Why Are Stocks Important to Businesses?

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When a company goes public, it means it has decided to sell shares of equity to the public rather than just privately to investors. These stocks are important to the business for a number of reasons, but the decision to go public can also come with risks that are sometimes not worth the benefits to shareholders.

TL;DR (Too Long; Didn't Read)

Stocks are important to a business because they can help the corporation quickly gain a lot of capital, raise the prestige of the company with the public since people can now invest in the company, and allow the initial investors to sell off shares and earn money on their investments.

How Company Shares Work

When companies are first formed, they are almost always privately owned. If and when they become incorporated, this means they will be owned by one or more shareholders, each of whom will own some portion of the company's stock.

Upon incorporation, the corporation must tell the Secretary of State the total number of shares it has authorized to be distributed among the shareholders. These shares indicate a percentage of ownership, and the number of shares a person has in the company will represent his total equity in the corporation. If one person owns over 50 percent of the shares, he is considered the majority shareholder and can make important decisions about the business.

When a company is private, this means that the business owners and investors are the only ones to hold shares, and the value of the corporation and the value of its shares are equal. At the initial meeting, the directors will issue shares to initial shareholders in exchange for money or other investments in the new company to be used as startup capital. This can limit the company's ability to raise capital, as it can only take on loans or take on additional investors in exchange for more shares, which requires the owners to give up more control of their company. This is why most private companies do not take on additional investors once they are fully up and running.

Why Companies Go Public

There are a number of reasons a company may go public, but the two biggest reasons are to raise a lot of money for the corporation and to allow the original shareholders to cash in some of their investments. When a company first goes public, it is known as an initial public offering, or IPO, and this is the only time the corporation itself will actually earn money for the stock. After this, all shares are sold by shareholders themselves in what is called the secondary market (the most basic stock market definition), but the company itself will not get any of the profits.

As a result, many companies go public when they are ready to make a big push, be it a product launch or expansion, and they need additional revenue to support the new move. This can be better than borrowing money because equity does not require interest payments to be made, and the ability to pay off this debt can sometimes limit a company's growth. In fact, equity never has to be paid back at all, although a corporation may wish to buy back its own stock at some point, reducing the amount of public shares.

Alternatively, the company may go public when it is ready to pay off its debts and become more profitable. By going public, the company can also reduce the overall cost of capital, providing it better standing when negotiating interest rates with banks and allowing it to reduce rates on any debt it may still have after going public.

More Reasons to Go Public

Initial shareholders may want to go public, as it allows them to spread the risk of ownership, which means they can sell shares and earn money on their investment with minimal risk to the company.

While shareholders can sell their shares while the company is private, this can cause troubles for the company, as the money may come directly from the corporation itself, or it can result in giving one person a large portion of control in the company.

When the shares are sold publicly, they are usually divided by a number of investors, so if the original shareholders hold on to the majority of their shares, they still retain the majority of power within the company. Plus, simply being in the stock market will often increase the value of shares (and thus the wealth of initial shareholders) simply due to the massive amount of money in the stock market.

Benefits of Stock Exchange Listings

Another benefit of going public is that it allows the company stock to be listed on a stock exchange, which can offer many advantages:

  • Giving the company additional prestige

  • Gaining the ability to offer securities in the purchase of other companies

  • Offering stock option programs to employees. (While this can be done in a private company, having public stock gives a concrete value to these shares, and it means they are easier to sell, both of which make them more valuable to employees.)

  • Providing additional leverage when obtaining loans

  • Obtaining free advertising whenever the stock is mentioned in the news

  • Acquiring increased public credibility and interest since the public can now choose to invest in the business

Risks of Going Public

It is hard to overstate the importance of stock offerings being made public, but there are still some risks, and risks are why many companies refrain from going public.

The biggest downside is by offering to sell off shares to the public, the public will then own a portion of the business. This risk may be minimal if only a small portion of the stock is offered publicly, but if a majority of shares are made public, the company could be subject to a takeover or subject to the whims of the masses.

Additionally, while many companies like to maintain a high level of privacy over their inner workings, in order to have a company publicly listed on stock exchanges, government regulations require that the company open up its books for public review.

Why Are Stock Prices Important?

Many people wonder why a company would even care about the price of its stock if the company cannot directly earn money after its IPO.

For one thing, companies can issue new stock and can buy back stock, so since they can trade their own stock, the value will affect these purchases. Of course, the shareholders who own the company and tend to make most of the major decisions regarding the company's future care about the stock prices because their wealth is directly dependent on the value of the shares.

High stock prices can also result in the company receiving positive press and are often used as validation of the company's leaders and business practices. Finally, stock prices are often viewed as an indicator of a company's financial health, so a high stock value is a good indicator that the company is doing well.