Before you understand what a stock is, you need to understand what a company is. A company is a legal body, made up of an association of people that conducts business. Because the company has its own legal identity, it can do business in its own name and succeed or fail independently of its owners. Just about every company needs money to get started, operate and grow. One way of getting money is to issue "shares" in the company which gives investors partial ownership of the company's profits and assets. The piece of paper that denotes ownership is called a "stock certificate" – hence the name, stock.
What Is a Share?
Fundamentally, a share is a percentage ownership of a company that people can buy. So, if five founders contributed $1,000 each to start a new company, they each would own a 20-percent share of the company. Companies issue shares in financial terms. For example, if a company needed to raise $5,000, it might issue 500 shares at $10 each. In this scenario, our five founders would each own 100 shares. Most companies only issue shares to the company's founders, managers or a small group of private investors. We call these companies "privately held companies." Public companies, by contrast, sell shares to the public, which gives them access to a large pool of investors if they need to raise cash for expansion and other projects.
What are the Advantages of Owning Shares?
Owning shares in a company comes with certain rights. Primarily, shareholders have a right to the company's declared profits. So, if the company did well and decided to return $100,000 of its profit to shareholders, each shareholder would each get a payout or "dividend" for every share they own. Continuing the example of our fictitious company, the company would pay $200 per share for each of its 500 shares, so the founders would receive $20,000 each. Shareholders also have a right to the company's net worth. If the company went bankrupt or was dissolved, the shareholders would be entitled to whatever was left over after all the company's debts had been paid.
Why Should You Invest in Stocks?
Besides the opportunity to receive regular dividend payments, shares in public companies can be bought and sold for cash on the U.S. Stock Exchange. Shares go up and down in value depending on how well the company is doing and, crucially, stocks have consistently outperformed other investments over the long-term. The Standard and Poor's 500 – an index that tracks how the stocks of certain market-representative companies perform over time – runs at around 10 percent annually, versus an average return for bonds of 5.4 percent and other short-term investments at 3.5 percent. In other words, you'd earn a much better return from putting your money into stocks than just about any other type of conventional investing. While significant gains can happen quickly, more usually, you'll need to give your stocks time to achieve these sorts of returns. Many people use stock investing as a way of saving for future goals like buying a home or retirement.
Should a Small Business Offer Stocks?
All businesses need money at some point or another. Generally, there are two main methods for raising that money: debt, in the form of loans and credit cards, and equity, in the form of selling the company's shares. With debt financing, the company is borrowing money that it has to pay back over time with interest. The company has to make the monthly payment even if it is not trading well and this can impact the company's cash flow. With equity financing, there are no loan payments so there's generally more cash available for projects and growth. The downside is, you're giving away a portion of your company, including a share in the profits, and you'll have to consult with shareholders over major business decisions. Issuing shares are not right for every company. It's wise to discuss the options with an accountant or business attorney before making a decision.