by Archie M. Richards, Jr., CFP^®
March 14, 2005

Jamie writes, "Could you please go back to the basics. I don't know exactly what a stock is."

Thanks, Jamie. Shares of stock provide a small portion of ownership of a business enterprise. The shares can be transferred easily, and they keep the corporation's creditors from reaching the shareholder's personal assets to repay corporate debt.

Let's say a friend, Tom, wants to open a hamburger stand. Capital is needed. Legal documents must be prepared and signed. A facility has to be built and furnished. A great many goods and services must be acquired before even the first hamburger is sold. Tom puts in his own money. He also asks you to invest $50,000 and offers 25-percent ownership in return. You trust Tom and decide to go ahead.

Tom files with his state of residence to create a corporation, called "Heavenly Hamburger, Inc." A corporation gives limited liability to the shareholders. If the venture fails, you'd lose your $50,000, but the creditors can't come after your other assets to repay the corporation's debts.

The ownership of the company is represented by 1,000 shares of stock. Tom has 750. You have 250. You and Tom are on the Board of Directors, with Tom as President.

The business succeeds. Some of the earnings is reinvested to acquire new stores, making the company even more profitable. Whatever's left over is paid out in dividends, three-quarters to Tom and one-quarter to you.

You and Tom later decide to build hundreds of hamburger stands and need $80 million to do it. The Board of Directors votes to increase the number of shares from 1,000 to 10 million. The purpose is simply to divide the ownership into ten million parts instead of one thousand. Tom owns 7.5 million, and you own 2.5 million.

You hire an investment banker on Wall Street. With the help of brokerage firms throughout the nation, the investment banker sells 8 million shares to the investing public at $10.50 a share, bringing in $84 million. The investment banker and the brokerage firms keep $4 million for themselves - investment banking doesn't come cheap - and the company receives $80 million.

This sale is called an "initial public offering" - IPO, for short. Except for the fees, the money paid by the public goes to the business to fund its growth.

Okay, the investing public now owns 8 million share of stock. Tom and you retain 2 million - 1.5 million shares for Tom and 500,000 for you. The initial price of the stock is $10.50 a share. Your holding is worth over $5 million. Way to go. A year passes. Your company is doing well. The price per share has risen from $10.50 to $15.

Kim, who bought 100 shares of your company at $10.50 a share in the IPO, wants to sell the stock and diversify to a mutual fund. Her holding is worth $1,500, but Kim can't get the money from Heavenly Hamburger, because the $80 million has been spent for expansion. The corporation has cash, of course, but that's needed to operate the business.

To sell her stock, Kim's broker finds a person who wants to buy shares of your company at $15 a share. They make an exchange: Kim's stock for the new buyer's money.

Note that the buyer's money does not go to the company; it goes to Kim. After an initial public offering, the trading of stock takes place among members of the investing public. Called "secondary trading," it has no direct effect on the company.

Most stock trading we read about is secondary trading, not initial public offerings. But without the opportunity to sell in the secondary market, investors wouldn't participate in initial public offerings in the first place. Secondary trading is vital.

Stocks enable investors to own small portions of business enterprises. The shares can easily be transferred, and they keep corporate creditors from reaching the owner's other assets. Nice invention, stocks.