Effectively, the holders of stock in a company assume the greatest risk of financial gain. All other forms of investments have priority in payment over the stockholders. But the reward function can be significant if the company is successful in operations.
To fully understand stock, the reader must first become familiar with the terms used in identifying the various forms of stock. This article will introduce the reader to the basic concept and identify the more common forms of stock: Common Stock, Class Stocks, Convertible Stock and Preferred Stock. Finally, this article will introduce to the reader current exchange systems used to purchase stock at the various levels of business.
Stock – Basic Principles
The key to understanding stock is the risk position the shareholder (owner of the stock) assumes. When a corporation is formed, it receives permission to exist from the state government or some other government entity. When the founding directors ask for permission, they indicate to the government a range of shares that will be issued to the investors. These shares are known as stock. Most stock certificates indicate a ‘Par’ value. ‘Par’ value is nothing more than some arbitrary number the directors told the state government the shares are worth like a face value. The most common denominations are $1.00 and $10.00. Think of it like issuing money. All money has a face value. It doesn’t mean it’s worth this much; it just has some face value to the paper.
To raise the money to start the company, the company sells these shares. They can sell one share to a single shareholder for all the capital needed or sell different issues (amounts of shares at the same time and/or on different dates) to one or more investors. Investors may be individuals or they may be other legal entities such as other companies or even trusts. The selling of the shares is referred to as a subscription.
At the point of sale, the company issues a numbered certificate to the investor in exchange for cash (sometimes property or other form of value – personal time, other stock, cancellation of debt, ownership rights etc.) is traded. The transaction is recorded in the legal books and the accounting books of the company. Most exchanges are for cash. The investor may and often pays much more than the face value of the certificate (Par Value). When the transaction is complete, this ‘Issue’ is recorded first in the legal records of the company, usually by recording the sale in the stock certificate book and then in the accounting records by debiting cash on the books and then crediting the respective accounts in the equity section of the books. If you desire to better understand the equity section of the balance sheet (part of the books), then please read this article: How to Read a Balance Sheet – Equity Section Simple Format.
The following is simple example of this transaction:
Jeremy purchases 100 shares of his father’s company. The company is selling the shares for $100 each. Each share is issued with a par value of $10. In the legal books, the transaction is recorded by the secretary that Jeremy purchased 100 shares on this date with certificate number ZZZ for $10,000. In the accounting records, a general ledger transaction is recorded stating cash is increased via a debit by $10,000 and the two respected equity accounts are increased via credits in the following amounts. Common Stock (Par Value times the number of Shares sold) is increased for $1,000 and Capital Paid in Excess is increased for $9,000.
The above is a simple and straight forward example. However, it gets more complicated as the level of sophistication increases with the various types of companies. Sometimes the corporate issue of stock is not a family or closely knit situation, but more of a regional capital fundraising event. A perfect example is starting a small local bank. The directors comply with the state laws and form a bank. To start out, the bank needs to raise money and prepares a prospectus and receives all the proper inspections by the regulatory agencies. The initial public offer is sold. Generally this offer is pre-subscribed by not only the directors, but their close colleagues and friends. Once money is raised the shares are typically exchanged via a division within the bank that offers the stock owned by the existing shareholders for sale to the public or existing shareholders. Sometimes the shares may be listed via an over the counter exchange system. Usually at this level, there are very few transactions and therefore little shift in ownership and ultimately the directors.
At the higher levels of business, the investor deposits money with a broker and then buys and sells his ownership of stock via the exchanges the broker participates with in the market. Modern technology has allowed individuals to open accounts and trade on their own via the internet. But the principle of ownership remains, the shareholder is last in line to get any proceeds in case of default by the company.
As stated above, the shareholder is last in line. Many businesses fail; actually most fail within five years of startup. Upon default or if the entity goes into bankruptcy some form of liquidation begins. All creditors are paid first before any money is issued to the stockholders for their respective ownership. Most often, practically every single time, failure results in zero value to the stock holder. It is important for the investor to understand the risk involved.
At the highest level of stock ownership, i.e. owning blue chip stocks, the likelihood of failure is remote, almost nonexistent. The shareholder may dispose of his ownership rights by offering to sell his shares in the stock market. Most blue chip companies exchange their shares via the New York Stock Exchange.
History of Stock
The first documented exchange of money for rights to the remainder of value in a common business venture occurred in seventeenth century. When the East India companies formed, the government charters allowed the organization to trade ownership rights for cash in the respected voyages to the East Indies. Initially the investments were one voyage at a time but the concept of spreading your risk by participating in a large group and having rights to all the voyages undertaken appeared more lucrative to the buyers. In effect, there was more security in volume. The investors received documents of ownership and would reap the rewards. These documents of ownership rights were traded over time and some form of an exchange venue was needed.
The idea behind stock is to bring together needs (those desiring capital) and resources (investors desiring large returns for their risk). The Dutch exercised this concept well in the 17th century as stock was sold to help build ships and fund large scale excursions overseas. In exchange, the investors reaped huge rewards as the Dutch economic power prospered during the 17th and 18th century. This economic tool made its way to the Americas and one of the first known stock trades takes place in Philadelphia. The Schuylkill and Susquehanna Navigation Company offered stock in trade for $400 per share.
The first stock exchange for the British Empire formed in 1773 and the first American exchange formed in Philadelphia in 1790. The New York Stock Exchange formed in 1792 and located its offices on what is now referred to as Wall Street. Given its location in a coastal harbor and next to the banking industry, the New York Stock Exchange flourished.
To give you an idea of the volume of sales, the New York Stock Exchange trades over 500 million shares every daily.
Not all of these shares are common stock. Stock comes in many varieties and it’s important for the reader to understand the most basic forms of stock.
Forms of Stock
There are several forms of stock and this list explains the increasing complexity of each form.
Common Stock – most straight forward in business, common stock allows the holder rights to vote their number of shares thus maximum power over management but at the same time, the highest risk because common stock holders are paid last if at all from profits and liquidation.
Class Stock – referred to as ‘Classes’ of stock, shares are sold with certain rights. As an example ‘Class A’ shares may have full rights of ownership including the right to vote. Whereas, ‘Class B’ shares may have no rights to vote but are paid first before ‘Class A’ holders of stock are paid. Examples include liquidation or if dividends are authorized. Sometimes, a class of stock is issued related to a project and have a set life expectancy.
Preferred Stock – this one is different in that preferred stock is paid first via dividends over any other form of stock. Often these certificates come with a guaranteed interest payment per year to the shareholder. They do not allow for voting rights and come with a call provision which means the company can buy them back at a given price once certain conditions are met (usually time and or earnings accumulation). Preferred Stock can be issued in classes which sets priority of payment. Notice that within a form of stock, attributes of other forms can exist.
Convertible Stock – this form of stock allows the holder to convert their certificate to some other form of stock once certain conditions are met. The most common reason for this form of stock is to allow existing common stock holders to gain from their investment related to existing projects. The convertible stock holders convert once a newer project or investment begins to return value to the company. This type of financial instrument is not usually found in smaller companies but is exercised with large multi-national organizations.
Now that you understand the four main forms of stock, you need to realize that common stock is the most often used financial instrument in the small business world. It is simple and straight forward allowing for novice investors to feel comfortable and fully understand their risk situation. How does the investor find the company and/or how does the company find the investor? The next section describes the most common methods at the various levels of business.
Modern Exchange Systems
There are several million companies in the United States. The majority is closely held (less than 75 stockholders), larger companies are regional in nature and use a multitude of investment instruments to finance the equity needed, and less than 20,000 are large publicly traded companies. The following subsections explain the use of stock and the exchange methods for each of the three respective groups.
Closely Held – this is your typical small business operation, usually family held or closely held (less than 75 investors). The company is normally formed by one individual and that individual makes the initial investment. Then other family members join and purchase stock too. Sometimes business colleagues buy stock but for the most part the stock is owned and held by a very tight knit group and all are familiar with the risk involved. As the company flourishes, others may get involved and several issues arise in the sale of stock. If a company crosses into another state to conduct business or to raise capital, the management team must consult legal advisors as federal law and other state laws come into play. Stock traded in the small business world is pretty much restricted to people who know each other or do business with each other. Here the exchange system is word of mouth.
Large Regional Corporations – as a company grows and begins to garner some market or brings to market a specialty, raising money from family and friends isn’t going to be enough. Capital must come from more significant or sophisticated investors. The sources of investors include Angel Investors, Venture Capitalists, and the more recent Mezzanine Financing. The key is that more folks get involved, financial statements are audited, government compliance is essential and business is more long term than your typical year to year in the closely held system. The exchange system used here is more national and industry focused and the investors are sophisticated enough to demand access to independently verified information. If successful, management will seek authorization from the Securities and Exchange Commission to have the stock traded on some publicly accessible exchange system such as the Over the Counter market or one of the smaller stock exchanges.
Publicly Traded – now it is much more complex. Business is conducted in regions and often across the entire country. In many cases, business transactions are consummated overseas. All of this requires a lot more legal work and associated financial compliance. Therefore, companies move capital fundraising into a more prestigious exchange system. This includes becoming a member of NASDAQ or if really successful, the New York Stock Exchange. Stock trading becomes easier and investors are more accessible.
For the reader, you need to realize that going public takes many years of hard work and often isn’t as lucrative as one may believe. For now, stay focused on getting capital in various ways. I have written two other articles to help you: How to Find Investment Capital – The Family Connection and How to Find Investment Capital – The Vendor Connection.
Summary – Stock
Stock is the one true form of pure risk. The owner of stock shouldn’t expect a reward given the inherent risks associated with ownership. However, if the business venture proves successful, the stockholder will reap significant returns on the investment. The basic principle of stock is the risk reward relationship and of course maximum ownership privileges in the form of voting rights. There are several forms of stock including common, class, preferred and convertible. Each has different rights but common stock has the most risk involved. Finally, the sale of stock is conducted through some type of exchange system. For the small business, it is essentially word of mouth. Act on Knowledge.