How Shares Work
The stock market can seem like legalized gambling from the outside looking in. Even new investors might feel this way. You put money into a company and, bam, they go huge. You make tons of money and you win. You feel like a high roller in Vegas. On the flip side, you can lose. You feel awful on that hung over flight out of Vegas. The truth is that the stock market is not legalized gambling. It is more of speculation. To understand how the stock market is not legalized gambling you need to understand why it exists in the first place.
Companies need money to start businesses. This money is called startup costs. You don’t just wake up one morning and say, “I’m opening a pizza shop, so I’m selling pizzas now.” You need a space, ovens, insurance, employees and on and on. All of these things cost money before you even start to make money. These startup costs get in the way. Now, there are two main ways to get the money for these startup costs: borrow money or sell shares in ownership of the business. Borrowing money is not a good choice because you have to pay that money back with interest.
So, let’s say you like your pets. You like them a lot. So, you decide that you are going to open a pet store. You add up the cost of the space, the costs of goods and you realize that you need $500,000 to start. Then you add up employee salaries, property taxes, and operating costs and you tally $250,000 per year. Then you speculate that you will make about $350,000 a year with the business. Now you understand that you can make up to $100,000 per year with your pet store.
The last thing you want to do is take out a loan to start this business. The bank will take a huge chunk of that $100,000 profit with interest. So, you decide to sell shares of the business to the public. You divide your business into smaller chunks called shares. The beauty of this is that you can set the price of your share. You don’t even need to set the price of the shares at the current value. You can set the price of the shares at a speculated value out into the future and you can dilute the shares down to attract individual investors.
So, you can sell parts of your company to cover the startup costs and promise the investor a guaranteed return. The investor puts down a lot of money for, say, a 10% return. So, if he puts down $250,000 to help cover the startup cost, you would owe him $25,000 when all is said and done. This would be interest-free. Now you can look at the stock market and understand what is going on. Yes, you make money when the business you invest in makes money and that is a gamble. But, it’s less gambling and more speculating.