Eli5: why the shareholders in a company are not liable to pay debts owed by the company?


Eli5: why the shareholders in a company are not liable to pay debts owed by the company?

In: 181

Because thats the law, which is made so that people arent afraid to start companies, which is good for the economy.

Shareholders don’t have any of the actual money, or assets of the company, they just own shares.

And unless they own a controlling share, or a significant amount of shares they have no power to make decisions about what the company does.

Basically, under normal circumstances a shareholder is just someone who buys a share of a company, and in reward, either receives a small portion of profits, or just has the ability to sell the share for a profit if it becomes more valuable.

Asking shareholders to pay debts would be sort of like asking employees to pay debts.

Now the real question is why are shareholders and banks paid out when a company goes bankrupt before customers are? Customers who haven’t received a product they purchased are far more deserving of getting their investment back than banks or shareholders who invested knowing there was risk.

The short answer: because legally we decided that was the case. If a shareholder is liable for the debts of the company, it’s either a sole proprietorship (one owner) or partnership (multiple owners). Everything else, essentially, gets that special treatment (corporation, LLC, LLP, etc).

Why is it that way? I’m sure another commenter will have a better historical answer. But generally, the legal protections encourage risk, which does on net create more benefit than harm. We could not have built the society we have on sole props and partnerships, just like we can’t feed the society we have on artisanal local farms.

The idea behind this system is that you should only be able to lose as much as you put in to begin with. So if your shares are worth 1 million, you can’t lose more than 1 million, which of course you would pay by simply liquidating those same shares when the company goes bankrupt.

Of course, this draws the expected criticism that you can lose no more than you put in, but you can gain far more than that…

Answer: This is only partially the case. Debts get paid as a legally higher priority than shareholders. Companies always pay debt obligations before dividends (to shareholders).

If a corporation’s debts default, go to collection, or otherwise get liquidated, all debts get paid before a single shareholder gets a penny. If the company has a negative net value in default, shareholders get nothing. Not a penny, even after every chair and pencil gets sold.

Hypothetical – let’s say a stock is worth $100 in the market and owes $100 on a bond, but runs out of money and gets liquidated for a total of $101 after everything is sold. In that case, bond holders get $100 (fully paid) and shareholders get $1 (and a 99% loss on their taxes). So to be clear, in a failed company, shareholders get meaningfully more screwed than debtors. If liquidation yielded $99, it all goes to bond holders, but shareholders don’t owe the rest (more on that below).

There is anther legal point that applies to shareholders – they’re passive (not involved in operations of the company). As such, they do not have liability beyond the capital they provide (by legal structures). So their losses cannot exceed their investment. So if you invest money passively in a new car company that fails, you lose every penny of your investment, but not your private house and your car itself. This essentially prevents those operating a company (poorly) from treating their shareholders as ATMs.

That’s not to say that there’s never any funny business, but that’s how it’s supposed to work. The timing of debt payments, bankruptcy, and nested legal structures can complicate the base case. I’m not suggesting that outcomes are reliably fair.