Peter Lynch, Learn to Earn, Introduction

Limited Liability

A company is a legal entity and hence punishable by law… hence, one motivation for incorporating a company is so that the corporation can bear the brunt of mistakes made in its name. Absent that, if a company makes some misstep, all of its investors (owners) can be sued for the mishaps/misbehavior of the company itself and the extent of their liability or exposure is unlimited (they could lose their life savings). Once incorporated, however, the company itself is liable. Its owners/shareholders are not hold responsible. This is what the phrase “limited liability” refers to – it means that the owners/shareholders have limited liability for mistakes made (damage done) by the company itself. Note that the employees of the company (managers, directors) can be sued, even if it is incorporated.

  • So what does the “limited” part mean? It means that shareholders are liable upto the value of their investment. So if I have 5 grand plugged into CostCo then I can lose that $5,000 but no more. My liability is limited to the size of my investment.

PROs/CONs of being public vs. being private

Private companies are typically owned by a small number of people; the distinguishing characteristic is that the general public cannot invest in them. Think of your local barber shop, salon, shoe repair shop, … By contrast a company is public if its stock is publicly traded. There are about 13,000 public companies in the US. The beauty of the stock market is that it lets “ordinary people” participate in the wealth and prosperity of public companies. And it lets those companies, in turn, finance their growth. You don’t have to work for Goldman Sachs to share in its success (and failure); you can just buy the stock.

  • The vast majority of companies are private.
  • The majority of employees work at public companies, however.
  • PROs of being public (the opposite of each is a CON of being private)
    • For investors, their investment is liquid – they can increase/decrease their holdings in the company at pretty much any time.
    • For investors: Stock that is traded on a national securities exchange must be registered with the SEC, which requires periodic audits (by an independent auditor) of the company’s financial statements. Also, the company must disclose various events. In theory, this results in a good flow of information to the investor.
  • CONs of being public (the opposite of each is a PRO of being private)
    • Very high regulatory requirements (as imposed by the US gov’t): administrative, financial reporting, corporate governance
      • E.g. Sarbanes Oxley (SOX) requires publicly traded companies to implement, doccument, and test controls which (are meant to) ensure proper and complete financial reporting “at all levels of the organization”
      • Disclosure requirements (i.e. the company has to announce when it’s doing foo)
      • Reporting requirements (the periodic audits)
      • Corporate governance dictates
      • Compliance costs (the consultants one must hire to do the SOX audits plus whatever costs lead up to that)
    • Pressure and focus of consistently meeting quarterly earnings expectations (can foster short-term thinking/orientation)

Being registered with the SEC, etc.

The SEC exists to protect investors, effectively, by imposing requirements on companies that would offer securities for sale to those investors. For example, a company with  SEC-registered securities must undergo periodic audits by an independent accountant and publish the audited financial statements. A company must register a class of securities (e.g. bonds, stock) with the SEC if: (1) the securities are “widely held” OR (2) the securities are traded on a national exchange (e.g. NYSE, Nasdaq, AMEX).

  • The criteria for widely held is:
    • If the company has significant assets (> $10MM),
      • >= 300 shareholders for the given class of securities
    • Otherwise,
      • >=500 shareholders for the given class of securities
  • Assets are measured as: total company assets for each of the last 3 fiscal years.
  • ALL securities offered in the US must either be registered or quality for an exemption to the registration requirement.

What are the requirements for companies that have securities registered with the SEC? Their financial statements must be audited periodically and published. If any entity attempts to purchase >= 5% of a company’s shares, this must be disclosed. Also, if shareholder input is to be solicited on some matter (e.g. via a proxy vote), then this solicitation must be filed with the SEC first so that it can ensure that all required background/context is provided (“disclosure of all important facts concerning the issues on which holders are asked to vote”). Illegal insider trading == If someone possesses material non-public info about a company AND is required not to trade on it BUT does so anyway.

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