a 4-for-1 split roughly halves the stock price).
Example from the lecture: a 4-for-1 stock split would convert 1,000 shares into 4,000 shares; the stock price would be about a quarter of the pre-split price.
Motivation for stock splits: to keep the stock affordable for the average investor and maintain liquidity when prices rise too high (as with Amazon or Apple historically).
Fractional shares and DRIPs:
Fractional shares can be issued in stock dividends; fractional shares may be handled via a DRIP (Dividend Reinvestment Plan).
DRIPs allow investors to receive dividends as additional shares directly from the company, often with no or very low fees, compounding over time.
Apple example:
Apple reportedly did a 4-for-1 stock split to reduce high share price and encourage broader ownership.
Summary of impact on financial statements:
Stock dividends: reduce retained earnings; increase common stock (at par) and APIC as needed.
Large stock dividends: same as above but at par value; APIC not used for the difference (since the difference is at par).
Small stock dividends: increase common stock at par; APIC captures the excess of market value over par.
Stock splits: do not affect total equity; only adjust the number of shares and par value; price adjusts accordingly; no APIC impact.
Front Office vs Back Office; Real-World Contexts and Anecdotes
Front office vs back office distinction:
Front office: client-facing roles (sales, interface with customers).
Back office: operations, finance, legal; less glamorous; often patching systems together to support front-office activity.
Real-world context and anecdotes from the lecture:
The speaker references working with Citibank and US Trust, and a historical memo about whether Citibank should enter the credit card business. This illustrates how strategic decisions in finance can change dramatically over time.
Emphasis on practical accounting: the cap table, treasury stock, and dividend mechanics directly affect ownership, liquidity, and investor perception.
The lecture also emphasizes personal finance advice: small individual investments, such as DRIPs or modest monthly contributions, can grow substantially over time and help with large goals like a house down payment. While anecdotal, the takeaway is the value of consistent saving and investing.
Quick reference: Key terms and takeaways
Cap table: capitalization table; records ownership breakdown by class (common, preferred), including equity and convertible notes.
Convertible notes: a form of debt that converts into equity (often preferred) at a future financing round; affects dilution and capitalization table upon conversion.
Common stock vs preferred stock: different rights and liquidation preferences; preferred stock typically has priority in dividends and liquidation.
Cumulative vs noncumulative dividends: cumulates arrears; noncumulative does not.
Dividends: declared date creates liability; record date determines recipients; payment date distributes cash; journal entries revolve around dividends, dividends payable, and cash.
Treasury stock: company’s own shares bought back; recorded as a debit to Treasury Stock (contra equity); reduces total equity; can be reissued with APIC adjustments; gains/losses on treasury stock do not affect net income.
Stock dividends: dividends paid in shares; small vs large; effects on retained earnings, common stock, and APIC vary by size; par value and share count adjust.
Stock splits: increase shares outstanding; decrease par value; no net change to equity; price adjusts accordingly; used to keep stock affordable and liquid.
DRIP (Dividend Reinvestment Plan): reinvest dividends to purchase more shares; compounding growth with minimal fees.
Real-world examples: Coca-Cola buybacks; Apple stock split; private cap table dynamics; (and the broader lesson on value creation through cross-disciplinary skills).
Formulas to remember:
Lump-sum present value: PV_{ ext{lump}} = rac{FV}{(1+r)^n}
Ordinary annuity present value: PV_{ ext{annuity}} = C imes rac{1 - (1+r)^{-n}}{r}
Total present value: PV{ ext{total}} = PV{ ext{lump}} + PV_{ ext{annuity}}
Exam-ready recap notes
Be able to explain why a cap table changes after each financing round and how convertible notes convert into equity.
Be able to calculate the PV of a lump-sum payment plus an annuity, and to adjust for semiannual or other timing via the rate.
Distinguish cumulative vs noncumulative dividends and apply the correct priority rules (arrears first for cumulative).
Describe how treasury stock affects equity and how to handle buybacks and reissues, including APIC treatment for gains and losses on treasury stock.
Differentiate stock dividends from stock splits, including when to treat a dividend as small vs large and how par value and retained earnings are affected.
Understand the role of the DRIP as a method to build wealth via dividend reinvestment.
Recognize the broader real-world implications of equity decisions on ownership, liquidity, and investor perception.