In order to invest in shares as part of your personal financial plan, one needs to have a basic idea of what a share is. Here is a short synopsis of this financial asset.
Let’s say an entrepreneur or group of entrepreneurs have started a company. They have used all their own money and have taken all the loans that they can get, but are still short of money to get their company off the ground. The entrepreneurs will look for investors to invest some money in the company. The entrepreneurs receive money from investors and the investors gets a stake in the company profits – a “share”.
The interesting thing about a “share” is that there is no promise that the investor will ever get anything in return. Also, if the company does not end up making profits and goes bankrupt, the shareholders will fall behind the debtholders (the people who gave the company loans) in the bankruptcy process.
Let me explain with an example:
Let’s say that the company goes bankrupt and has R100 in assets and owes R120 to debtholders. Let’s also say that the company received R1,000 from investors when they became shareholders. Even though the shareholders have invested R1,000 there is only R100 of their money left. In the bankruptcy process, the debtholders will get the full R100 (they will lose R20) and the shareholders will get nothing. Shareholders will lose their full R1,000 in “shareholder capital”. If I, as an investor put in R100 of that R1,000, I have lost my full R100, without being able to sue anyone for the money (in most cases).
This is the reason you are at risk of losing money if a company goes bankrupt. When investing in new companies or companies struggling, one must always keep an eye on the risk of this happening.
“If” the company ever decides to distribute some money to investors it pays the investor a “dividend” – a periodic cash payment. The amount of dividend will depend on what percentage of the shares the investor owns. For instance, if the investor owns 10% of the shares, she will get 10% of the declared dividend.
So why would an investor want to invest in a company if they may never get a dividend and they only get the leftovers, after debtholders are paid if the company goes bankrupt?
The secret is that shares are able to be traded in the “secondary market”. The “primary market” is where shares are first issued, the “secondary market” is where the shares can be traded between willing investors. For public companies, this normally happens on a “stock exchange”.
Investors are willing to pay a certain amount for the share of a company. For instance, if a company is doing well and there is a good chance that a substantial dividend will be declared by the company, an investor may be willing to pay for the opportunity to participate in this dividend. They will approach someone who owns shares in the company and offer to buy the shares. They will then become owners of the shares and get their proportional piece of the dividends declared according to their percentage of shareholding.
It needs to be understood that most shareholders do not have a direct say in what the company does with their money. Investors put trust in the “Board of Directors” to look after their interests in the company. This “Board of Directors” are appointed by shareholders periodically, by a vote in a “Shareholder’s Meeting”. If you, as a shareholder, do not like what a company is doing, you can appeal to the Board of Directors to make a change in company policies, but you cannot go directly to management and tell them what to do. You, as a shareholder only have indirect control of the company. The management of the company is responsible to the Board. You can appeal to the Board and the Board, if they agree, can tell Management to make the changes.
Where does debtholders fall into this?
Debtholders don’t have a vote in the running of the company, but they do hold some power in that they can demand their loans to be paid off immediately. This can force a company into bankruptcy, because they may not have the cash available immediately to pay the loan. The company always lives under the threat of this happening, so will look after the debtholders interests, so the company can continue as a going concern.
This is a basic overview of what a share is. There are many other issues involved, such as: how to value shares, corporate governance (how the Board manages the company), difference types of shares, etc. I will cover these in other posts here on mzansifinance.
I hope this helps you if you are looking for a basic understanding of what shares are. Stay tuned for other posts on this topic.