what is a corporation how does it work

How do Corporations Work? The Basics Regular People Need to Know

If you’re going to invest in corporations through stocks, mutual funds, a 401(k) plan, exchange traded funds (ETFs) or some other means, it’s important to understand the basics of how they work.  In keeping with that theme, the purpose of this article isn’t to provide an exhaustive, technical explanation of what a corporation is and how one works, but to focus on fundamental principles related to corporations that you need to understand so that you can be a more informed, knowledgeable investor (or even a potential business owner!).

A corporation is a separate legal entity

A corporation is a legal entity that is recognized in the eyes of the law.  That is extremely significant, because as a legally recognized entity a corporation has certain rights, such as the right to own property, to open and maintain bank accounts, to hire employees, to protect its rights in court, and so on. With these rights corporations also have responsibilities, such as the responsibility to pay taxes and to otherwise operate within the law.  Finally, a corporation’s ongoing status as a separate legal entity is not automatic.  The owners of corporations must make annual filings, pay fees, and follow certain legal formalities.

The owners of a corporation have limited liability

One of the greatest benefits and protections of investing through a corporation is that it provides limited liability to its shareholders.  In other words, when it comes to the debts or legal liability of a corporation, shareholders are only at risk to the extent of the value of the stock they own.  Said another way, individual shareholders are shielded from the debts and liabilities of the corporation they own.

The fact that shareholders have limited liability does not mean that they (or corporate employees) are exempt from prosecution if they engage in criminal activities.  In other words, people who own and operate a corporation cannot evade taxes, intentionally dump chemical waste in the town water supply, or engage in fraud and the avoid criminal prosecution simply by hiding behind “the company.”  In all such cases the authorities can criminally prosecute those responsible for breaking the law because it’s recognized that you can only put people in prison, not corporations.[1]  Following are some practical examples to illustrate how these principles work.

  1. You sell bananas out of your home as an individual.  If a customer comes over and slips on a banana peel and is injured then you could personally be sued for damages.  In other words, if there was a $200,000 judgment against you then you could stand to lose your savings, home, cars, and other assets.
  2. Assume the same facts as Example #1, except you are the owner of the corporation Deadly Bananas Inc. (“DBI” for short).  In that case the clumsy customer could only name the corporation in the lawsuit, not you personally.  In the unfortunate event that DBI lost the lawsuit and could not pay the full amount, the clumsy customer could not come after your personal assets such as your home, car, savings, investments, etc.
  3. You sell bananas out of your home as an individual.  You place a large order on your personal credit card.  If your business were to fail then you would be personally liable for the credit card balance.
  4. Assume the same facts as Example #3, except this time, as the owner of Deadly Bananas Inc., you get a loan from a bank to purchase a large shipment of bananas.  If the corporation is later unable to pay back the loan then the bank can seek to recover corporate assets to pay it off, but they cannot lay claim to any of your personal assets (assuming you didn’t sign something personally guaranteeing the loan!).
  5. You steal a massive crate of bananas and purposefully set banana peel traps all over town in an intentional attempt to cause chaos, injury and mayhem.  You could be criminally prosecuted for your actions, whether you were acting in your capacity as an individual or as the CEO of DBI.

Corporations have continuity of life

If you run your banana business as an individual, which is technically known as operating a “sole proprietorship,” then the business will die when you do.  Granted someone else could step into your shoes and continue to run the same business, but they would be doing business, signing contracts, and developing customer relationships in their name, not yours.  On the other hand, if you do business as Deadly Bananas Inc. (you really need to do something about that name) then the corporation will live on as a separate, distinct legal entity as long as it makes the necessary legal filings, pays the appropriate fees, etc.  In summary, there are many, many corporations in business today that have long outlived their original owners.

Corporations allow for the easy transfer of ownership

You can easily transfer ownership in a corporation by selling (or giving) the stock in the company to someone else.  Because all of the company’s property, contracts and business relationships are already in the name of the corporation, the business can continue to roll on just as it did before; all that’s happened is that the company has a new owner.  On the other hand, if someone wanted to by your unincorporated, home-based business, then they would have to do so one asset at a time.  And what would you do about liabilities?  For example, what if you had a shipment of 10,000 bananas on order?  Unless you made special arrangements, that order would still be in your name and you would have to pay for it.  But again, if you were incorporated and sold the stock of your company then not only would ownership of the assets transfer with the stock, but responsibility for the debts and other liabilities of the company would transfer as well.

Ownership in corporations can easily be divided

Generally speaking, ownership in a corporation is determined by how many shares you have in the company.  The owners of a corporation have the ability to divide their shares, something that provides them with a substantial amount of flexibility in managing the overall structure of the company.  Following are some examples to illustrate these principles.

  1. A company has 10 shares outstanding, and you own 7 of them.  That means that you own 70% of the company (your 7 shares divided by 10 total shares).
  2. Assuming the same facts in Example #1, you want to sell 1% of the company to 3 different investors.  The problem is that each share of the company has an ownership percentage of 10%.  The solution?  You could increase the total shares outstanding by doing a 10 for 1 (or 10-1) stock split.  That would increase the number of shares you own to 70 (7 shares x 10) and the total number of company shares outstanding to 100 (10 shares outstanding x 10).  Now you could sell one share (each equal to 1% of the company) to 3 different investors, leaving you with 67 shares.
  3. True or false – By increasing the number of your shares you increase the overall value of the company?  The answer is false; stock splits only increase the number of shares outstanding, not the value of the company itself.  For example, if a company is worth $100,000 and there are 1,000 shares outstanding then each share is worth $100 ($100,000 divided by 1,000 shares).  If the company did a 100 for 1 (or 100-1) stock split then the total shares outstanding would increase to 100,000 (1,000 shares outstanding x 100), but then each share would be worth $1 rather than $100.

Stock can be divided into classes

If all a corporation has is “stock” then it is generally considered to be “Class A common stock.”  Each share of Class A common stock has equal voting and economic rights with respect to the company.  But other classes of stock can be created which have different voting and economic rights.  These principles can be illustrated as follows.

  1. A couple wants to give shares in their company to their children, but they want to maintain control of the management of the company.  They create Class B shares and give these to their children.  These shares have equal economic rights to the Class A shares held by the parents, so the children can share in the profits of the company just as if they had Class A shares, but the Class B shares do not have voting rights.  As a result, the children do not have a say on who will be officers in the company, or in other major decisions such as whether the company will merge, acquire, or be acquired by another company, etc.
  2. The owners of a company want to raise additional funds for expansion, but they don’t want to give away a significant amount profit potential in the process.  The owners find a group of investors who want a higher potential investment return than what is offered by interest bearing investments, but they don’t want to take on an excessive amount of risk.  In this case the owners of the company could issue “preferred stock” to the investors.  Generally speaking, preferred shareholders are first in line when corporate distributions are made and are promised a certain rate, but once they receive an agreed upon amount then the rest of the distributions belong to the Class A shareholders.[2]

Corporations can be “publicly held”

One huge advantage of corporations is that they can “go public,” or be “publicly held.”  In other words, corporations can be listed on a public stock exchange such as the NASDAQ or the New York Stock Exchange, which enables the shares of the corporation to be sold to the general public.  And what is the significance of a company being publicly traded?  It means with a little bit of money and a few clicks of a mouse (or a phone call) that you and I can become part owners of any company listed on a stock exchange: Exxon, Walmart, Google, Bank of America, GE, IBM, just to name a few.

While the process going (and remaining) public is long, complicated, expensive, and involves a tremendous amount of work on the part of a company, it also provides extraordinary opportunities.  It gives the owners of the company an opportunity to “cash out,” or to sell some of their stock to the public.  And for the company as a whole, it provides a means to raise capital (which means raising money) from a huge pool of investors in order to fund projects that will (hopefully) further drive the growth of the company.

Corporate governance

The corporate organization provides a framework to govern the affairs of a company so that it acts in the best interests of the shareholders while also being a responsible corporate citizen.  This is primarily done through the board of directors.  The shareholders use their voting rights in the company to elect members to the board who then select a chairman.  One of the main responsibilities of the board is to select a chief executive officer (“CEO”) to run the day-to-day operations of the company as well as to monitor that person’s performance.  Boards of directors generally grant a degree of latitude to CEOs to run a company according to their best business judgment.  However, if the company under-performs for an extended period of time and/or engages in questionable business practices then the board has the power to replace the CEO.

As a practical matter, corporate governance is of greater importance in companies whose stock is widely held by many owners as opposed to a company where stock ownership is concentrated.  For example, if a shareholder owns 75% of a company then they can effectively make all of the decisions: they can elect all members of the board, appoint themselves as chairman of the board, and even appoint themselves CEO.  In addition, no matter how poorly such a “closely held” company performs, the only way a majority owner can lose their job as CEO is if they fire themselves!  On the other hand, at a very large company the CEO may own less than 1% of the outstanding stock.  In such cases the CEO’s performance and the relationship they have with the board of directors is more important and takes on a greater degree of formality.

As a shareholder you generally want a board of directors to take a balanced approach in overseeing the affairs of the company.  On the one hand, you don’t want them so involved that they interfere with the CEO’s running of the day-to-day operations of the company.  On the other hand, you don’t want them to be overly passive either, effectively rubber stamping everything the CEO does and asks for.  Such an approach creates an environment where there is a sense of complacency and a lack of accountability, which is a recipe disaster.  In summary, an effective board is informed and involved, mostly using its position to influence rather than interfere, but also acting decisively when needed to protect the overall interests of the shareholders.

Corporations do NOT have a life of their own

Following on the concept of corporate governance, one final thing I want to point out is that corporations themselves are not inherently good or evil; they don’t make smart or dumb decisions; they don’t hire or fire people; they are neither charitable nor ruthlessly capitalistic.  In fact, corporations don’t make any decisions at all.  Only the people who are part of corporations can do that.

Applying this concept to one of the examples above, was it really “Deadly Bananas Inc.” or, more generally, “The Corporation,” that deviously spread banana peels all over town in an attempt to wreak havoc on the general public?  Of course not, the corporation itself is simply a set of documents locked away in some filing cabinet.  No, the real culprit was the individual(s) at the company who was orchestrating all of the mayhem.  While it may sound obvious that, for good or bad, people are always behind the acts of corporations, I point it out because it’s a frequently overlooked concept.

Summary: Corporations provide a powerful means to do business and to raise capital

In reviewing all of the above characteristics of a corporation it becomes much easier to see why they’re a very attractive means to do business.

  • Separate legal entity – Assets and liabilities can be in the name of the company.
  • Limited liability – Shareholders are not personally liable for the actions and debts of the company.
  • Continuity of life – A corporation can exist indefinitely.
  • Transferability of ownership – Shares of a corporation can be transferred, bought and sold.
  • Division of shares – Ownership in a corporation can be divided in an infinite number of ways.
  • Corporate governance – Corporations have formal processes to appoint officers and to oversee the business.

For all of the above reasons, a business organized as a corporation has intrinsic value.  In other words, even if a corporation had no assets or liabilities, meaning that it was just a shell company, it would still have value in and of itself because it’s organized in a manner that’s extremely effective for doing business…it just needs someone to pull the switch to get the business going.  And it’s for all of these reasons that in terms of assets owned, goods and services produced, and people employed, the corporation is the most dominate form of business in the United States (and the world!).


[1] While this is true, it’s also important to note that a corporation as a separate “person” can get hit with legal, administrative and operating sanctions that can hamper its ability to do business.  For example, if an oil company has a major industrial accident then the corporation can be hit with fines and/or lose the right to drill in certain areas.  In extreme cases a company can even get shut down altogether.

[2] I will write about preferred stock in more detail at a later time.  The point I am trying to illustrate for now is that a corporation’s stock can be divided into classes.

Start a 401k plan

Starting A 401k – Everything You Need To Know

The employees or workers think about their accounts of 401K to be the essential part of the package of compensation. The principle behind 401K account is that cash or money overdue from the yearly revenue is invested in the publicly traded finances for disbursement on the retirement. You require adding the accurate amount of the cash to the 401k account to get the advantage of the benefits.

Starting A 401k- Adding Money to Your 401k Account

  • Make the automatic payroll deduction to the 401K in order to include the funds during every period of pay. The company sponsored plans of 401K don’t allow the workers to include cash to the accounts of retirement by check, funds transfers or the credit card.
  • Calculate the deferment amount from every check of pay, which will not be available for you to spend in the near future.  This requires making budget for the month, which accounts for the 401k, the savings and the other tools of finance. The 401K account must form the majority of the retirement investments in the given monthly.
  • You should review every plan of investment your company sponsors for the plan of 401K. Most of the workers choose the conservative cash market account which is low danger however offers the steady return over longer time. You must look very closely at the riskier imitative or the index based programs. Even though they provide opportunity for the high returns, there’s an opportunity as well of losing the investment.
  • You should cut the yearly deferrals of 401k from the annually income if you use the contributions of pre tax. And if you really submit two thousand dollars to the plan of 401k and you really make the thirty two thousand, the burden of tax for this fiscal year is really calculated on the income of the thirty thousand dollars.
  • You should save your family members from the high taxes in future by just investing in the after tax IRA accounts. And these accounts need taxation on approximately all the deferred revenue however offers the withdrawals, which are tax free from principal amount on the retirement.
  • You should ask the benefits manager of company about matching the funds for the account of 401k. The workers provide contributions to the retirement accounts of employee as the enticement for investing in future. If provided a choice then you must select the level of proportional contribution where you really supply the funds at the specific percentage of the investment. When adding money to your 401k you must keep all these upper mentioned things in your mind.

Stock Valuation – How To Value A Company

Stock Valuation – The Relationship Between A Company’s Stock Price and Cash

In another article titled Companies To Invest In, I made the point that, at its core, a well-run company is simply a money making machine.  That concept – that the value of a company is ultimately tied to cash – is one of the keys to understanding how to value a company and it’s relationship stock price.  Stock valuation are great to get quick snapshot of a company’s value.  I’ll illustrate this point with a simple example, and then build on it in ensuing articles.

How To Value A Company – Cash Per Share Example 1

If there were a company that had $1,000 in cash with 100 shares of stock outstanding then you could calculate the value of each share of stock as follows.

Stock Valuation Cash Per Share Example

How To Value A Company – Acquiring 20% Ownership Example 2

If that were the case and you wanted to own 20% of the company then how much stock would you have to buy, and how much would it cost?  The answer is that you would have to pay a total of $200 for 20 shares of stock, which can be calculated as follows.

Stock Valuation Ownership Example

How To Value A Company – 10:1 Stock Split Example 3

What if the company did a 10 for 1 stock split, meaning instead of having 100 shares outstanding, it had 1,000 shares outstanding?  Would that change the value of the company?  The answer is no.  The company’s only asset is $1,000 of cash, and no amount of stock splitting (or combining) can change that.  However, by doing a 10 for 1 stock split the value of each individual share is diluted, going from $10 to $1 per share.  So in summary, a stock split affects the value of each share of stock, not the value of the company itself, which can be illustrated as follows.

Stock Valuation Stock Split Example

Now, what if our little company went public and was traded on the New York Stock Exchange?  Wow, that’s big time!  Wouldn’t that would boost its stock price above the $1 it’s now trading at after the stock split?  Not at all!  The stock could be traded on the moon, and that still wouldn’t alter the fact that the total assets of the company are worth $1,000, making the value of each of those 1,000 shares equal to $1.

How To Value A Company Using The Terminal Valuation Method

But wait, isn’t just focusing on a company’s cash overly simplistic?  After all, there’s no company of any size or consequence whose only asset is cash.  While that may be true, at the end of the day, determining how to value a company is ultimately measured in money (or cash) – nothing else.  This is known as the terminal value of a company.

The application of this concept is known as the Terminal Valuation Method.  To illustrate how it works, say a company’s stock price is trading at a value that suggests the total worth of the company is $10,000,000.[1]  How can you tell if this stock valuation is reasonable?  One way to go about it is by to pretending that the company sold everything off: its inventory, furniture and fixtures, real property, and so on, until it converted all of its assets to cash.  After going through exercise you estimate that upon liquidating all of its assets and settling all of its outstanding debts (or “liabilities”) that the company would end up with $4,000,000.

“It’s Important To Note Stock Valuation Can Vary Greatly Depending On A Number Of Factors Such As: Industry, Maturity Level of Company, Ect.”

What…$4,000,000?  Didn’t we say that the value of the company’s stock suggested that it was worth $10,000,000?  Does this mean that the company’s stock price is vastly over inflated relative to its true worth? Perhaps, but not necessarily.  For example, aside from tangible assets (assets that you can touch) that could be converted into cash, an established company might have valuable intangible assets that would substantially contribute to its ability to make money: established business relationships, a highly skilled workforce, an efficient supply chain, secret formulas and patents, widely recognized brands and trademarks, etc.  In short, there can be a lot more to the value of a company than just its “hard assets” such as cash, inventory, property, etc.

However (and this is a BIG however), if a company is being valued at $10,000,000 and yet it would only be worth $4,000,000 upon liquidation, there still has to be a financial explanation for where that remaining $6,000,000 of value is coming from.  In other words, what is it about the company that makes it worth more than sum of its tangible assets?  If there is a compelling story there – a story that explains how the company’s business prospects, activities and operations are worth an extra $6,000,000 – then the stock valuation of the company can be justified.  If not then the company’s stock price is being pumped up by hype and hot air.

Summary

While it’s true that you cannot you cannot fully measure the value of a company based on its hard assets (cash, inventory, buildings, etc.), it’s also true that a company’s value is ultimately measured in dollars.  That means when it comes to a company’s stock valuation, cash is king!


[1] This would be the case if, for example, a company’s stock was trading at $50 a share and there were 200,000 total shares outstanding ($50 x 200,000 shares = $10,000,000).

Actively Managed Funds vs. Index

Index Funds Consistently Outperform Actively Managed Funds

A recent survey once again shows what has long been the case, that index mutual funds consistently outperform actively managed mutual funds (see below).  So if that’s the case then why do so many people invest in actively managed funds?

5 Common Reasons People Fall For Actively Managed Funds

Reason #1 – Ignorance

Some people simply do not understand the long-term performance of index mutual funds handily beats that of actively managed mutual funds.

Reason #2 – Sales Efforts

Firms make much more money off of actively managed mutual funds, often 1%-2% of principle per year vs. 0.18%-0.25% for many index funds.  As a result firms put relentless efforts behind selling actively managed funds (with great success!)

Reason #3 – Greed/Temptation

By definition you can’t beat the market if you’re in an index fund designed to mirror the market.  What are you, some kind of wimp?  And so people pour billions into actively managed funds only to see their returns lag year after year.

Investor Pride – This is a close cousin of “greed/temptation.”  Here’s how the story goes.  Yes, there are lots of lousy actively managed mutual funds out there, but by virtue of your penetrating insight you are smart enough to pick a fund that will beat the market…and that’s how the train wreck begins.

Reason #4 – Fund Manager Pride

So despite the sub-par performance of actively managed funds, show me one that doesn’t have a fund manager that thinks they can be the market every year.  If you can find one then I would love to see what the marketing material looks like, “Invest with us – we guarantee we’ll charge you more and underperform relative to the market in the process!”

Reason #5 – Performance Chasing

Maybe you’ve had a reality check and realize if you’re like most regular you can’t consistently beat the market (but don’t worry, the pros can’t either).  But wait, you don’t have to be smart enough to beat the market, right?  You’ll just find some mutual fund rankings and pick the ones that performed the best last 1-3-5 years, right?  That’s called performance chasing, which is another name for buying high and often selling low (instead of the other way around!).

Low Cost Index Funds are the Best Long-Term Investment Strategy

So what’s the solution?  What’s a good investment strategy for regular people?  Unless you’re able buy stock or another investment at an amount that’s comfortably below the market price (such as pre-IPO stock) then you’re best bet for the long-term is to invest in low-cost index funds (view Best Vanguard Funds for specific recommendations).  It may not get you riches anytime soon but hey, slow and steady worked out pretty well for the tortoise!

How to Invest in Stocks

Learning How to Invest in Stocks 101

Regardless of how many Wall Street films you have seen in the past, stocks and shares is not an easy topic. Those who are searching online for resources on how to invest in stocks for beginners or with little money thinking that they will “certainly” become the next overnight millionaires should, first and foremost, receive a word of warning: Yes, some people can really get rich overnight playing with shares at the stock exchange market; however, but that happens once a blue moon. Every person willing to dip a toe in the world of stocks investment should, at the very least, get prepared first and —as if you were playing chess— think his moves twice beforehand to prevent regrets after.

That being said… How to invest in stocks?

First Things First: Get Informed

Before spending one penny in a stock market, the first thing you should do is to get informed. Let’s ask a few questions so you can ask yourself if you know the answers:

  • Do you know what a stock is, and how they are currently stored?
  • How many kinds of shares are there, and which of them you can buy?
  • Do you know what a stock broker is? Have you found any for yourself already?
  • Lastly, have you spoken with your accountant about the financial and tax consequences (if any) of becoming a stock investor?

If you do not know the answer to any of these questions, then please let me suggest you the following readings:

  • Investing articles on stocks and the stock market could be a reasonable starting point.
  • The Beginners’ Guide to Investing, by the American Securities and Exchange Commission can provide you a more specific introduction to the topic.
  • Investor’s glossary page can help you clear your doubts.
  • Lists of stock brokers such as this one by Nasdaq can help you find a reputable stock trader for your assets.

Learning How to Invest in Stocks

Next, choose how you will invest in stocks

Once you have covered the basics and feel better informed to start investing, you need to find out a way to do it suitable for yourself and for your money.  There are many options and approaches for this, yet, for beginners, I like to keep things simple. Remember the goal is to make money, and that you have basically two ways to get it with stocks:

  • You either buy stocks to resell them after a short time.
  • You buy stocks to expect a profit sharing payment or resell them after a longer term.

In both cases, your goal will be to make more money from what you invested, a profit.

What are the best stocks to invest in?

The best stocks are on companies or markets you understand, so this answer will depend strongly in your background. Let’s try to make it clear with an example, anyway:

Let’s say someone offers us stocks from an ice-cream company… would you buy them? An uninformed person may go buy them just because “heard” those shares are “about to go up”, and that “it is the exact moment to buy them.” Someone who understands the ice-cream market, however, would pause for a moment and think: Ice-creams are mainly sold in summer. During the winter, their demand falls down. The wisest move would be to buy the stocks in winter, when demand is low and prices go down; and to sell them in spring or at the beginning of summer, when demand goes up and so do prices.

After learning how to invest in stocks, remember knowing the market you are about to invest in will help you get a better understanding of when to buy or sell your stocks.

Certainly, your stock broker should advise you about your investments too.