One investment choice, among many options, is share ownership. With the advent of mutual funds and ETFs, some investors may not understand what share ownership represents. In order to explain it, let’s explore a simple example.
Let’s imagine a young person who starts a business. For this example, we’ll assume that it’s a simple business, with a single input and a single output. When a young man starts a coffee shop, it requires start-up capital. The value of the business is equivalent to its assets. When the man, who is owner, employer and employee, starts building relationships, increasing the value of his brand and developing recurring revenue, the value of the business increases. The value is based on the ability of the company to produce income.
What happens when the young man wants to expand to a second location? He can approach the bank for a loan, or he can sell bonds, which is essentially a non-bank loan. He will need to pay back the capital at a set date, and pay interest on a specific schedule. Let’s say that the second location is successful and he wants to open five new locations. Suppose either the bank won’t lend the money, or the interest payment schedule is not realistic. Another alternative for raising money is to sell shares.
Shares represent ownership in the company. In the previous example, the owner could use all the income, after paying interest and saving for principal repayment, for his own personal income (salary). When he divides ownership in the business, with shareholders, each owner has a proportional claim on the profits of the business. In a given year, the owner will pay loan interest, set aside money for loan repayment, pay salaries and reinvest in the business. The remaining profit, after taxes, can be paid to owners as a dividend.
The owner no longer works as an employee and has had to hire employees to run all the additional stores. A time may come when the owner no longer wants to work as the employer. Hiring and firing and managing the employees, the assets and the procedures may be outside of this man’s competence. He can hire a manager to run his company for him. This frees the owner from day-to-day management of the company, and may allow him to focus on other strategic activities, such as developing new markets, building relationships with suppliers and communicating his vision to stakeholders (owners and lenders). At this point, he is called the president. The manager is referred to as the CEO.
In order to ensure that the CEO is running the company for the benefit of the owners, the president can put together a board of directors. This divides the work between more people and allows for more input and complementing points of view. For example, the board will discuss the long-term vision of the company, review the financial statements (via the audit committee), determine appropriate income for the managers (the compensation committee), set a dividend policy, and use their connections to advance the interests of the company. Board members are sometimes paid a fee for their services. The purpose of the board of directors is to ensure that the interests of the owners are advanced.
Once a year, the company holds an AGM (annual general meeting) for shareholders to gather. They have an opportunity to hear their managers report to them and to ask their questions of management. The directors are nominated and voted on, and business may be brought before the shareholders for voting. There is little difference between a privately-held or publicly held company. The main difference is that a public company’s shares trade on an exchange, which makes it easy to buy and sell shares. Most exchanges require that the financial statements of the company be filed publicly, which makes the information easily accessible.
Buying stock means sharing ownership of a corporation. It gives the shareholder a right to future profits. It also confers rights to attend the AGM, nominate and vote for directors. The value of the stock will fluctuate, depending on expectations of future profit. If the company is public, the shares are easily tradable on an exchange. The shareholder should have directors that ensure satisfactory performance by management and shareholders should take an interest in the health of their company.