by Archie M. Richards, Jr., CFP^®
December 24, 2001

Many investors believe that when they acquire the stock of a company on a stock exchange or on Nasdaq, they're benefiting the company directly.

They are not. The money paid for the purchase does not go to the company. But there is an indirect benefit. Here's the story:

Successful companies begin with talent, an idea, a willingness to work, and a fierce desire to succeed. Revenues and profits are delayed. In the meantime, the entrepreneur needs money. She must obtain space to work. She must organize equipment and people. In addition to effort, a great deal of money is required to transform her ideas into profits. The raising of money to build a business is referred to as financing.

The entrepreneur may have money of her own. She also raises funds from relatives, friends, banks, and other sources. Some of the financing is obtained as loans. Other money is obtained in return for partial ownership in the business.

Eventually, to propel the company to a higher level, large-scale financing is needed. This is acquired by selling stock to the investing public, in what's called an "initial public offering," or IPO, for short.

A special kind of broker, called an investment banker, organizes a team of other brokers who tout the stock vigorously to their customers. The investment banker controls the IPO and takes a hefty fee for the service, perhaps 5-to-8 percent, which it shares with the brokers.

The net income from the IPO, probably several million dollars, goes directly to the company. It's used to buy equipment, hire employees, and acquire whatever's needed to make the company grow. This sort of financing also helps the nation prosper.

Let's say you buy shares of stock that are sold in an IPO. A year later, you decide to sell your shares. You can't sell them back to the company. It doesn't have the money. Every dollar raised in the IPO has been spent to build the business.

Through the facilities of a stock exchange or Nasdaq, you therefore sell your shares to another investor. If no one wants to buy the shares at the very moment they're offered, a market maker buys them with his own money and holds them temporarily until someone else steps forward to acquire them. The buying and selling of shares of stock by investors is called the "secondary market" or "secondary trading."

A similar process takes place in the automobile business. Buying a new car from the factory is the equivalent of an initial public offering. When you later want to sell the car, the manufacturer won't buy it back. Instead, you sell it in the used-car market to another member of the buying public. If you don't happen to know anyone who wants to acquire your car at the time, a dealer buys it with his own money and holds it temporarily for sale.

The amount of money engaged in buying and selling stocks in the secondary stock market is far larger than the amount raised in initial public offerings. Almost all of the trading on the New York Stock Exchange, other exchanges, and Nasdaq is secondary trading. The money simply passes among investors and financial institutions. Very little of it serves to buy equipment, hire employees, or build the businesses of the companies whose stocks are being traded. Those business-building activities, which are vitally important to the economy, are financed by IPOs.

Nevertheless, secondary trading is essential. No one would acquire stock in initial public offerings unless they could sell the shares whenever they choose. The secondary market provides this assurance.

About a century ago, Thomas Edison and others sold to the public the stock of a new company called General Electric, to finance the manufacture of electric motors. The only place you'll find the motors is in museums. But the stock sold to the public so long ago still changes hands among investors today.

When you acquire stock in the secondary market, you're not benefiting the companies directly. But indirectly, you're advancing the interests of those companies, and you're advancing America 's interests, too.

Have a Happy and Prosperous New Year!