Lena wants a second shop: Lena's bakery is two years old and there is a queue at seven every morning. She and her business partner Marco want a second shop across town, and a third after that.
That needs money they do not have, and it means risking more than the savings they started with. If a new shop fails owing money, the bank can take Lena's flat and Marco's car.
Their accountant suggests a different animal: stop being two people who run a bakery, and set up a company that owns it.
A company is a business that the law treats as a person in its own right (a separate legal entity). It is created by registering it with the state (incorporation). Once Lena's Bakery Ltd exists, it can own the ovens, sign the lease, borrow money and owe money. Lena and Marco own the company; the company owns the bakery.
Four words that come with a company
A share
The company is cut into equal pieces called shares. Lena's Bakery Ltd issues 1,000 shares: Lena takes 600, Marco 400. Each share is a slice of the ownership and a slice of the profit.
A shareholder
Anyone who owns a share. Lena and Marco are the shareholders. A shareholder's say in the company matches the shares they hold: one share, one vote.
Limited liability
If the company fails owing money, a shareholder loses what they paid for their shares and nothing more. The debts belong to the company, because the company is the person that borrowed.
A dividend
The part of the profit the company pays out to its shareholders, so much per share. Profit kept in the business to buy the next oven is not a dividend.
Why limited liability is the big idea: As a partnership, if the second shop failed owing $80,000, the bank could come for Lena's flat (unlimited liability). As Lena's Bakery Ltd, the bank's claim stops at what the company owns. Lena loses the value of her shares; the flat stays hers.
That protection is why the law makes a company register, keep proper accounts and file them. The people who lend to a company need to know that the company, not its owners, is the one they can chase.
A company also does not die with its owners. If Marco leaves, he sells his shares and the company, the lease and the staff contracts carry on unchanged (legal continuity). A partnership would have had to be wound up and started again.
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Lena's Bakery Ltd is a privately held company (a private limited company, with Ltd after its name). 'Private' describes who can own it. The shares are held by a few people, and they are sold privately, to family, friends or business associates. They are never offered to the public and never traded on a stock exchange.
Nobody buys in without a yes: Marco's cousin wants to put in $20,000 for 200 new shares. He can, but only because Lena and Marco agree to it.
In a privately held company, shares can be sold to an outsider only with the agreement of the existing shareholders. Lena and Marco decide who joins them, and nobody can buy control of the bakery behind their backs. That single rule is where most of the advantages below come from.
What it is (features)
- Shareholders have limited liability
- Shares are sold privately to family, friends or associates, not on a stock exchange
- Registered (incorporated), so a separate legal person from its owners
- Owned by a few people, who control who can buy shares
- Not required to publish its accounts
- Profits are shared among a small group of shareholders
What it gives Lena (advantages)
- Limited liability: her flat and savings are protected
- Easier to raise money than a sole trader or partnership: new shares can be sold to investors
- Finances stay private, so the supermarket and Goldcrust cannot read them
- Legal continuity if an owner dies or leaves
- The owners keep control: no takeover threat, because the shares are not traded publicly
- More credibility with banks and suppliers than an unregistered business
What it costs her (disadvantages)
- Less access to finance than a publicly held company: the public cannot buy in
- A restricted number of shareholders, so the money it can raise is capped by who the owners know
- Higher costs and more legal requirements than a sole trader or partnership: registration, accounts, filings
Feature or advantage? Not the same question: 'Owned by shareholders' is a feature: it says what the company is. 'Limited liability protects the owners' savings' is an advantage: it says what that does for them.
Asked for features, describe the company. Asked for advantages, say what the owners gain. 'Owned by shareholders' offered as an advantage is neither one thing nor the other.
Lena's bakery has become a company but stayed a family affair: three shareholders who all know each other, and a bank statement nobody outside sees. If she ever wanted a hundred shops, she would need a different kind of company.
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Goldcrust plc: Across the country, Goldcrust runs 400 bakeries. Anyone with a phone can buy a piece of it this morning: its shares are listed on the stock exchange, and thousands of people and pension funds own them.
Goldcrust is a publicly held company (a public limited company, with plc after its name). 'Public' means the public can own it.
Selling shares to the public is the whole point. When Goldcrust wants $50 million for new ovens, it issues new shares and sells them on the stock exchange, the market where company shares are bought and sold, to strangers rather than friends. No privately held company can raise money on that scale. The price is that Goldcrust must tell those strangers the truth: it publishes its financial statements every year, and anyone, including its rivals, can read them.
How a publicly held company is run
Thousands of shareholders own it
Most have never set foot in a Goldcrust shop. They bought the shares as an investment, and what they want is a dividend each year and a rising share price.
They elect a board of directors
At the yearly general meeting the shareholders vote, one share one vote, for a board of directors. The board sets the direction and appoints the managers.
Managers run it day to day
The chief executive and the managers under the board decide what to bake and where to open. The owners are not in the room.
Any owner can sell up any morning
An unhappy shareholder sells on the stock exchange, to anyone. Nobody at Goldcrust has to agree, or is even told.
This is the split between owning and running (the divorce of ownership and control). In Lena's Bakery Ltd the people who own it are the people behind the counter. In Goldcrust the owners hold shares and the managers hold the keys, and the two groups can want different things: a bigger dividend this year against a new factory that pays off in five.
| Lena's Bakery Ltd (privately held) | Goldcrust plc (publicly held) | |
|---|---|---|
| Who can own shares | Family, friends, associates, with the other shareholders' agreement | Anyone who buys on the stock exchange |
| How much money it can raise | What three people and their friends can put in | Tens of millions, from the public |
| Who runs it | The owners themselves | Managers, under a board the shareholders elect |
| Accounts | Kept private | Published every year for anyone to read |
| Limited liability | Yes | Yes |
| Can it be taken over against its will | No: outsiders cannot buy shares without consent | Yes: a buyer can collect shares until it holds more than half |
The takeover risk: Because Goldcrust's shares can be bought by anyone, another company can buy them, quietly, until it holds more than half. Then it controls Goldcrust, whether or not the board wanted to be bought (a hostile takeover).
A privately held company cannot be taken this way. Its shares are not for sale to outsiders without the owners' consent, so the only way in is to ask.
Owning shares is owning votes. Your share of the votes is your share of the company, so control comes down to arithmetic: your shares divided by the total number of shares, times 100. When Marco's cousin buys his 200 new shares, the total goes from 1,000 to 1,200, and every percentage moves.
| Shareholder | Before (1,000 shares) | After (1,200 shares) | What it means |
|---|---|---|---|
| Lena | 600 of 1,000 = 60% | 600 of 1,200 = 50% | She had majority control. At exactly 50% she can block a vote but no longer win one on her own. |
| Marco | 400 of 1,000 = 40% | 400 of 1,200 = 33.3% | Second-largest holding. With the cousin he reaches 50%: enough to tie Lena, not to beat her. |
| Marco's cousin | none | 200 of 1,200 = 16.7% | A vote and a slice of every dividend, but no control on his own. |
| Majority control | Lena, alone | Nobody: 601 shares are needed | One more share, 601 of 1,200, is more than half. Lena would need to buy one share to be back in charge. |
The three questions the numbers answer: A combined holding. Add the shares, divide by the total, times 100. Marco and the cousin together: (400 + 200) divided by 1,200, times 100 = 50%.
Who controls. The largest shareholder dominates. More than half of the shares is majority control; exactly half is not, because the rest can tie every vote.
How many more shares for a majority. Enough to go one past half. With 1,200 shares, half is 600, so 601: Lena needs one more share. Not 'one more per cent', which at 1,200 shares would be twelve.
So why would Lena ever convert Lena's Bakery Ltd into a publicly held company? For the money. Twenty new shops cost about $4 million, far more than three shareholders and their friends can find. Sell shares on the stock exchange and the public pays for the ovens. Here is what she would gain and what she would give up.
What converting gains
- Shares can be sold to the general public on the stock exchange, so far more capital can be raised
- The existing owners can sell some of their own shares and take money out
- A listed name carries weight with banks, suppliers and large customers
What converting loses
- Control: anyone can buy the shares, so a rival can collect enough to take over (a hostile takeover)
- Privacy: the accounts must be published, so competitors read the numbers
- Freedom: thousands of shareholders expect a dividend every year, and more accounting and reporting rules apply
The trade in one line: A privately held company keeps control and privacy and raises little. A publicly held company raises a great deal and gives up both.
Lena with 50% of a private company decides everything with one more share. Lena with 50% of a listed company can be outvoted the morning a rival buys 51%.
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How this comes up: Short questions first: state two features of a privately held company, or of a publicly held company, for two marks; state two advantages of operating as a privately held company, for two; describe one feature, for two, which means name it and say how it works.
Then the case: explain one advantage and one disadvantage for a named business of converting from a privately held company to a publicly held company, for four.
And with a table of shareholdings: a combined percentage, a comment on who now controls the company, and how many more shares would give a majority.
The four-mark pattern
- Name the advantage. A publicly held company can sell shares to the general public on the stock exchange, so it can raise far more capital.
- Show it in the case. Lena's Bakery needs $4 million for twenty new shops, more than Lena, Marco and their friends can put in privately.
- Name the disadvantage. Anyone can buy the shares, so control can be lost to a hostile takeover; the accounts must be published and shareholders expect dividends.
- Show it in the case. Goldcrust plc has already tried to buy the bakery; once the shares are on the stock exchange it could simply buy them.
Two traps: Feature or advantage. A feature says what the company is: shares traded on a stock exchange. An advantage says what that does for the business: it can raise more money. Asked for one, do not give the other.
No case, no second mark. 'It can raise more capital' is one mark. 'It can raise the $4 million it needs for twenty shops' is two. Every point needs a name or a number from the case.
Explain one advantage and one disadvantage for Lena's Bakery of converting from a privately held company to a publicly held company.
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