All companies are cakes. As an entrepreneur, you control what kind of cake your company is. Your company might become the $32,000 cake adorned with Swarovski crystals from the wedding of Stan and Anthony in Sex and the City 2. Or your company could end up being a pile of saltine crackers and rotten beef, arranged in the form of a circle, with frosting on top of it. The type of cake that your company becomes will depend, to a significant extent, on the way that you choose to distribute its pieces.
When an entrepreneur incorporates a business, ownership of that business will be made up of a certain amount of authorized shares. If ownership of a company is made up of 1,000,000 authorized shares, one might say that the company is a cake that is made up of 1,000,000 pieces.
Treasury Stock and Issued Stock
Treasury stock is stock that the company owns but is not necessarily in the hands of anyone in particular. So if the founders of the company take 750,000 shares of the company for themselves, and there are 1,000,000 shares of authorized stock, or pieces, of the company that are in existence, then that means that 250,000 shares of the company are treasury stock. The 750,000 shares of stock held by the founders would be known as issued stock.
If the founders of the company wanted to raise capital for the company, they could do this by selling some of their own shares of issued stock to a new investor and then putting the proceeds of that sale into the company. Any founders that did this would have to give up the shares that they sold to that new investor and the money that was made off of that sale would go towards enriching the company but not towards enriching the individual founder(s) who sold the shares. Furthermore, the founder(s) who sold the stock would need to pay tax on the proceeds of the sale.
The founders could also raise capital for the business by issuing stock, which is currently treasury stock, to a new investor. If the founders did this, the new investor would take shares of the company and the money that the new investor paid for those shares would go directly to the company. If the new investor took 100,000 shares of the company, and the founders still owned their 750,000 shares, then 850,000 shares of the company would be issued stock and 150,000 shares of the company would be treasury stock. It is easy to see why, if the founders want to raise capital for the company, it would be better for them to issue stock, that is currently treasury stock, to a new investor than to sell the stock that they personally own to a new investor.
The founders could also choose to raise funds by taking out loans. However, it is advisable for companies, especially startups, to try to avoid debt. The term capital structure “refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets” and startups should aim to have a capital structure that is free of debt.
Decisions Have Consequences
It is beneficial for a company to be run by people who are happy with what the company is doing for them. Similarly, it is probably true that they quality of cakes positively correlate with how much their bakers enjoy baking. Imagine if a baker baked a cake and then gave out pieces of the cake to people but every time a person received a piece of cake they picked it up out of their plate and smashed it into the baker’s face. That baker might start to dislike baking cakes.
If you are a business owner, you can raise capital by issuing treasury stock to new investors, instead of selling them stock that you personally own or taking out loans which can force you to deal with the problems that can come with debt. By doing so, you can put money into your company without making yourself feel like you are getting a piece of cake smashed into your face. By avoiding that feeling, you can increase the likelihood that your business will become the kind of business that people might compare to a cake from Sex and the City 2 as opposed to becoming a business that people might compare to a circular pile of garbage.
In addition to knowing about treasury stock and issued stock, entrepreneurs should also be familiar with enterprise value. The enterprise value of a company is equal to that company’s equity plus the debt that it owes minus the amount of cash that it currently possesses. An organization’s enterprise value indicates the total cost a buyer would incur by purchasing it. When someone buys a company they need to pay the seller an amount of money that is equal to the company’s equity. Once the buyer takes ownership of the company she will assume the debts that the company owes and will eventually need to pay them off. However, the new owner will be able to use the company’s cash to pay the company’s debts.
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Although you might now know more than you previously knew about distributing shares to investors, current and aspiring business owners can always further enrich themselves by adding to their reservoir of knowledge. If you’d like to find out what you can learn from other entrepreneurs, and if you’re in the Phoenix, AZ area, head to our events page so you can stay notified of future live events from Aha To Exit!