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Wednesday, September 5, 2012

Stocks, lemonade and pizza

Most companies’ beginnings are humble. Those who survive the treacherous first years find themselves needing money. Remember your sister’s lemonade stand? (If you don’t have a sister, or she did not have a stand, just humor me). They need money to grow (if you want to sell more lemonade you need more lemons, and maybe a bigger blender and eventually a refrigerator, a truck, an accountant and a lawyer). In order to get this money, business owners are willing to split their ownership into smaller pieces called shares or stocks… Think pizza

Before the expansion, your sister owned the whole Lemonade stand, 100% of it.

In our case, your sister  is willing to sell a share of her pizza in exchange for the money needed to grow her business. She will no longer own 100%. Depending on how much money she needs she will have to sell more or less shares.  If this is the first time you sister does this sale, it  is called “going public” or IPO, Initial Public Offering

Your sister’s share on the company after the IPO

A shareholder’s share on the company after the IPO

A share of stock is the smallest unit of ownership in a company. If you own a share of a company’s stock, you are a part owner of the company.

Why would anybody buy share on your sister’s lemonade stand?
Share buyers, AKA investors or shareholders buy shares because they believe in the business, they believe that your sister will be a successful lemonade stand owner. In particular they have two basic reasons;
        a)     Your sister is now obligated to share the profits of the lemonade proportionally with all other shareholders. Your sister will send a quarterly check to shareholders. This is called a dividend.
        b)     The investor hopes he or she may be able to re-sell the share at a higher price than he/she paid for in the future. This is called capital gain.

An alternative way to finance her business
What if your sister did not want to let go control/ownership of her company? Did she have any options? The answer is yes. She could have borrowed the money from your parents (bank). We would call them debt holders. In this case your sister needs not to share profits, only to repay what she borrowed (plus interest). 

Separation of Management and Ownership
After a few years, there would be hundred if not thousand of of owners. This makes it practically impossible for  owners (principals) to  run their own company. They must hire managers (agents) to do the work.  Just imagine how long it would take all owners of Toyota trying to agree on what a new model should look like.
An important conflict arises when managers (the agents) entrusted to look after the interests of others (the principals) use their authority or power for their own benefit instead. 
It is a pervasive problem and exists in practically every organization whether a business, church, club, or government. Organizations try to solve it by instituting measures such as tough screening processes, incentives for good behavior and punishments for bad behavior, watchdog bodies, and so on but no organization can remedy it completely because the costs of doing so sooner or later outweigh the benefits of the results. 

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