Stocks are the most common creator of wealth in the United States and - more or less - around the world. You want to have wealth, don’t you? It’s going to be tough to become the world’s first real-life Batman without it.
A share of stock represents ownership in a company. Let’s say you start a chocolate pretzel stand. You need $100 of capital to start it and you have 10 friends who want to invest in you because they think you make the best darned chocolate pretzels this side of 2nd Street. (No one’s going to compete with those 2nd Street pretzels. Let’s be realistic.)
There are a few ways you could structure this investment. Your friends could just give you the money as a loan. They get, say, 10% interest or 10 bucks a year on the $100 (each kid loaning you the 10 bucks gets a buck a year in interest and then gets their 10 bucks back). If the chocolate pretzel stand goes bankrupt, the kids loaning you the money get the wood from the stand, and whatever chocolate and pretzels they can make off with before the rioting starts.
Your lenders sell the leftovers for $100 on eBay and get their money back. You get nothing. Your equity (the overall value of your ownership in a property or company) is wiped out.
If, on the other hand, your business is a huge home run and gets sold to the local grocery store for $10,000, the kids who invested the initial $100 in you as a loan only get back their $100 plus the interest on the bonds (which are basically loans). They would not have benefited from the “upside” gains of your wildly successful company.
They don’t share in the upside because they chose bonds (read: safer but not as lucrative; lower risk, lower reward) as the manner in which to invest in you rather than as an equity investment to buy stock in you (read: a percentage ownership). They likely did not read Shmoop. Boneheads.
Let’s say they HAD read Shmoop Finance and invested in you in the form of stock. The hardest question to answer initially then is “What percentage ownership does our $100 collective investment represent in you?”
In a publicly traded company (one which allows Joe SixPack to buy shares of stock in it), there are already precise ways to determine its value. In the case of a brand new start-up chocolate pretzel stand, it’s much harder to come up with what it’s worth. Calling it “priceless” isn’t going to help you much.
So many entrepreneurs just “make it up.” Let’s say you want to keep things simple and just say “Let’s split it” – meaning you claim that your time and effort and good faith to build a successful chocolate pretzel business is worth $100 alone.
So if you are the entrepreneur taking in $100 in “investment capital” purchased in the form of equity, or as a stock or ownership percentage, then we’d say that your chocolate pretzel company now has a total capitalization of $200.
We started with a made-up number of it being worth $100 – we added $100 of capital in the form of cash from your trusting friends. Their $100 bought half of the company.
Go back to the blow-up example – you go bankrupt and sell your leftover stuff on eBay for $100. In this case, the equity investors own half the company so they get $50 instead of $100. You get $50 yourself for your 50% sweat equity ownership of the company. Sweat equity is where you are given ownership of a company in return for you just working for it, i.e. you didn’t invest your own cash for that ownership.
But what if the chocolate pretzel stand is a huge success? It gets sold for $10,000 three years later. In this case, the investors keep $5,000 – and you keep $5,000.
How do you feel about that?
Likely, you feel great because you just made 5 grand... and you’re a kid. And you totally stole that chocolate pretzel recipe from your grandmother. Not bad. But if you’d taken the money in the form of debt, you would have made $9,900 ($10,000 - $100 in loans). You gave up $4,900 in profits to yourself because you took equity investors instead of just getting a loan.
From the investors’ perspective, they put in $100 and made 50 times their money in 3 years. Awesome. They didn’t have to work for it. They just wrote you a check and played hoops and video games the whole time while you’ve been slaving away in the land of sweet and savory.
Their key asset was that they had the cash handy and they were willing to take the risk investing it in you. If your stand had gone bust, they would have lost everything (or at least quite a bit), whereas you would have just lost sweat. And time.
If you’re the son of a wealthy oil baron (first of all, we would not want to try your pretzels), you likely have a different attitude than if your folks are scrubbing toilets to save money to send you to college. Backgrounds and tolerance for risk is everything in assessing the structure for these deals from the investors’ perspective.