Chapter 04 – The nuts and bolts. What is a company and what is a share

What is a Company?

Companies are entities that exist separately from the people who own them. While they are not actual people, companies have many legal rights and responsibilities that a ‘natural’ (human) person has. For this reason, companies are regarded as ‘legal persons.’

Ownership of a company is divided into a number of shares, and thus the owners of a company are typically known as ‘shareholders.’ (The Corporations Act 2001 refers to shareholders as ‘members.’)  A shareholder must exercise certain responsibilities to the company, and the company must exercise certain responsibilities to the shareholder. The responsibilities of the shareholder are typically restricted to paying some money into the company in return for the original issue of the shares. This amount may be so small as to be negligible, or it may be substantial.

Forming a company – known as ‘incorporating’ – allows the owners to separate the activities of the company from themselves as individuals. For example, many sporting clubs form a company (incorporate) so that the activities of the club become separate from the individuals who play sport within it. This means that those individuals are not responsible for such things as debts owed by the club or accidents that occur while the club goes about its activities. 

In commerce, companies are formed to allow a business to be conducted separately from the owners of the business. Commerce is only one aspect of the community in which companies are used: not all companies are formed for the carrying on of a business. Sporting and other leisure groups, religious organisations, schools etc all make use of company structures to allow their activities to be separated from the individuals within them. For the purpose of this unit, which looks at investing in the shares of a company in the pursuit of economic benefit, the term ‘company’ is taken to mean a commercial enterprise. 

Given their status as legal persons, companies in Australia are heavily regulated. The Australian Securities and Investment Commission (‘ASIC’) is the chief regulator, with regulatory authority devolved to it by the Commonwealth Corporations Act 2001. ASIC is, of course, also the main regulator of financial service providers in Australia.

Types of Company

There are various types of company. The following sections discuss the main forms of Australian company: 

Limited Liability Companies 

The ANZ online financial dictionary defines limited liability as follows: 

“A legal concept which protects shareholders in a company by restricting their liabilities to the value of their shares, even if the company has debts exceeding that value. The limited liability company is the basic commercial structure developed during the nineteenth century to allow individuals to carry on a business without exposing all their personal assets to the risk of the business failing, resulting in personal bankruptcy.” 

Limited liability is the major way in which company owners separate the activities of the company from themselves. Limiting liability is usually the main benefit of forming a company. The term ‘limited liability’ refers to the fact that the liability of the shareholder for the actions of the company is limited to the amount the shareholder paid to the company upon the initial issue of the shares. Once the shareholder has paid the required amount for his or her shares, he or she will not need to pay any more to the company, even if the company finds itself facing financial hardship. 

Limited liability allows the owners to operate the company without taking on personal responsibility for its debts and other legal obligations. Compare this to the situation where a person conducts activities in their own name (a ‘sole trader’). Sole traders are responsible for all of the consequences of their actions, and cannot limit their liability. If an sole trader cannot pay their debts, for example, the law may force them to sell personal assets in order to make payment. If they have no assets to sell then the individual may be forced into bankruptcy

As a legal person, a limited liability company can also be sent into bankruptcy, or forced to sell it’s (ie the company’s) assets in order to meet its obligations. 

Limited liability companies are required to have the word ‘limited’ as the last part of their name. The abbreviation Ltd can be used. For example, the official name of Wesfarmers is Wesfarmers Limited. This requirement allows anyone transacting with the company to know that they are dealing with a company and that the shareholders are not taking personal responsibility for the finances of that company.

The concept of limited liability has had far-reaching implications in the developed world. Some commentators rank the formation of limited liability companies alongside the industrial revolution in terms of its impact on the industrial world. This is because without limited liability it would be impossible to have large companies such as we now know them. Bernstein described the importance of limited liability companies as follows: 

“In a world without limited liability – where all business partners are ordinary shareholders are fully liable for each other’s actions, and where business failure can result in imprisonment or even slavery (these were frequent punishments for bad debtors prior to the 1800s) – large impersonal corporations are not possible. In this situation, the only viable structure for businesses of even a modest size is the trustworthiness of the family group.”

(Bernstein, W.J. The Birth of Plenty. 2004. McGraw Hill. Page 150).

The alternative to a limited liability company is an unlimited liability company. As these companies confer few benefits on shareholders, they are relatively rare. 

Proprietary Companies.

Proprietary – or private – companies are limited companies which also have restricted ownership. Usually, the number of shareholders is limited to fifty, and these shareholders are typically not free to trade their shares with whomever they like. Proprietary companies are also limited companies, and must have the words ‘Proprietary Limited’ or Pty Ltd at the end of their name. 

Proprietary companies cannot raise money from the public, either via shares or by soliciting loans (for example in the form of a debenture). Shares in proprietary companies cannot be traded on public exchanges such as the Australian Stock Exchange. 

As this training is on share investment, we will not discuss private companies any further. 

Public Companies 

These are companies in which the general public can typically hold shares. Public companies may be either limited or unlimited liability companies. Almost all are limited. In terms of share investing, public companies are the companies in which the investor will generally trade. In this unit, unless otherwise stated, the term company should be taken to mean a public company. 

A public company may have one or more subsidiary companies which are private. In turn, a private company can own shares in a public company. 

Holding Companies

A holding company is one that holds shares in (an) other company. That is, it is a company which owns (an) other company. Holding companies are sometimes referred to as ‘parent’ companies, and the company (companies) they own as ‘subsidiary’ companies.

Directors and Shares

Directors

The ANZ online financial dictionary defines a company director as follows: 

Someone appointed to take responsibility for the policy formation and control of a company because of particular ability and expertise in an industry. Directors advise management of the company on behalf of the shareholders (the owners of the company). A public company must have at least three directors; a proprietary limited company at least two. Under a company’s articles of association, directors undertake the supervision of management collectively as a board. They can delegate management functions to a managing director, but some activities require the board’s participation, for example, signing the annual accounts or authorising dividend payments. Directors’ responsibilities have increased, following a heightened awareness of concepts such as duty of care and more specific definition of fiduciary duty. company directors’ responsibilities are governed by section 232 of the Corporations Law.

Because companies are not real people, their activities must be overseen by real people. These real people are defined as directors. Proprietary companies must appoint at least one director. Public companies must appoint at least three. In public companies, the main role of directors is to oversee the functions of the managers employed by the company. These managers in turn oversee the functions of all other staff, so the directors are presumed to oversee the functions of all of the company’s employees.

Collectively, the directors of a company are known as a board. Directors may also be employed by the company. Where the director is employed by the company, they are said to be an executive director. Where the director is not employed, they are said to be non-executive. Where a director is also employed as the Chief Executive Officer (ie the most senior employee of the company) they are often called the Managing Director. 

Directors are governed by the Corporations Act 2001. This Act confers certain responsibilities upon directors, mostly concerned with ensuring they exercise a duty of care in that they act in the interest of the shareholders, and that they do not allow the limited liability of the company to be abused. Penalties apply to directors who fail to meet their responsibilities. The Act also disallows certain people from being company directors. For example, people who are bankrupt (unable to pay their personal debts), are not allowed to act as company directors.

Shares

Shares are units of ownership of companies. These units may be owned by real people or by other companies, either in their own right or as trustees of things such as family trusts or superannuation funds. Being a shareholder confers certain rights and responsibilities on the share owner. Originally, the ownership of a share was proved by the possession of a share certificate, such as the one shown above. These days, with digital record-keeping, such hard copy certificates are typically not issued, especially in the case of public companies. 

The issuing of shares is a main way in which a company can raise finance. The proceeds of the issue – the amounts paid by shareholders to purchase their shares – are used by the company to finance its operations. Unlike other ways of raising finance (such as borrowing), there is no requirement for a company to repay money raised through a share issue. 

Because the company raises money by issuing shares, shares are one of a class of assets known as securities. This is because the shareholder purchases a proprietorial right over (a portion of) the net assets of the company. Net assets are those assets that remain when the company has met all of its other obligations, such as loans that it may have taken out.

For the shareholders, contributing finance via share ownership allows them a different form of return than they would get if they were to provide a loan to the company. If they provided a loan, then their return would be in the form of interest on that loan. This interest is fixed, meaning that there is an upper limit on the size of the return that the investor can receive.

By buying shares, shareholders acquire the rights to a share in the profits of the company, and a share in the company assets should the company cease to trade. When a shareholders receives a portion of this profit, this is known as a dividend.  In theory, at least, there is no upper limit on the size of a company’s profits, and thus no upper limit on the amount that each shareholder receives.

If the company is a public one, shareholders also acquire the right to pass on their unit of ownership to someone else, via a sale. These sales typically take place on share markets.

Shares are broadly divided into two main forms: ordinary shares and preference shares. 

Ordinary Shares

The ANZ online financial dictionary defines ordinary shares as follows: 

Fully paid shares which carry voting rights but rank after debentures and preference shares for dividend payments. If the company is wound up, ordinary shareholders rank as unsecured creditors, behind secured creditors such as debenture holders. 

All companies (except companies limited by guarantee) must have ordinary shares. These shares usually give holders the right to vote at annual general meetings and at extraordinary meetings. Directors of the company are appointed at such meetings: thus ordinary shareholders have a vote in who directs a company. As the directors oversee all operations of the company, it is through the right to elect directors that shareholders can exert the most influence on the actions of the company.

Ordinary shares also entitle the shareholder to any share in profits that are distributed while the company continues to exist (dividends) and a share of the distribution of net assets upon the winding up of the company. Most shares traded on the Australian exchange are ordinary shares. 

Preference Shares 

The ANZ online financial dictionary defines preference shares as follows: 

Shares which rank ahead of ordinary shares for the purposes of claiming dividend payments or any assets of the company should it be wound up. Preference shares rank behind debentures.

Preference shares typically have the first (or preferential) rights to dividends and the return of capital in the event of a company winding up. Winding up is where a company ceases to trade and sells its assets, pays out its debts and then distributes anything that is left.

Preference shareholders receive their full entitlements before ordinary shareholders receive theirs. This is the case both in the event of dividends being paid and the distribution of assets should the company wind up. The amount of the dividend that is paid to the preference shareholder is often fixed. While this gives the preference shareholder greater certainty as to the dividends they will receive, it can also place an upper limit on what they can receive. Thus, while at times ordinary shareholders may receive less dividend than the preferential shareholder, at other times they may receive a higher dividend than preference shareholders. This will typically depend on the size of the company’s profits.

Some preference shares are known as cumulative preference shares. If a company does not make sufficient profit, it may not be able to pay the dividend due to the preference shareholder. If the preference share is cumulative, the shareholder is entitled to have any unpaid dividends paid out of future profits before other dividends are paid. For example, if a cumulative preference shareholder has a right to a ten cent dividend each year, and there is a year in which no dividends are paid, the shareholder would have a right to a twenty cent dividend the next year. 

The holder of a cumulative preference share effectively receives a fixed rate of return on their investment. The only threat to this return (risk) stems from the possibility that the company may never make a profit. In such a case, while the cumulative preference shareholder may accumulate a large entitlement, if the company cannot make a profit the shareholder is not paid. 

There is a further category of preference shares known as participating preference shares. Where such shares exist, the preference dividend is paid first. Then, ordinary share dividends are paid, to some prescribed value. Once this prescribed value is reached, the preference shareholder may then receive a further share of the dividend. In this way, they are able to ‘participate’ in the remaining dividends.

The Dover Group