Many entrepreneurs prefer to use corporations as the legal entity within which to start up new businesses, and electing S corporation status can give an entrepreneur valuable tax benefits compared to traditional corporations. However, there are limitations on how many shareholders an S corporation can have, and so being aware of the distinction between authorized and issued shares in an S corporation is more important than it is in a typical business.
Below, we'll go through some of the technicalities involved in understanding the difference between issued and authorized shares.
Authorized shares set a maximum limit
In order to form a corporation, one of the things you have to do is draft what are known as articles of incorporation. This formation document includes several legally required elements of the corporate entity. One of the things it sets forth is the number of authorized shares of stock that the corporation will have.
For S corporations, the authorized-share limit takes on added significance because of further restrictions on share ownership. S corporations can have a maximum of 100 shareholders, and they can offer only a single class of common stock with no preferred stock allowed. If an S corporation wants to have more shares than its articles of incorporation authorize, then its shareholders have to agree to an amendment to the articles of incorporation that reflect the higher amount.
Issued shares reflect actual ownership
Just because a corporation has a set number of authorized shares doesn't mean that it has to issue all of them. Typically, corporations will issue just a portion of their authorized shares in its initial financing, retaining the right to make secondary offerings of stock to additional investors in the future without requiring a shareholder vote to amend the corporation's formation documents.
Having shares that are authorized, but not issued, also gives companies the ability to make other strategic moves. For example, if a company wants to execute a stock split, it can do a stock dividend that raises the number of issued shares in the company. Again, if the articles of incorporation have enough leeway to accommodate the higher number of issued shares, then no special action will be necessary.
The relationship between authorized shares and issued shares is important for any start-up investor to understand. By being smart about how it issues its shares to investors, a corporation can put itself in a much-better position to attract future capital, as well.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.