How Stocks Work

Corporations

Any business that wants to sell shares of stock to private or public investors needs to become a corporation first. The legal process of turning a business into a corporation is called incorporation.

If you start your pizzeria with your own money (even if it's borrowed from the bank), then you've formed a sole proprietorship. You own the entire restaurant yourself, you get to make all of the decisions, and you keep all of the profits. If three people pool their money together and start a restaurant as a team, then they've formed a partnership. The three people own the restaurant themselves, sharing the profit and decision-making.

A corporation is different, and it's a pretty interesting concept. A corporation is a "virtual person." That is, a corporation is registered with the government, has its own Social Security number (called a federal tax ID number), can own property, sue and make contracts. (It can also be sued.) By definition, a corporation has stock that can be bought and sold; all of the owners of the corporation hold shares of stock in the corporation to represent their ownership. One characteristic of this "virtual person" is that it has an indefinite and potentially infinite life span.

There is a whole body of law that controls corporations. These laws are in place to dictate how a corporation operates, how it's organized, and how shareholders and the public get protection. For example, every corporation must have a board of directors. The shareholders in the company meet every year to vote on the people who will "sit" on the board. The board of directors makes the decisions for the company. It hires the officers (the president and other major officers of the company), makes the company's decisions and sets the company's policies. 

Consider the board of directors as the virtual person's brain: Even if a corporation has a single employee who also owns all of the stock in the corporation, it still has to have a board of directors.

Another reason that corporations exist is to limit the liability of the owners to some extent. If the corporation gets sued, it's the corporation that pays the settlement. The corporation may go out of business, but that's the worst that can happen. If you're a sole proprietor who owns a restaurant, and the restaurant gets sued, you're the one being sued. "You" and "the restaurant" are the same thing. If you lose the suit, then you can lose everything you own in the process.

A Stock Exchange

Let's get back to our pizzeria example. If you want to launch one and are interested in recruiting a pool of investors, where would you find these people? You could place an ad in the paper or online, or you could simply contact friends and family. But what if some of your initial investors decide a year later that they want to sell their shares? They would each have to go out and find a new buyer, which might prove difficult, especially if the company isn't performing very well.

A stock market solves this problem. Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange). The New York Stock Exchange (NYSE) is an example of such a market. In your neighborhood, you have a "supermarket" that sells food. The reason you go the supermarket is because you can go to one place and buy all of the different types of food that you need in one stop -- it's a lot more convenient than driving around to the butcher, the dairy farmer and the baker. The NYSE is a supermarket for stocks. The NYSE can be thought of as a big room where everyone who wants to buy and sell shares of stocks can go to buy and sell.

Modern stock exchanges make buying and selling easy. You don't have to actually travel to New York to visit the New York Stock Exchange. You can call a stock broker who does business with the NYSE, or you can buy and sell stocks online for a small fee.

There are three big stock exchanges in the United States:

NYSE - New York Stock Exchange

AMEX - American Stock Exchange

NASDAQ - National Association of Securities Dealers

If these exchanges didn't exist, buying or selling stock would be a lot harder. You'd have to place a classified ad in the newspaper, wait for a call and haggle on a price whenever you wanted to sell stock. With an exchange in place, you can buy and sell shares instantly.

Stock exchanges have an interesting side effect. Because all the buying and selling is concentrated in one place, and since it's all done electronically, we can track the constantly fluctuating price of a stock in real time. Investors can watch, for example, how a stock's price reacts to news from the company, media reports, national economic news and lots of other factors.

For example, all publicly traded companies need to issue quarterly earnings reports through the Securities and Exchange Commission (SEC). If those earnings are lackluster, shareholders might decide to sell some of their stock, which would lower the stock price. But if the newspaper reports an overall increase in the popularity of pizza, more people might buy shares and the price would go back up.

But before we delve too deeply into the intricacies of stock prices, let's talk about corporations. Even if you own your own pizza business, you can't sell stock in the company unless you become a corporation. We'll discuss that on the next page.