What it means
When a company is formed, its ownership is divided into shares. Founders hold them at first, and the company can later sell new shares to investors in return for cash, which it uses to grow.
The more shares an investor holds, relative to the total, the larger their ownership. Shareholders have rights, but they come after the claims of lenders and other creditors.
If a business does well, the value of its shares can rise and dividends may be paid. If it fails, shareholders are the last to be repaid and can lose their entire investment, but their loss is normally limited to the amount they put in.
There are different classes of shares. Ordinary or common shares usually carry voting rights and a share of profits, while preferred shares typically pay a fixed dividend and rank ahead of ordinary shares if the company closes.
Some companies issue several classes with different voting power to keep control with the founders. Several terms describe how many shares exist.
Authorised shares are the maximum the company is permitted to issue, issued shares are those it has sold, and outstanding shares are those currently held by investors, which excludes any the company has bought back and holds in treasury. The number outstanding is used to calculate per-share measures such as earnings per share.
Shares can be held privately or traded publicly. A private company's shares change hands through negotiated sales and are hard to value, while a listed company's shares trade daily on an exchange with a visible price.
Listing gives investors an easy way out, but it also brings disclosure rules and regular scrutiny. The nuance is that owning shares is not the same as owning the company's assets.
The company is a separate legal entity that owns the assets, and shareholders own a claim on the value that remains after liabilities. Share prices also reflect expectations about the future, not just the current accounts.
In practice
Real-world examples.
Example
A founder of a small software company sells 20% of the business to an investor in return for $500,000. The company issues new shares to the investor, and the founder's percentage falls but the business has cash to grow.
Example
An employee receives share awards as part of her pay. The finance team records the cost of the awards over the vesting period, and she becomes a part-owner of the company once the shares vest.
Example
A retail investor buys 200 shares of a listed company through a broker. She receives dividends when the company pays them, and can vote at the annual meeting on matters such as electing the board. If the share price later rises, she can sell on the exchange and keep the gain, subject to the tax rules where she lives.
Formula
Calculation
Market capitalisation = shares outstanding x share price
Ownership percentage = shares held / shares outstanding x 100
Suppose a company has 2,000,000 shares outstanding and the share price is $15. The market capitalisation is 2,000,000 x 15 = $30,000,000. An investor who holds 100,000 shares owns 100,000 / 2,000,000 = 5% of the company. The value of the holding is 100,000 x 15 = $1,500,000, which is also 5% of $30,000,000.Case study
Seen in the real world.
Brightpath Foods is an illustrative, fictional start-up with 1,000,000 shares, all owned by its two founders. To fund a new factory, it sold 250,000 new shares to an investor for $2,000,000, or $8 each.
After the sale there were 1,250,000 shares outstanding, so the investor owned 250,000 / 1,250,000 = 20% and the founders together owned 80%. The post-money valuation was 1,250,000 x 8 = $10,000,000.
The founders held a smaller percentage than before, but the value of their stakes was higher because the new cash supported growth. Before the sale, each founder's 500,000 shares were worth $4,000,000 on paper at $8, and afterwards the same shares still carried that value, with a stronger business behind them. The illustrative lesson was that selling shares trades a slice of ownership for capital, and the question is whether the business can use the capital to create more value than the stake given up.
Watch out
Common mistakes.
- Assuming that owning shares means owning part of the company's assets directly, when shareholders own a claim on the company, which owns the assets.
- Confusing the number of shares with their value, when value depends on the price per share and the company's prospects.
- Forgetting that new share issues dilute existing owners, reducing their percentage stake.
Questions
People also ask.
What is the difference between shares and stocks?
In everyday use the words are interchangeable, although stock sometimes refers to ownership in general and shares to individual units.
Do all shares pay dividends?
No, dividends are decided by the board and depend on profits and policy, and many growing companies pay none.
What are shares outstanding?
They are the shares currently held by investors, including insiders, excluding any shares the company has repurchased and holds as treasury shares.
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