The Blog of Xangis

I recently bought a copy of Peachtree By Sage Pro Accounting 2007, extremely on sale because 2008 was just about to be released. Since then I’ve been entering the scattered check receipts, Excel worksheets, Paypal transactions, and miscellaneous purchases from the past year. I don’t know what surprised me more — what a mess it all was, or how good I was about saving and recording all my receipts.

In the process of entering all of this data in to a real accounting program, I’ve had to classify it more thoroughly than I would have otherwise — both pain in the butt and a good thing. Having an intuitive grasp of where all the money is coming from and where it is going is useful, but seeing it on paper is even better.

Most accounting is pretty straightforward, but one thing that has never “clicked” with me is how the sale of stock in a company and paid-in capital was supposed to work. Even though I have a degree in business (*barely* — it’s a Management Information Systems degree), such a simple concept never really made sense to me. Now it does.

Here’s my best description of paid-in capital:

“Paid-in capital is money that doesn’t cost the company anything other than ownership.”

If a company receives $1,000 in paid-in capital for the purchase of 10 shares of stock, the company doesn’t pay taxes on that capital. The purchaser gets their shares at a cost basis of $1,000.

To get this “paid-in capital” a company has to receive more than the par value of its shares of stock in cash or goods. Since most companies’ stock has either no par value or a miniscule par value, such as $0.001 per share, just about anything received for a share of stock is “paid-in capital”.

OK, so what kind of dummy would pay $10 for something worth a thousandth of a cent? The owner(s) and founder(s) would, of course and so would investors who think the company will be worth a lot more in the future.

Getting this paid-in capital becomes a lot easier when the company has built up some “book value”. If the assets represented by one share of stock are worth $10, it will be a lot easier to get someone to pay $10 for a share with a par value of $0.001 than if the assets were worth $0.001.

It’s even better for the company if the stock is trading on a stock exchange at a value greater than the book value. This will allow them to sell above both book value and par value and raise an even greater amount per share.

The crazy thing about the stock market — and one that a lot of people don’t get — is that if a company issues stock at $10 per share in an initial public offering and the stock later runs up to $50 per share, the company gets no direct benefit. The company’s income doesn’t increase and they don’t get any of the additional value directly.

The secondary market doesn’t have a direct effect on a company until it decides to issue more stock or buy back outstanding shares. It’s then that a company with a $10 book value will be able to sell new shares at $50 each into a market that is trading their shares at $50. If the company has 1000 shares outstanding and issues another 1000, its book value will grow to $30 per share, making the company more valuable. Even though the existing shareholders are having their shares diluted, they benefit from the increased total value of the company as reflected in the book value per share.

In another scenario, if the company’s stock is trading at a price less than the book value, the company would benefit by buying its own shares back off the market. Here’s how it would work:

A company valued at $10,000 has 1000 outstanding shares at a book value of $10.00. If shares are trading on the market at $6 each and the company buys back 500, then the company will have a value of $7,000. When this is divided into the remaining 500 shares, each share ends up with a book value of $14. Although the company has decreased in value, the shareholders benefit from an increased per-share value.

The company can later re-issue these shares, presumably at a higher price due to the increased book value. In this case, if the company reissued the 500 shares at $14 each, the book value per share would remain at $14, while the value of the company would rise to $14,000.

What can really hurt a company is being forced to issue shares when they are trading below book value. Existing shares lose value, AND the company is unable to raise as much money for the sale. This sort of ‘negative dilution’ should be avoided if at all possible.