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Let's say Business man X is the owner of a private company. At one point, he decides to take the company public by offering stocks (without distributing dividends). As the private company, now public, is anticipated to undergo further expansion, individuals begin purchasing its stocks with the expectation of selling them at a higher price in the future.

Is X essentially receiving free money By Initially selling the stocks to the shareholders ?

Shareholders are making profits by trading the stocks of X's company among themselves, while X only needs to focus on growing the company.

Djebbar Abderrahmene
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    It's not free, there's the ownership part of it – littleadv Nov 22 '23 at 08:41
  • @littleadv yes I know, but it is just a label, the owner of the company will just sell the stocks, without actually paying back the other "Owners" or distributing the profit – Djebbar Abderrahmene Nov 22 '23 at 08:49
  • @littleadv they will just make money by trading the stocks among them – Djebbar Abderrahmene Nov 22 '23 at 08:50
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    The point is that it's not free. The company does give something in return. – littleadv Nov 22 '23 at 09:02
  • @littleadv I understand what you are saying and I agree ,theoretically speaking the company isn't getting free money, because free would mean it isn't providing anything in return but it actually is, However what it is providing is just a declarations of ownership which are just labels which will allow the shareholders to earn money by trading the stocks between them, so practically speaking this is free money. – Djebbar Abderrahmene Nov 22 '23 at 09:46
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    X doesn't get the money from the IPO - the company gets the money. – AakashM Nov 22 '23 at 10:47
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    "the owner of the company will just sell the stocks, without actually paying back the other "Owners" or distributing the profit" this make no sense. If the company issues shares to new shareholders, the company gets the cash, not the owner. – D Stanley Nov 22 '23 at 18:02
  • @AakashM isn't that the same thing ?? if a company gets money, that would mean the company will grow more, which will just increase the profit of the owner. so I think it is actually more than receiving free money, it is increasing the base revenue of the owner for free, am I right ?? – Djebbar Abderrahmene Nov 22 '23 at 19:38
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    @DjebbarAbderrahmene X is no longer the owner, so he doesn't get the profits from the company. It's a trade-off: X gets money but no longer gets future profit. – Christopher King Nov 22 '23 at 20:05
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    "However what it is providing is just a declarations of ownership which are just labels" This isn't true. The shareholders get a voice in the control of the company. Depending on how many shares the owner has retained, the board (who represent the shareholders) may kick X completely out of the company if they are unsatisfied with their performance. Famously this happened to Steve Jobs in his first stint at Apple. Most recently this happened to the co-founder of Uber, and the founder of WeWork. – Charles E. Grant Nov 23 '23 at 04:00
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    @DjebbarAbderrahmene You're overlooking something fundamental, possibly by being fixated on the word "stocks". The directors are selling /shares/ in the company, so each one is by definition worth some fixed fraction of the value of the overall enterprise. – Mark Morgan Lloyd Nov 23 '23 at 08:24
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    @DjebbarAbderrahmene If, by "free money", you mean "the value of the shares go up" then sure, it's "free money". But in reality, the value of a share relates to the perceived competence and performance of the company. The money does not get printed out of thin air. It is given to the share holder in exchange for shares, based on faith in the company. You could certainly build up a fake company, sell your shares and bail before investors figure out that they've been scammed, but it's still not "free" money. It's money taken from investors based on fraudulent promises. – Emil Karlsson Nov 23 '23 at 11:12
  • Does this answer your question? As a small investor, what do we really get while we buy a stock of a company which never pays a dividend? – Grade 'Eh' Bacon Nov 23 '23 at 19:56
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    This is a question about Twitter, right? – aroth Nov 24 '23 at 02:21

5 Answers5

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Common stock in a company represents ownership rights in that company.

If you own stock of a company you become a shareholder with certain rights. Among other things, you are allowed to vote during the general shareholder meeting on the company policy (e.g. who is on the board of directors). You are also entitled to your share of the profits of a company. However, it is up to the general shareholder assembly (or other boards influenced by the shareholders - this may depend on the company's statute or from which country it is) to decide how much of the profits should be distributed to the shareholders.

If profits are retained by the company and not distrbuted to its shareholders, it does not mean the shareholder provides free money because the future value of the company increases through profitable investments of the retained earnings. At least, this is what the shareholders would like to see. Berkshire Hathaway (Ticker BRK.A) is an excellent example of shareholder value creation without distributing dividends.

Another remark. When a company decides to go public, there are at least two different options:

First, the existing owners (your business man X) can decide to sell stock at the stock market to new shareholders. That is, the current owner reduces his or her shareholding and receives the selling price for the common stock. No free money because the existing shareholder gives up some of the ownership rights.

Second, another option is that the company goes public by increasing its equity. In this case, the money from the new shareholders is paid directly into the bank account of the company. Existing shareholders don't receive any money. The number of shares owned by existing shareholders stays constant but the total number of available common stock increases. The existing shareholders now own a smaller precentage of a more valuable company. However, they also don't receive free money.

Finally, there are other types of stock with slightly different rights but at the end of the day they all do not create 'free money' for the existing owners. However, there are a few cases that might come close to that. For example, when the company WeWork tried to go public the first time it used some highly controversial policies to limit the rights of common shareholders which where seen by many as a very bad example of governance. At the end, WeWork failed.

Financial Freedom
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    The original owner can still retain at least 51% of the company, so shareholder votes mean nothing at all. – vsz Nov 23 '23 at 05:23
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    @vsz this might differ depending on jurisdiction, but minority shareholders with a large enough minority can veto at least some decisions. So saying they mean "nothing at all" might be a bit misleading. – Syndic Nov 23 '23 at 09:08
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    @vsz keep in mind that corporate law will typically attempt to protect the rights of minority shareholders. ie: it is typically illegal to act in a way that benefits the majority shareholders to the detriment of the minority. – Grade 'Eh' Bacon Nov 23 '23 at 19:58
  • "No free money because the existing shareholder gives up some of the ownership rights" - Debatable, as giving up say 10% of the ownership rights could have basically zero practical implications for the person who holds the other 90%. – aroth Nov 24 '23 at 02:20
  • @aroth, I am exaggerating, but would you give me 10% of your company (your house, your car) for let's say 1000$? If giving up only 10% has no practical implication, you should be happy to accept my 1000$ of "free money". – Financial Freedom Nov 29 '23 at 22:58
  • You mean the random "company" I have set up for when I take once in a blue moon freelance gigs, which mostly sits around doing nothing? You can have 10% of that for $1000, sure. Be my guest. Bumper profits this year. :) – aroth Nov 30 '23 at 15:04
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The corporate investment bank that facilitates taking the company public is in the best position to get "free money". (Well, it's free in exchange for services rendered, but I digress...)

Say I own Frobozz Inc. and I want to take it public. And say Bank of San Seriffe (BSS) agrees to do the work. Suppose we decide on a million shares, and I'll keep 51%. Then BSS offers 490,000 shares for sale -- but not on the open market. Maybe it's a bunch of telephone calls to interested big players at other institutions. So by opening day, the Illuminati have already carved up Frobozz Inc. and settled on an opening price at which they then offer shares for sale to the general public.

Maybe you're wondering where Frobozz gets anything. Well, in some separate negotiation, BSS deposits $X per share actually sold (which may not have anything to do with the opening price) into an account with Frobozz's name on it. In theory Frobozz can buy back those shares on the open market, but in practice it becomes an operating-capital war-chest for the company.

Remember I said I own Frobozz. Well, that's no longer quite accurate. Now I own 51% of Frobozz. It's still a controlling interest, but it's not mine to do with as I please. In principle I could liquidate the company and keep 51% of the assets remaining after liabilities are discharged, but chances are that would be a losing proposition because otherwise the smart money wouldn't have invested in the first place.

So to finally solve the paradox: Going public is a losing proposition in the short run. I'm giving up more than I'm getting because the investors expect a deal. But I'm also getting something I don't have, which is cash money that I can put immediately towards growing capacity, sales, and hopefully profits. Along with my investors, I am betting that the cash infusion will speed up the company's growth enough to make up for the risk I'm taking.

Ian
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X only gets "free money" if their share of the company is worth more that it was initially sold for.

Say X's company (Y) is worth V and X owns N shares. X's private shares are worth V/N per share. X then sells another N shares to public investors and they also sell for V/N, which the company receives V in cash (V/N per share * N shares).

X now owns 50% of a company that is worth 2V (the V from before the sale and the V received in cash). So X's wealth has not changed. It only changes if the shares are worth MORE than V/N while being traded in the public market.

And X cannot just use the cash for themself. Firstly, it is the company's money, not X's. Secondly, The reason that investors buy the cash in the first place is because they expect X to use it to grow the business. If X uses the money for themself, then the company is not just worth V and the stock (and the investors that bought it) loses half of its value.

Company owners do not get rich just because their company goes public (meaning the IPO money does not go directly to the company owners). They get rich because the company receives investments from the public that allow it to grow (making the owners more money), and provide a way for them to sell their ownerhip on th public market.

D Stanley
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    If going public "makes them rich," they were already rich, just not in spendable terms. Going public just converts one form of wealth into another. There's no magic. – keshlam Nov 22 '23 at 16:13
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Is X essentially receiving free money By Initially selling the stocks to the shareholders?

No, because X does not get the money; his company does. By making the company public, X is no longer entitled to put the company's money directly into his bank account. In fact, he is no longer in control of the company's asset. (If the company has no initial assets, X will get no shares unless he pays for them.)

The only way X can directly get the money the investors paid is to pay dividends (which also gives money to the investors or whoever currently holds the stock).

Christopher King
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  • "No, because X does not get the money; his company does." Yes in the case of an IPO, not true in a direct listing. – ruohola Nov 23 '23 at 12:26
  • @ruohola hmm, I'll try to split my answer into two cases when I get the chance. (For direct listing X still loses the right to future profits, which is the trade-off.) – Christopher King Nov 23 '23 at 16:55
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Yes in essence they are, but with strings attached

An owner could try to convert investments into private profit. But most jurisdictions would consider this fraud. In essence the owner is promising the investors a fair share in the company, most tricks to defraud the investors of their share (in the company and its profits) are illegal.

A company will usually have bylaws which detail what rights shareholders get and what the original owner (majority shareholder) can do with the company. If these bylaws are too unfair to minor shareholders they may be illegal depending on jurisdiction. But even if they are legal, unfortunate bylaws will drive the stock price down. Because who would want to invest in a company which promises nothing in return? The more investors are protected the more they will be willing to spend for a share.

But of course the law has blind spots. So there is a long history of companies who tried to defraud their investors by treating their investments as free money. Some successful and some ending in jail. In essence every stock you buy poses the risk of major shareholders trying to profit of your money. If you don't want to study the law and company structure yourself you will need to trust reviews or the market to spot and call out potentially fraudulent investments.

Falco
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