8.3. Incorporating a Business

The law views a corporation as a real, live person. Like an adult, a corporation is treated as a distinct and independent individual who has rights and responsibilities. (A corporation can't be sent to jail, but its officers can be put in the slammer if they are convicted of using the corporate entity for carrying out fraud.) A corporation's "birth certificate" is the legal form that is filed with the Secretary of State of the state in which the corporation is created (incorporated). A corporation must have a legal name, of course, like an individual. Some names cannot be used, such as the State Department of Motor Vehicles; you need to consult a lawyer on this point.

Just as a child is separate from his or her parents, a corporation is separate from its owners. The corporation is responsible for its own debts. The bank can't come after you if your neighbor defaults on his or her loan, and the bank can't come after you if the corporation you have invested money in goes belly up. If a corporation doesn't pay its debts, its creditors can seize only the corporation's assets, not the assets of the corporation's owners. (However, see the sidebar "Be careful what [and how] you sign.")

8.3.1. Issuing stock shares

When raising equity capital, a corporation issues ownership shares to persons who invest money in the business. These ownership shares are documented by stock certificates, which state the name of the owner and how many shares are owned. The corporation has to keep a register of how many shares everyone owns, of course. (An owner can be an individual, another corporation, or any other legal entity.) Actually, many public corporations use an independent agency to maintain their ownership records. In some situations stock shares are issued in book entry form, which means you get a formal letter (not a fancy engraved stock certificate) attesting to the fact that you own so many shares. Your legal ownership is recorded in the official "books," or stock registry of the business.

The owners of a corporation are called stockholders because they own stock shares issued by the corporation. The stock shares are negotiable, meaning the owner can sell them at any time to anyone willing to buy them without having to get the approval of the corporation or other stockholders. Publicly owned corporations are those whose stock shares are traded in public markets, such as the New York Stock Exchange and NASDAQ. There is a ready market for the buying and selling of the stock shares.

The stockholders of a private business have the right to sell their shares, although they may enter into a binding agreement restricting this right. For example, suppose you own 20,000 of the 100,000 stock shares issued by the business. So, you have 20 percent of the voting power in the business (one share has one vote). You may agree to offer your shares to the other shareowners before offering the shares to someone else outside the present group of stockholders. Or, you may agree to offer the business itself the right to buy back the shares. In these ways, the continuing stockholders of the business control who owns the stock shares of the business.

8.3.2. Offering different classes of stock shares

Before you invest in stock shares, you should ascertain whether the corporation has issued just one class of stock shares. A class is one group, or type, of stock shares all having identical rights; every share is the same as every other share. A corporation can issue two or more different classes of stock shares. For example, a business may offer Class A and Class B stock shares, where Class A stockholders are given the vote in elections for the board of directors but Class B stockholders do not get a vote.

State laws generally are liberal when it comes to allowing corporations to issue different classes of stock shares. A whimsical example is that holders of one class of stock shares could get the best seats at the annual meetings of the stockholders. But whimsy aside, differences between classes of stock shares are very significant and affect the value of the shares of each class of stock.

Two classes of corporate stock shares are fundamentally different: common stock and preferred stock. Here are two basic differences:

• Preferred stockholders are promised a certain amount of cash dividends each year (note I said "promised," not "guaranteed"), but the corporation makes no such promises to its common stockholders. Each year, the board of directors must decide how much, if any, cash dividends to distribute to its common stockholders.

• Common stockholders have the most risk. A business that ends up in deep financial trouble is obligated to pay off its liabilities first, and then its preferred stockholders. By the time the common stockholders get their turn the business may have no money left to pay them.

Neither of these points makes common stock seem too attractive. But consider the following points:

• Preferred stock shares usually are promised a fixed (limited) dividend per year and typically don't have a claim to any profit beyond the stated amount of dividends. (Some corporations issue participating preferred stock, which gives the preferred stockholders a contingent right to more than just their basic amount of dividends. This topic is too technical to explore further in this book.)

• Preferred stockholders generally don't have voting rights, unless they don't receive dividends for one period or more. In other words, preferred stock shareholders usually do not participate in electing the corporation's board of directors or vote on other critical issues facing the corporation.

The main advantages of common stock, therefore, are the ability to vote in corporation elections and the unlimited upside potential: After a corporation's obligations to its preferred stock are satisfied, the rest of the profit it has earned accrues to the benefit of its common stock.

Here are some important things to understand about common stock shares:

• Each stock share is equal to every other stock share in its class. This way, ownership rights are standardized, and the main difference between two stockholders is how many shares each owns.

• The only time a business must return stockholders' capital to them is when the majority of stockholders vote to liquidate the business (in part or in total). Other than this, the business's managers don't have to worry about losing the stockholders' capital.

• A stockholder can sell his or her shares at any time, without the approval of the other stockholders. However, as I mention earlier, the stockholders of a privately owned business may agree to certain restrictions on this right when they first became stockholders in the business.

• Stockholders can put themselves in key management positions, or they may delegate the task of selecting top managers and officers to the board of directors, which is a small group of persons selected by the stockholders to set the business's policies and represent stockholders' interests.

  Now don't get the impression that if you buy 100 shares of IBM, you can get yourself elected to its board of directors. On the other hand, if Warren Buffett bought 100 million shares of IBM, he could very well get himself on the board. The relative size of your ownership interest is key. If you put up more than half the money in a business, you can put yourself on the board and elect yourself president of the business. The stockholders who own 50 percent plus one share constitute the controlling group that decides who goes on the board of directors.

Note: The all-stocks-are-created-equal aspect of corporations is a practical and simple way to divide ownership, but its inflexibility can be a hindrance, too. Suppose the stockholders want to delegate to one individual extraordinary power, or to give one person a share of profit out of proportion to his or her stock ownership. The business can make special compensation arrangements for key executives and ask a lawyer for advice on the best way to implement the stockholders' intentions. Nevertheless, state corporation laws require that certain voting matters be settled by a majority vote of stockholders. If enough stockholders oppose a certain arrangement, the other stockholders may have to buy them out to gain a controlling interest in the business. (The limited liability company legal structure permits more flexibility in these matters. I talk about this type of legal structure later in the chapter; see the section "Considering Partnerships and Limited Liability Companies.")

8.3.3. Determining the market value of stock shares

If you want to sell your stock shares, how much can you get for them? There's a world of difference between owning shares of a public corporation and owning shares of a private corporation. Public means there is an active market in the stock shares of the business; the shares are liquid. The shares can be converted into cash in a flash by calling your stockbroker or going online to sell them. You can check a daily financial newspaper — such as The Wall Street Journal — for the current market prices of many large publicly owned corporations. Or you can go to one of many Internet Web sites (such as http://finance.yahoo.com) that provide current market prices. But stock shares in privately owned businesses aren't publicly traded, so how can you determine the value of your shares in such a business?

Well, I don't mean to sidestep the question, but stockholders of a private business don't worry about the market value of their shares — until they are serious about selling their shares, or when something else happens that demands putting a value on the shares. When you die, the executor of your estate has to put a value on the shares you own (excuse me, the shares you used to own) for estate tax purposes. If you divorce your spouse, a value is needed for the stock shares you own, as part of the divorce settlement. When the business itself is put up for sale, a value is put on the business; dividing this value by the number of stock shares issued by the business gives the value per share.

Other than during events like these, which require that a value be put on the stock shares, the shareowners of a private business get along quite well without knowing a definite value for their shares. This doesn't mean they have no idea regarding the value of their business and what their shares are worth. They read the financial statements of their business, so they know its profit performance and financial condition. In the backs of their minds they should have a reasonably good estimate regarding how much a willing buyer might pay for the business and the price they would sell their shares for. So even though they don't know the exact market value of their stock shares, they are not completely in the dark about that value.

My son, Tage C. Tracy, and I discuss the valuation of small businesses in our book Small Business Financial Management Kit For Dummies (Wiley). Space does not permit an extended discussion of business valuation methods here. Generally speaking, the value of ownership shares in a private business depends heavily on the recent profit performance and the current financial condition of the business, as reported in its latest financial statements. The financial statements may have to be trued up, as they say, to bring some of the historical cost values in the balance sheet up to current replacement values.

8.3.4. Keeping alert for dilution of share value

Watch out for developments that cause a dilution effect on the value of your stock shares — that is, that cause each stock share to drop in value. Keep in mind that sometimes the dilution effect may be the result of a good business decision, so even though your share of the business has decreased in the short term, the long-term profit performance of the business (and, therefore, your investment) may benefit. But you need to watch for these developments closely. The following situations cause a dilution effect:

• A business issues additional stock shares at the going market value but doesn't really need the additional capital — the business is in no better profit-making position than it was before issuing the new stock shares. For example, a business may issue new stock shares in order to let a newly hired chief executive officer buy them. The immediate effect may be a dilution in the value per share. Over the long term, however, the new CEO may turn the business around and lead it to higher levels of profit that increase the stock's value (see the sidebar "The motivation for management stock options").

• A business issues new stock shares at a discount below its stock shares' current value. For example, the business may issue a new batch of stock shares at a price lower than the current market value to employees who take advantage of an employee stock-purchase plan. Selling stock shares at a discount, by itself, has a dilution effect on the market value of the shares. But in the grand scheme of things, the stock-purchase plan may motivate its employees to achieve higher productivity levels, which can lead to superior profit performance of the business.

Now here's one for you: The main purpose of issuing additional stock shares is to deliberately dilute the market value per share. For example, a publicly owned corporation doubles its number of shares by issuing a two-for-one stock split. Each shareholder gets one new share for each share presently owned, without investing any additional money in the business. As you would expect, the market value of the stock drops in half — which is exactly the purpose of the split because the lower stock price is better for stock market trading (according to conventional wisdom).

8.3.5. Recognizing conflicts between stockholders and managers

Stockholders (including managers who own stock shares in the business) are primarily concerned with the profit performance of the business; the dividends they receive and the value of their stock shares depend on it. Managers' jobs depend on living up to the business's profit goals. But while stockholders and managers have the common goal of optimizing profit, they have certain inherent conflict of interests:

• The more money that managers make in wages and benefits, the less stockholders see in bottom-line net income. Stockholders obviously want the best managers for the job, but they don't want to pay any more than they have to. In many corporations, top-level managers, for all practical purposes, set their own salaries and compensation packages.

  NOTE

  A public business corporation establishes a compensation committee consisting of outside directors that sets the salaries, incentive bonuses, and other forms of compensation of the top-level executives of the organization. An outside director is one who has no management position in the business and who, therefore, should be more objective and should not be beholden to the chief executive of the business. This is good in theory, but it doesn't work out all that well in practice — mainly because the top-level executive of a large public business typically has the dominant voice in selecting the persons to serve on its board of directors. Being a director of a large public corporation is a prestigious position, to say nothing of the annual fees that are fairly substantial at most corporations.

• The question of who should control the business — managers, who are hired for their competence and are intimately familiar with the business, or stockholders, who may have no experience relevant to running this business but whose money makes the business tick — can be tough to answer.

  In ideal situations, the two sides respect each other's contributions to the business and use this tension constructively. Of course, the real world is far from ideal, and in some companies, managers control the board of directors rather than the other way around.

As an investor, be aware of these issues and how they affect the return on your investment in a business. If you don't like the way your business is run, you can sell your shares and invest your money elsewhere. (However, if the business is privately owned, there may not be a ready market for its stock shares, which puts you between a rock and a hard place.)