Nov 4, 2014 What you will learn from reading Chapter 2 of “Why Stocks Go Up and Down”
In Chapter 2, readers will learn how and why companies issue their first shares of stock, essentially venture capital, and why investors may want to invest in the company. These early share issues are private offerings, meaning they are not registered with the Securities and Exchange Commission. ( In later chapters, we will see how and why a company does a public offering of its stock. The important distinction between private and public stock will be discussed in detail.)
JMC, the fictitious company we created in Chapter 1, has been a sole proprietorship. i.e. owned by one person, Mr. Jones. With his decision to raise money by bringing in new investors, we will see why it made sense to change from being a sole proprietorship to being a corporation. We will also see how shares of stock are used to reflect each person’s ownership.
My co-author and I have found that explaining the use of stock at this venture capital level, and then having the company grow and eventually “go public”, makes the basic concepts of stock ownership much clearer.
With JMC now incorporated, we discuss annual meetings, directors, voting rights, proxy fights and more. Importantly, we also discuss the difference between the number of shares authorized, the number of shares issued, and the number of shares outstanding. This has been a source of misunderstanding by many new investors. We also explain the difference between retained earnings and cash. Chapter 2 and Chapter 1 are the basics. They prepare readers to get the most from subsequent chapters of this book and other investment material.
Excerpt 1:
Next, he explained the use of stock as a way to reflect ownership in a company. A share of stock is a piece of paper or electronic notation that says the owner of this stock owns whatever portion of the company his or her shares represents. Until now, Jones owned the entire company. Therefore, he owned all the company’s stock; he could have had one share worth the entire company, or two shares each worth 50 percent of the company, or ten shares each worth 10 percent of the company. It made no difference; Jones owned them all, reflecting his 100 percent of the company. Now, he agreed to give up 40 percent of the company to his friends who were investing their money in the company. They decided to draw up 100 shares of stock. Jones would keep 60 shares and each of the four investors would get 10 shares. They could just as easily have printed 200 shares and Jones would have kept 120, and the four investors 20 each. It makes no difference how many shares there are as long as each partial owner of the company has his or her proper proportion.
Excerpt 2:
“Authorized 100 shares” simply means that the stockholders agreed that the company’s ownership may be split into as many as 100 shares.. If the stockholders thought they might want to sell more shares later on, they would first have to vote to authorize or permit themanagement of the company to sell more. To authorize simply means to give permission. It does not require that such shares actually be sold.
“Issued 100 shares” means that at some point in the past the company issued 100 shares. Issued usually means sold, but a company may also issue shares of stock in exchange for assets, or may give shares away – perhaps to employees as part of an incentive plan. Once a share has been issued, it is outstanding and will remain outstanding unless the company buys it back. When a company buys back some of its shares of stock from its shareholders, those repurchased shares are called Treasury shares. Treasury shares do not represent ownership in the company and are not considered to be outstanding.
“Outstanding 100 shares” means that JMC’s ownership is currently divided into 100 shares. If JMC bought back 10 of those shares, there would only be 90 shares outstanding, and JMC ownership would be divided into 90 shares. In this case, the Common stock account on the balance sheet would say: “Authorized 100 shares, issued 100 shares, outstanding 90 shares.”
End of excerpt
The information in these two excerpts is expanded on in Chapter 2, and will be important for other topics later in the book
On a separate note, I think that the founding of a company and early use of stock to reflect ownership, as seen in Chapters 1 & 2, is a good way to introduce business, finance, and capitalism, as well as investments. One of my goals is to write a high school level text explaining business, finance and capitalism so that young people will be educated about the role and mechanisms of capitalism. With this understanding they will be better equipped to understand history and the modern world, and be better able to sort through all the misleading rhetoric, positive and negative, about capitalism. My plan is to use much of the material in the first 8 chapters of Why Stocks Go Up and Down as the beginning of this new book. If anyone would like to collaborate on this project, please contact me through the Contact Us button on our website at www.whystocksgoupanddown.com
Excerpts and comments about the other chapters will be posted over the next few weeks. If you want a preview of what is covered in the book immediately, please visit our website at www.whystocksgoupanddown.com and click on Contents.
For more about investment education, please see the blog on our website at www.whystocksgoupanddown.com
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