From the shareholders’ perspective, they make a one-time purchase that can potentially make them massive profit with minimal effort on their part, but for the company, isn’t that like taking out a high-interest loan that they can never pay off? Wouldn’t an actual loan be better if they just need money?
In: Economics
When a company sells stock, it’s essentially selling small pieces of itself to the public or investors. This is done for a few key reasons:
1. Raising Capital: Selling stock is a way for a company to raise money without taking on debt. This money can be used for various purposes like expanding the business, research and development, or paying off debts.
2. Sharing Risk: By selling stock, a company spreads the financial risk of the business among a larger group of shareholders. This can be especially appealing in industries where the financial risks are high.
3. Employee Incentives: Companies often use stock as a way to attract and retain employees. Employees might be offered stock options or shares as part of their compensation package.
4. Public Profile: Going public and selling stock can increase a company’s visibility and prestige. This can help attract more customers and business partners.
5. Exit Strategy for Founders: For the original owners or early investors, selling stock in a public offering can be a way to cash out some of their investment and reward them for their early risk.
Selling stock is a significant decision for a company and comes with both benefits and responsibilities, like the need to disclose financial information and be accountable to shareholders.
Why not a loan?
1. No Repayment Obligation: When a company sells stock, it doesn’t have to repay the capital it raises, unlike a loan which must be paid back with interest. This can be less burdensome, especially for growing companies that might not have stable cash flows.
2. Again, Sharing Risk: Equity financing (selling stock) spreads the financial risk of the business. Shareholders bear part of the risk if the company doesn’t perform well. In contrast, debt must be repaid regardless of how well the company does.
3. Less Impact on Cash Flow: Loan repayments can strain a company’s cash flow. Equity doesn’t require regular payments, allowing the company to use more of its revenue for growth and other operational expenses.
4. Access to Large Amounts of Capital: For many companies, especially large ones, the amount of capital that can be raised through equity can be substantially higher than what can be borrowed.
Whether it’s “high-interest” depends on how successful the company ends up being.
Let’s say you’re opening a restaurant and need $1,000,000 to buy cooking equipment before you’ll be able to serve any food to customers, and there are two available options for funding:
* Option 1 (loan): An investor offers you $1,000,000 now, in exchange for you promising to pay them $200,000/yr for ten years. Five years later there’s a global pandemic and you don’t sell any food that year, so you end up having to sell off the cooking equipment in order to pay your investor their $200,000. Your restaurant goes out of business.
* Option 2 (stock): An investor offers you $1,000,000 now, in exchange for you promising to pay them 50% of your future profits. Five years later there’s a global pandemic and you don’t sell any food that year, so you don’t owe the investor anything that year. Your restaurant survives.
Sure, if your restaurant ends up wildly successful, you may regret having promised to give the investor 50% of your profits. But the restaurant is more likely to *become* successful in the first place if you choose Option 2 than if you choose Option 1.
“The company” is not an entity on its own, it isn’t like “the tree that owned itself”. It started out with one or more owners and those owners can have a variety of reasons to sell shares of ownership. Selling stock can provide more funds to a company than they could ever borrow, and increase the value of the owner’s remaining shares. Or perhaps the original owner just wants to cash out and realize the value of some of their shares.
Banks don’t like giving high risk loans. If you want to open a restaurant, they want to see a business plan, they can compare it to other restaurants in the area, see if it makes sense, evaluate the risk. If you want to develop property, they can look at what similar houses sell for, look at size of development, see if it all makes sense. If either of these businesses fail, the can reposes the equipment and property.
But something high risk, like developing a new type of software, the bank has much less idea how much the product will be worth, if it fails, they have no idea how to reposes the source code and sell it. Also, it will take years for software to be ready, so no way to make loan payments. So the bank just isn’t interested in making the loan.
See as how this is the ELI5 subreddit, I will try to use simpler terms than the very thorough and detailed explanations that others have posted.
In essence selling stocks is a way to raise capital other than through selling products. For many startups, stocks may as well be their main product, since their real products might not be viable/competitive/turning a profit yet. Stocks are in the end just a piece of paper that promises a pay-out at a later date *if* the line goes up. If prices plummet and stockholders are left holding the bag then tough cookie. But investors dreaming of cashing out and so there will always be enough money rolling in through stocks. This is one of the unavoidable and likely necessary inventions of the capital market.
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