Let’s say that we start a business in Switzerland, where I live (Germany and Austria have the same forms as well). We can choose one of these common business forms as our business structure:
- Einzelunternehmen (Sole Proprietorship)
- Kollektivgesellschaft / Partnergesellschaften (Partnership)
- Gesellschaft mit beschränkter Haftung (GmbH) (Limited Liability Company (LLC))
- Aktiengesellschaft (AG) (Corporation)
The AG and GmbH forms have the right to sell stocks to the public if they list themselves in an exchange. The reason that only these two forms can be listed is that they consider a legal entity, unlike the rest that they are indistinguishable from their owners, that they consider natural persons in the eyes of the law.
All companies can fund their operations through either debt or equity. By selling equity, the owner gives a percentage of ownership on the company to the buyer.
Let’s assume that from 100% of a company, we sell 10%. The owner of 10% has the right to get 10% of the profits. If let’s say we’ve sold the 51% of the company, then the buyer also controls the company. The equity investor, because of his bigger risk, is entitled to be the first who will collect liquidated assets of the company, if the company files bankruptcy, equal to his total investment. This type of ownership is called common stock or common equity. Investopedia defines common stock as…
Common stock represents shares of ownership in a corporation and the type of stock in which most people invest. When people talk about stocks they are usually referring to common stock. In fact, the great majority of stock is issued is in this form. Common shares represent a claim on profits (dividends) and confer voting rights. Investors most often get one vote per share-owned to elect board members who oversee the major decisions made by management. Stockholders thus have the ability to exercise control over corporate policy and management issues compared to preferred shareholders.Common stock tends to outperform bonds and preferred shares. It is also the type of stock that provides the biggest potential for long-term gains. If a company does well, the value of a common stock can go up. But keep in mind, if the company does poorly, the stock’s value will also go down.
The other, a much smaller proportion of the market, type of equity is calls preferred stock or preferred equity. Preferred stockholders are been paid after the loan holders and before the common stock holders. Investopedia, on the other hand, writes about preferred equity…
A main difference from common stock is that preferreds come with no voting rights. So when it comes time for a company to elect a board of directors or vote on any form of corporate policy, preferred shareholders have no voice in the future of the company. In fact, preferred stock functions similarly to bonds since with preferred shares, investors are usually guaranteed a fixed dividend in perpetuity. The dividend yield of a preferred stock is calculated as the dollar amount of a dividend divided by the price of the stock. This is often based on the par value before a preferred stock is offered. It’s commonly calculated as a percentage of the current market price after it begins trading. This is different from common stock which has variable dividends that are declared by the board of directors and never guaranteed. In fact, many companies do not pay out dividends to common stock at all. Like bonds, preferred shares also have a par value which is affected by interest rates. When interest rates rise, the value of the preferred stock declines, and vice versa.
Raising money through debt is a different story. In that case, a simple example will be that we took $1000 from an investor, and we promised to pay back the $1000 with, let’s say, a 10% interest per year in a time-space of 5 years. Debt is a less risky investment, from the investor’s point of view, that equity. Of course, less risk comes hand in hand with less return. A loan comes in many ‘flavors’. A mortgage is a loan that is securitized by a house. A bond is a loan with a specified maturity date. Companies often sell company bonds to finance their operations.
Before an IPO, all the financing activities are held in private. When a private company is ready to sell stocks to the public and to be listed in an exchange, then it goes through a process called IPO or Initial Public Offering. From this point on all the accounting and financial information will be available in public.
The company needs to decide the percentage of the equity that would like to have available to the public. After that decision, the CEO (Chief Executive Officer) and the CFO (Chief Financial Officer) of the company meet with an investment bank, and they will try to ‘sell’ their company. The law and finance team of both sides will then create and file the so-called S1 file (also known as Prospectus). The whole process takes about 12 months.
This file will talk about the risk, opportunities but also all the financial statements of the company that wants to go public. Six mentions…
The principal disclosure items are:
– Risk factors
– Business description
– Information on the supervisory body, the executive management and the auditors
– Financial information
– Capital structure, shares, voting and other shareholder rights
– Overview of capitalisation and indebtedness
– Dividend policy
– Principal past, current and future investments
– Principal shareholders
The investment bank will then decide if it wants to invest in the company and how much will pay per share. This S1 file will be available to the public long before the IPO for the investors to study and make decisions on it.
On the 1st of February 2012, Facebook filed its own S1 file. In this particular S1, the United States Securities and Exchange Commission (SEC) and the Federal Communications Commission (FCC) commented heavily on the file to protect the initial public investors.