What are Stocks and why does company issue Stocks?

What are stocks?

Plain and simple, a “stock” is a share in the ownership of a company.  A stock represents a claim on the company's assets and earnings. As you acquire more stocks, your ownership stake in the company becomes greater.

Note: Sometimes different words like shares, equity, stocks etc. are used. All these words mean the same thing.

So what does ownership of a company give you?

Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim to everything the company owns. This means that technically you own a tiny little piece of all the furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company's earnings as well.

These earnings will be given to you. These earnings are called “dividends” and are given to the shareholders from time to time. 

A stock is represented by a "stock certificate". This is a piece of paper that is proof of your ownership. Review some examples of stock certificates throughout the history:
However, now-a-days you could also have a “demat” account. This means that there will be no “stock certificates”. Everything will be done though the computer electronically. Selling and buying stocks can be done just by a few clicks.    

Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, “one vote per share” to elect the board of directors of the company at annual meetings is all you can do. For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run.

The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions.

For ordinary shareholders, not being able to manage the company isn't such a big deal. After all, the idea is that you don't want to have to work to make money, right? The importance of being a shareholder is that you are entitled to a portion of the company’s profits and have a claim on assets.

Profits are sometimes paid out in the form of dividends as mentioned earlier. The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid.

Another extremely important feature of stock is "limited liability", which means that, as an owner of a stock, you are "not personally liable" if the company is not able to pay its debts. In other legal structures such as partnerships, if the partnership firm goes bankrupt the creditors can come after the partners “personally” and sell off their house, car, furniture, etc.  So, owning stock means that, no matter what happens to the company, the maximum value you can lose is the value of your stocks. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets.

Why does a company issue stocks?

Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to "raise money". To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock.

A company can borrow by taking a loan from a bank or by issuing bonds. Both methods come under "debt financing". On the other hand, issuing stock is called “equity financing”. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way.

All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO).

The money a business raises from an IPO comes not from the sale of the actual shares, but from a bank or group of banks that underwrites the offering. Once a market capitalization is determined, the bank lends the business the full amount. The bank, in communication with the SEC, then divides the amount of the loan into shares, which are priced and sold to recoup the principal of the loan. Often, underwriters retain some portion of the publicly traded shares in their investment portfolio.

Subsequent to the IPO, a company may choose to raise additional capital by issuing more shares. This is done through either a private placement or a secondary offering. In both cases, because more shares are created, the percent of ownership in the company represented by each share is diluted. The price of each share in a secondary is determined through a similar process as in the IPO, but dilution in general decreases the value of the initial shares.
In general, there are both certain advantages and disadvantages for the companies to issue stocks. Here are some of them:

Advantages of Issuing stock:
  1. A Company can raise more capital than it could borrow.
  2. A Company does not have to make periodic interest payments to creditors.
  3. A Company does not have to make principal payments.
Disadvantages of Issuing Stock:
  1. The principal owners have to share their ownership with other shareholders.
  2. Shareholders have a voice in policies that affect the company operations.
Debt vs. Equity

It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments.

This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful.


Sources and Additional Information:
http://www.qwoter.com/college/Trading-Basics/why_do_companies_issue_stock.html



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