What a share is · RiskAtoms Academy

Know these first

L1.1.03 Primary and secondary markets
L1.4.01 What is a bond?

By the end you will be able to

1Explain the ownership rights a share gives: a vote, dividends when declared, and a claim on what is left.
2Explain limited liability, and why a shareholder can never lose more than they paid.
3Place shareholders in the queue for payment when a company fails.
4Tell an ordinary share from a preference share.

Why it matters

When Enron collapsed in 2001, its shareholders lost almost everything they had invested. Yet not one of them was sent a bill for Enron's debts. Owning a share means you share in the profits and in the losses, but only up to a limit.

Core explanation

A slice of a company

Imagine a baker who wants to open a second shop and needs €100,000. She has two choices. She can borrow the money, as a loan or a bond, and promise fixed repayments. Or she can sell part of the business. If she cuts the business into 1,000 equal slices and sells 400 of them for €250 each, she raises €100,000 and the buyers own 40% of the bakery between them.

Each slice is a share, and its owner is a shareholder. You will also hear shares called stocks or equities. A lender is promised set payments. A shareholder is promised nothing; instead, they own a piece of whatever the business becomes.

What does ownership give you? Click each card.

Limited liability. Suppose the business fails owing more than it owns. Lenders and suppliers lose money. Can they come after the shareholders' homes and savings? No. Under limited liability, the company is a separate legal person. It owes the debts, not its owners. The most a shareholder can lose is what they paid for their shares. That is what “Ltd”, “plc”, “Inc.”, “AG” and “SA” at the end of a company's name tell you.

Limited liability is what lets millions of strangers invest in the same company. Without it, every shareholder would need to check every other shareholder's wealth, and the company's debts, before buying a single share.

The queue. When a company is insolvent and is wound up, its assets are sold and the cash is paid out in a set order. Each group is paid in full before the next gets anything. Shareholders come last. Put the queue in order:

Who is paid first in a wind-up?

0 of 4

Click in order, first to last

Your order

1…
2…
3…
4…

Ordinary and preference shares. Most shares are ordinary shares (called common stock in the US). Some companies also issue preference shares, which sit between debt and ordinary shares:

	Ordinary share	Preference share	Bond
Payments	Dividend if declared	Set dividend, paid first	Fixed coupon, owed
Vote	Yes, usually	Usually not	No
In a wind-up	Last	Before ordinary	Before both
Upside	Unlimited	Capped	Capped

Notice the trade. Shareholders stand last in the queue, but when things go well, all the extra profit is theirs. That is why shares are riskier than bonds, and why investors expect a higher return from them.

The formal version

Definition

An ordinary share is a unit of ownership in a limited company. It gives a residual claim on the company's profits and assets, a vote in proportion to the shares held, and no right to any fixed payment. Its holder's liability for the company's debts is limited to the amount paid for the share.

We can write the residual claim in one line. If a company is wound up and its assets raise $V$ , its debts and other claims ahead of the shareholders total $D$ , and there are $N$ shares, each share receives:

\text{payout per share} = \frac{\max(V - D,\ 0)}{N}

The $\max(\cdot,\ 0)$ means “the larger of the two”. If $V$ is less than $D$ , the payout is zero, never negative. That zero floor is limited liability written as maths. Above the floor, every extra euro of $V$ goes to shareholders.

Try it

Slide the cash raised from the company's assets from zero upwards. Watch the groups fill up in order, and watch your result: the loss stops at what you paid, but the gain keeps growing.

Try itWho gets paid when a company is wound up?

Cash raised from selling the assets£60m

Fenwick Tools plc has 10 million ordinary shares and owes £80m to groups that rank ahead of its ordinary shareholders. You hold 1,000 shares, bought at £3.00 each.

Your 1,000 shares get back

£0

You paid£3,000

Gain or loss−£3,000

Most you can lose£3,000

owed paid left for shareholders

1Secured lenders£30m of £30m£30m of £30m
2Bondholders and other creditors£30m of £40m£30m of £40m
3Preference shareholders£0m of £10m£0m of £10m
4Ordinary shareholders£0m£0m

Groups ahead of shareholders are still owed £20m. Shareholders get nothing, but they do not have to make up the gap: their loss stops at what they paid.

Worked example

Owning part of Kestrel Foods

You buy 500 shares in Kestrel Foods plc, a listed UK food maker, at £4.00 each. Kestrel has 20 million shares. All amounts are in pounds.

What you own, and what you can lose

Step 1 of 6

1
What you paid
$500 \times \text{£}4.00 = \text{£}2{,}000$

Regulatory lens

Because shareholders absorb losses first and are never owed a fixed payment, regulators treat ordinary shares as the strongest form of capital a bank can have. Under Basel III, a bank's Common Equity Tier 1 (CET1) capital is built mainly from its ordinary shares and retained profits, and minimum CET1 ratios are set against its risks. Lesson L1.8.06 returns to capital, equity and leverage.

Sparks

SparkLimited liability is younger than you think

For most of history, owners could be pursued for all of a business's debts. In England, limited liability became widely available only with the Limited Liability Act of 1855 and the Joint Stock Companies Act of 1856. Before that, most companies needed a special charter or an Act of Parliament.

SparkA share is a kind of option

The payout per share,

\max(V - D,\ 0)/N

, has the same shape as a call option on the company's assets with a strike equal to its debt. Robert Merton used exactly this idea in 1974 to value corporate debt, and banks still use models built on it to estimate default risk. Options arrive in L1.7.06.

Key takeaways

A share is a slice of ownership in a company. Nothing is promised to its owner: no fixed payments and no repayment date.
Ordinary shareholders vote, receive dividends when the board declares them, and own whatever is left after all other claims.
Limited liability means a shareholder can lose what they paid for their shares, and no more.
In a wind-up, shareholders are paid last, after secured lenders, other creditors and preference shareholders.
Last in the queue but with unlimited upside: that is why shares are riskier than bonds and expected to earn more.

Reaction

Check what stuck

Question 1 · objective 1

Which of these does an ordinary share normally give its owner?

AA fixed interest payment every yearBA vote, a share of any dividends declared, and a claim on what is left after creditors are paidCA right to have the company buy the share back at the price paidDRepayment of the price paid on a set date

Question 2 · objective 1

A company has 50,000,000 shares. You own 2,500 of them. What percentage of the company do you own? Give the number of per cent.

Question 3 · objective 2

You paid $3,000 for shares in a company. It fails, and its assets fall $5 million short of its debts. What is the most you can lose, in dollars?

Question 4 · objective 3

A failed company's assets sell for €50m. It owes €20m to secured lenders and €40m to unsecured creditors. What percentage of their claim do the unsecured creditors get back?

Question 5 · objective 4

How does a preference share usually differ from an ordinary share?

AIt has more votes and is paid lastBIt pays a set dividend and ranks ahead of ordinary shares, but usually has no voteCIt is a loan that must be repaid on a set dateDIt can only be held by the company's founders

Glossary

Share: One equal slice of ownership in a company. Also called a stock or an equity.
Shareholder: A person or institution that owns shares in a company.
Dividend: A cash payment a company makes to its shareholders out of its profits, when its board decides to.
Residual claim: A claim on whatever is left after everyone with a fixed claim has been paid.
Limited liability: The rule that a shareholder cannot lose more than they paid for their shares, whatever the company owes.
AGM: The annual general meeting: the yearly meeting where shareholders vote on board members and major decisions.
Pre-emption rights: A right for existing shareholders to buy new shares first, so their slice of ownership is not shrunk.
Preference share: A share that pays a set dividend and ranks ahead of ordinary shares, but usually carries no vote.
Insolvent: Unable to pay debts as they fall due, or owing more than the company owns.

Deep Dives & Origins

Deep Dives

Brealey, Myers and Allen, Principles of Corporate Finance, the chapters on how corporations are financed. Beginner.
R. C. Merton, “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates”, Journal of Finance 29(2), 1974. Advanced.

Origins

Brealey, Myers and Allen, Principles of Corporate Finance, McGraw Hill.
Bodie, Kane and Marcus, Investments, McGraw Hill, chapter 2 (asset classes).
Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010 (revised June 2011).
Limited Liability Act 1855 and Joint Stock Companies Act 1856 (UK).

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Securitisation basics

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How companies issue and retire shares