How Corporations Raise Cash by Selling Equity
Raising money by selling shares of equity is a little more complicated both in theory and in practice than borrowing money using loans. What you’re actually doing when you sell equity is selling bits of ownership in a company. Ownership of the company is split up into shares called stock.
When you own stock in a company, you own a part of that company equal to the proportion of the number of shares of stock you own compared to the total number of stock shares.
For example, if a company has 1,000 shares of stock outstanding (meaning that this is the total number of shares of stock that make up the entire company) and you own one share, then you own 0.1 percent of that company, including any profits or losses it experiences (because profits belong to the owners of the company).
So when you sell equity to raise cash, what you’re really selling are the rights to a certain amount of control over how the company is managed in addition to your rights to the future profits of that company.
Sell stock to the public
When a company is getting ready to go public, meaning it’s opening up the purchase of equity to the public, it must first put all its records and reports in the proper format. The U.S. Securities and Exchange Commission (SEC) requires that all U.S. public companies follow specific criteria for keeping track of financial information and reporting it to the public.
The company must also meet a number of accountability requirements and other more minor requirements. In other words, before becoming a corporation, a business must act like a corporation. Often this includes hiring a consultant or an investment banker to help make sure everything is in order. Then, finally, the company can go through the process of becoming established as a corporation and selling stock.
The easiest way to become a corporation is to go through a full-service investment bank. Often the investment bank can take a company through all the steps, including legally reorganizing the company as a corporation, registering with the proper regulatory authorities, underwriting, and selling stock on the primary market.
During the underwriting stage, an underwriter evaluates the value of the company and estimates how much the company needs to raise, how much it should raise, and how much it’s likely to raise. That same person verifies that the company meets all the requirements for being a corporation and selling stock. After that, the company can have its first IPO.
An IPO, or initial public offering, occurs when a company sells stock to the public. The IPO is when selling stock actually raises money for the company. After all, the company will use the money that people pay to own stock in the company to purchase things the company needs to operate or expand.
The people who buy stock from the company during the IPO make up the primary market because they take part in the initial sale of stock. After the initial stock is sold to the public, it can be resold over and over again, but the company itself doesn’t make any more money.
The subsequent selling of stock is just an exchange of ownership between investors for a price negotiated between those same investors. The exchange of stock between investors is called the secondary market; it doesn’t raise any more money for the company.
The different types of stock
Like most aspects of corporate finance, stocks come in many varieties, but no matter which type of stock your corporation has, its value increases or decreases based on the performance of your corporation. Here are three of the main stock types, along with their distinguishing characteristics:
Common stock: If you hold common stock in a corporation, you’re a partial owner, so you get to vote in any decisions regarding company policy, the board of directors, and many other issues.
Keep in mind that to be brought to a vote, an issue usually needs to be instigated by one stockholder and then supported by others, at which point a voting form goes out to all stockholders of that company to fill out and return.
Holding common stock also gives you rights to a share of dividend payments (profits returned to the company owners) when they’re issued, although this is optional. In case of company liquidation (selling assets after going out of business), common shareholders get whatever value is leftover after the lenders and preferred shareholders get what they’re owed.
Finally, holding common stock gives you the right to receive specialized reports or analytics from the company.
Preferred stock: If you hold preferred stock in a corporation, you get your dividend payouts in full before common shareholders get even a dime. That holds true for liquidation as well. As with common stock, being a preferred shareholder gives you the right to get information from a company.
But the key difference between common and preferred shareholders is that preferred shareholders don’t have voting rights. So although they have a right to the ownership and success of a company, they have no voice or control over the actions the company takes.
Treasury stock: When a company issues common shares of stock, it has the opportunity to repurchase those shares on the secondary market as any investor would. When a company does so, those common shares become treasury shares. The stock itself hasn’t changed at all; it’s just owned by the company that the stock represents.
So, in essence, the company owns itself, which is only one step away from becoming completely self-aware and destroying us all! Companies tend to do this (buy treasury stock, not destroy us all) because they can generate income in the same way that many investors do, but buying treasury stock also allows them to more effectively manage their stock price.
Another stock-related term you need to know, though it isn’t a type of stock per se, is stock split. A stock split occurs when a company takes all of its common shares of stock and splits them into pieces.
Companies use stock splits to increase the liquidity of stock shares, making them easier to buy and sell and, in the long run, driving up the total value. Note that this process can easily backfire if there isn’t already a demand for a company’s stock from people who would buy it at the cheaper post-split rate.