Monday, January 31, 2011

Birth of a Business

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Almost every area of study has its specialized vocabulary.  Medicine, law, engineering and science each have special terms.  Although unfamiliar to those outside the profession, they have meaning and significance to those who practice in the field.  The same is true of investing.  Those who want to invest must know the terms used on Wall Street.  For readers familiar with investment/business terms, the following may be tedious, but I have to assume that some visitors to this blog may not understand some or all of them.  Vocabulary exercises tend to be boring, so we'll avoid the dictionary style of defining words.  I started this blog to share information with individual investors.  But, what if I was in it for the money?  The business/investment terms you as an investor must understand will be highlighted in bold in the story below.  Here is how a business comes into being.

Assume I have an idea for a new business.  The only problem is that I don't have enough money to get it off the ground.  I want to run a blog site and charge people a subscription fee to read my blogs.  I will need an office to work in;  a powerful, fast computer to work from; lots of servers to handle the traffic I expect to generate with my blogs; professional help with the design and launch of the site, and employees to keep the site up and running.  All of that takes money, also called capital.  No bank is going to lend me the money to launch my dream.  Therefore, I have to find people who share my belief that the site can make a profit.  They would want to own a piece of the company I want to start; to buy shares of the corporation I will form.  They are providing venture capital for the new business. They agree with me that my blog site will be so informative that it will attract lots of visitors from the web who would pay a subscription fee in order to read my blogs.

There are companies, venture capital firms, who make a business of investing money in start up businesses.  They provide the initial capital to an entrepreneur to get his or her business going.  They make this investment with the goal of getting in on the ground floor of a business which will be so successful that the venture capitalists, or VCs, can sell their shares, once the business is successful, to other investors at a  big profit.  It is possible that some lucky folks gave Bill Gates his start up money for Microsoft.  Too bad it wasn't you or me.  My blog site idea would not qualify as a business that the VCs would be interested in as an investment; it's too small.  So, I contact people I know, asking for the money I will need for my blog site business.  For our purposes, we will assume the needed capitalization to be $5,000.

After badgering my friends and family, I get 5 people to commit to buying shares.  They could be called angel investors, since their money seems almost heaven sent.  However, not everyone is willing to invest an equal amount, in this case, $1,000 from each of the 5 investors to raise the necessary $5,000.  Some are willing to invest only $200, while others may have more money to risk.  I have $1,000 to put into the business.  Having secured investment commitments, I organize a corporation and call it Best Blogs Ever, Inc. We will call it BBE for short.  BBE will issue (sell to the investors) shares of its common stock for $10 per share.  The price per share is called the stock's par value.  Someone with $200 to invest will get 20 shares.  I get 100 shares for my $1,000 investment and so on with each of the other investors.  For their money, the investors each get a stock certificate indicating the number of shares they own in BBE.  The corporate papers I file with the state, the Articles of Incorporation, provide that the company has the right to issue up to 1,000 shares.  Those shares are authorized, but only 500 of them are needed at this time in order to raise the $5,000.  The 500 shares sold by the corporation at $10 each to the investors are now outstanding.  Each investor owns a percentage of the corporation equal to the percentage his or her cash investment represents of the total $5,000 of capital raised.  Since I put in $1,000 of the $5,000, I have a 20% interest in the business and its profits or losses.  The money raised is the equity in the company.  It is invested in, not loaned to, the company.  The company need not pay it back.

With the $5,000 in the bank, the business is ready to go.  The corporation can rent the office, buy the needed equipment, get the blog site up and running and hire employees to keep it going.  My job will be to write those money making blogs.  The capital will keep the company going and pay its expenses until the blog subscriptions start rolling in.  My 5 investors were willing to invest money, but they have no interest in spending time running the day to day operations.  However, they do want to remain involved to a certain extent.  Therefore, the shareholders elect a  board of directors to keep an eye on the company.  Each shareholder has one vote per share, so the person who bought 20 shares gets 20 votes, and I have 100 votes for my 100 shares.  Let's assume that, since I will be involved in the operations, I get elected to the board with two other investors who agree to maintain some level of involvement.  The corporation now has three directors on its board of directors.  The directors elect me to be in charge of the board,  the Chairman of the Board.  The board then elects officers to manage the operations, typically a president, vice president, secretary and treasurer.

The officers may or may not be directors or shareholders, but they are in charge of the business and report the results of the business periodically to the board of directors.  Similarly, the board will inform the shareholders how the business is doing.  The shareholders will want to know if the company is making or losing money and, in either case, what the directors and officers intend to do about it.  This usually happens once a year at an annual meeting of the shareholders.  The officers and directors provide this information to the shareholders in what is called the annual report.  The annual report is usually mailed to all shareholders before the annual meeting so everyone gets the information even if they can not attend the meeting.  At the annual meeting, the shareholders have the right to reelect the directors or, if they don't like how things are going, to vote new ones into office.  They may also vote on any other items of business which require a shareholder vote under the law or for which the directors and officers want shareholder input.  It is, after all, the shareholders' company, and they ultimately call the shots.

Now that BBE has been started, we will follow its progress in the next post.

Feel free to leave a comment by clicking the comments link below.  It is easiest to choose the "Anonymous" profile to send it.  It will be posted within 24 hours of receipt.  I reply to any comments on Fridays and  post on Mondays.



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