What you’re about to read might be what happens when a person watches too much Cake Boss before writing about financial topics. No regrets.

If you or a friend works at an early stage business, you might have heard about equity compensation or stock options. To understand these concepts, let’s start with the basics: stock, shares, and equity. To own a stock is to own a portion of a company’s equity. It means you have certain rights to the company’s assets and profits.

A Business in the Oven

To explain equity and shares further: a silly and tasty example.

Fiona bakes a beautiful cake. The cake becomes famous. It’s so beautiful that people start paying money to see the cake. As it gains popularity, an investor asks to buy a slice of the cake. Fiona could use the money on future frosting, so she says sure. Although the investor owns a slice, the cake does not get physically cut; if cut, it wouldn’t be as beautiful.

Other investors come along and also want slices of her cake. She assigns more slices and receives more money. She keeps over half of the cake ownership for herself. More and more people are paying to come see the cake, which makes the investors happy.

As part of her investor agreement, she updates these investors – the cakeholders – regularly on the cake’s condition. Since Fiona still owns more than half the cake, she makes all the decisions about the business. The investors are just along for the ride.

The slices of cake represent shares or stock of a business. A share and a stock basically mean the same thing. People refer to shares when talking about a specific company, and generally use stock when talking about shares of many companies or an unspecified company.

I own three shares of Coca-Cola.

vs.

I own three stocks: Coca-Cola, Dr Pepper Snapple, and Pepsi Co.

When you own a share of a company, you own one slice of the cake. All slices are equally sized, but you can own more than one.

The Value of Cake

Now for the third part of this equation: equity. Equity refers to the value of the shares that shareholders own. This is found by taking everything the company owns – its assets, including cash – and subtracting the company’s liabilities – debt. #mathmathmath

For Fiona’s cake, she already owned all the ingredients and the oven, so she has no debt. As far as assets, there are two: the cake, the money people spend to see the cake, and the cake’s intangible beauty. How does one value a cake’s beauty? Sure, you could add up the value of all the ingredients in the cake plus the admission profits, but, Fiona argues, that doesn’t represent the full value of the cake’s fame. The intangible value of a business allows business owners and investors some wiggle room in determining a company’s equity value.

To determine share price, take the equity value of a company and divide by the number of shares available. In Fiona’s case, she’s given away 20 equal-sized slices of cake (the shares) and has kept 30 for herself. If her business had an equity value of $1 million, each share of cake would be $20,000.

Why Companies Issue Stock Publicly

After a year, Fiona’s cake investors want to cash out their investment. Fiona decides the best way to do this is to become a publicly trading company, aka launch an IPO. Other reasons companies go public:

• To raise money that will help the business buy things (like new headquarters or another company)
• To reduce debt
• To share the ownership of the company with lots of people, thereby reducing one person’s risk
• To increase the company’s public profile (there are a lot more private companies than public ones)
• If they have over 500 non-accredited shareholders (people with net worth < $1 million) or over $10 million in assets
  • There is a rule that if a private company has over 500 shareholders or $10 million in assets, they must file their financials publicly with the SEC

A Word about Dividends

Dividends are like “thank you for your loyalty” fruit baskets. Except instead of fruit, you get money. Not all companies pay them. Some companies use them to reward their shareholders or to entice people to buy and hold the stock. The dividend payouts could be regularly scheduled payments or irregular; it’s completely up to the company’s discretion. As an individual investor, you will receive dividends even if you only own a stock via an ETF or mutual fund.

RECAP

When you own stock, you own a small slice of a company, otherwise known as a share. Equity is the value of all the company’s things minus any debt it owes. This value can sometimes skyrocket if investors value certain intangibles (like brand value, logo recognition or growth potential) highly. Reasons companies sell stock: to raise money, give existing investors exit opportunities, increase the number of people with ownership exposure.

We’ll leave you with a question. What was more unrealistic about Fiona’s cake business: that the entire business consisted of one cake, or that people paid to SEE a cake rather than EAT it?

You ponder this. We’re going to go find some cake.