Why do Companies Issue Stock?

Why do companies turn willing to share their profits with thousands of people when they could keep profits to themselves?

At some point or the other every company needs to raise money for its expansion or likewise. In order to raise money the company can borrow it from someone or can raise money by selling a part of the company. The company can borrow money by taking a loan from a bank or by issuing bonds. Both these methods are termed as debt financing where as selling part of the company for raising money is known as issuing stock.

Issuing stock is called equity financing. As it does not require the company to pay back the money or make interest payments along the way, issuing stock is more advantageous for the company. The people become share holders of the company by buying their shares with the hope that the shares will someday be worth more than what they paid for initially. The first sale of a stock is issued by the private company itself. This is called the initial public offering (IPO).

Debt vs. Equity – What is the difference?

The distinction between a company financing through debt and financing through equity is important. You are guaranteed the return of your money (the principal) along with promised interest payments when you buy a debt investment such as a bond. This is not the case with an equity investment. In an equity investment you assume the risk of the company not being successful. Just like a small business owner is not guaranteed a return, in an equity investment, a stock owner has the risk of the company not being successful. This means that you as a shareholder do not get any money until the banks and bondholders have been paid out first if unfortunately the company of which you are a shareholder goes bankrupt and liquidates. This is called absolute priority. Shareholders stand to lose their entire investment if the company isn’t successful and if the company is successful they earn a lot.

This means that there are risks involved. It must be emphasized that there are no guarantees when it comes to individual stocks. There is no obligation to pay out dividends even for those firms that have traditionally given them. It is seen that even though some companies pay out dividends to their investors many others do not. An investor can make money on a stock only through its appreciation in the open market without dividends. Your investment is worth nothing if any stock goes bankrupt. There is also a bright side although risk might sound all negative. You can get greater return on your investment if you take on greater risks. And this is the reason why stocks have historically been more popular than other investments such as bonds or savings accounts. An investment in stocks, over a long term has historically had an average return of around 10-12%.