Let me tell you a story about a man named Boniface and his good friend, Mercy, and how they learned first-hand why companies issue stock and why investors love to invest in them.
Meet the Entrepreneur
Boniface owns a small shop in his village – the SmileSave Supermarket. It’s an ambitious name, and Boniface is an ambitious man. He sells maize meal, sugar, soap, batteries, and candles. He even has a small refrigerator so that he can stock ice cold bottles of cola and beer.
People enjoy shopping at SmileSave because the prices are reasonable, the goods are plentiful, and Boniface greets each person warmly when they enter. So, as the years go by, the shop does quite well. Boniface saves up enough of the profits to buy a small, used truck which allows him to transport a greater quantity and variety of items to sell. Soon, customers are coming from neighboring villages to shop at SmileSave.
With profits accumulating rapidly, Boniface hires workers and opens another store ten kilometers down the road and then yet another a few years later.
Then one day Boniface hears some interesting news from his friend, Mercy, a math teacher at the local high school. She tells him that a large textile factory is being built near a small village 50 kilometers away. Many people were moving to the area in the hopes of finding jobs.
Boniface senses opportunity. Surely, all of these people will need a place to shop when the factory opens.
Unfortunately, Boniface has next to nothing in his bank account, having just bought several solar panels to provide electricity to his stores. It would cost $10,000 to build and stock a new SmileSave Supermarket near the factory. If he waits until he has saved sufficient funds, there is a risk that some other shop-owner may discover the opportunity. He decides that he can’t afford to wait and calls his bank to request a loan.
Borrowing Isn’t Always a Viable Option
The banker gives him good news and bad news. The good news is that he will happily lend him $10,000. The bad news is that he will charge him an interest rate of 25% on that amount.
“Twenty-five percent!” Boniface exclaims, “That amounts to $2500 per year and will reduce my profits to almost nothing!”
The banker sympathizes but explains that he’s simply unable to offer a lower interest rate.
The Venture Capitalist
Later that same day, Mercy stops by SmileSave after school to buy her two favorite snacks: pilchards and Weetabix. She notices that Boniface is frowning over a ledger book and punching numbers into his calculator. He is so preoccupied that he forgets to even greet her when she walks through the door.
“Why the glum face, Boniface?” she asks.
After explaining his plan to open another shop near the textile factory and his frustration with the bank’s lending terms, he jokingly asks Mercy whether she might be able to lend him $10,000 at a more favorable rate.
“I’m afraid I don’t have $10,000 to lend, but I do have an idea,” Mercy replies as she pulls a pen and paper from her purse. “Tell me, Boniface, what is the price of your business?”
A Valuation Exercise
The shopkeeper makes a puzzled face. “I’m sorry, but SmileSave Supermarket is not for sale.”
“No, No. How much is SmileSave worth?”
“Ah, I understand you now,” says Boniface and puts his hand to his chin as he takes a mental inventory of his business assets. “Well, each of the three shops are sturdy buildings and located along busy paths between villages. Together, I estimate they are worth $60,000. Plus, they each contain about $5000 worth of goods and equipment. And, I also have my old truck. I’m not sure of its precise value, but my cousin offered to pay me $5000 for it last week.”
Mercy sums all the assets on the piece of paper.
- Three SmileSave Supermarket shops ($20,000 x 3): $60,000
- Store inventory and furnishings ($5,000 x 3): $15,000
- Truck: $5,000
- Intangibles: ???
“That’s a total of $80,000,” she says, “but you have forgotten to estimate the value of your intangible assets.”
“Indeed!” says Mercy. “You’ve built up a very loyal customer base because you offer fair prices, and your staff greets them warmly every time they walk through the door. SmileSave is becoming synonymous with good service. You’re also a great businessman, which is proven by how quickly your business has expanded. These intangible qualities are easily worth $10,000 all by themselves!”
Embarrassed, Boniface disagrees at first, but eventually concedes that his unique leadership skills are a valuable asset to SmileSave.
“Very good,” says Mercy, “we’ve estimated the fair value of your business to be $90,000.”
“That’s very interesting. But how exactly does it help me purchase supplies to build a shop near the new factory?”
“You will see soon enough,” Mercy replies while folding the list and putting it in her purse. “I must be on my way now, but I will be back to speak with you in two days time. Rest well!”
And with that she was out the door. Boniface shakes his head bemusedly and smiles. She had forgotten her pilchards and Weetabix on the counter.
A Capital Injection
Mercy was true to her word. Two days later she returned to SmileSave, greeting Boniface excitedly.
“I have a business proposal for you,” she said, as she reached in her purse and slowly counted out $1000 in $100 bills.
“Thank you very much, Mercy. That is very generous of you, but I’m afraid I need much more than that to open another SmileSave Supermarket.”
Mercy ignored him, reaching into her bag and counting out another $1000, and another, and another, until there was $10,000 in cash sitting on the counter.
“Where did you get all of this money?!” Boniface gasped.
“It was quite simple,” said Mercy. “I told the other teachers at the high school about your situation, and they were all eager to help. John, Susan, Sharon, Isaac… Ten of us altogether have formed an investment club. We each contributed $1000, because you are an honest man, and we think SmileSave is a business with great potential.”
Boniface shook his head slowly. “I am very thankful for this. But I’m not sure how quickly I can repay it. Can you accept a lower interest rate than the bank?”
“This is not a loan, Boniface,” Mercy chuckled. “We are proposing to buy a portion of your business.”
She continued, “Two days ago, you told me that SmileSave was worth a total of $90,000. With this $10,000 capital injection, the new value of the business would be $100,000. Only instead of owning 100% of SmileSave, you would own 90%. The remaining 10% would belong to me, John, Sharon, and the other teachers. We would each own a portion of each shop, each refrigerator, each solar panel, the truck, and even the intangible assets. And you would be the majority shareholder.”
“But how will you ever receive a return on your investment?” asked Boniface, perplexed.
Dividends on the Horizon
“Aha! Excellent question,” Mercy replies. “As part of the agreement, we ask that you provide us with a financial report every quarter. This will show all of SmileSave’s sales, expenses, assets, liabilities, and cash flow. You will also make a judgement each quarter as to how much of the company’s profits should be saved for future expansion. If there is any money left over, we ask that it be distributed to shareholders in an amount proportionate to their ownership stake in the business. Because you own 90% of the company, you would receive 90% of this profit. The teachers and I would receive the other 10%. This is called a dividend.”
“Very interesting,” says Boniface, “So, the better SmileSave performs, the more money you and the other teachers will earn.”
Boniface rubs his chin. “I like this proposal, Mercy.You have yourself a deal.”
“Fantastic!” exclaims Mercy. “I will run and inform the teachers that we are now part-owners of SmileSave Supermarkets. But before I go, may I please buy a can of pilchards and a package of Weetabix?”
“Of course, partner,” says Boniface, and they shake hands as she leaves SmileSave Supermarket #1.
What’s Next for SmileSave?
Will Boniface successfully expand SmileSave’s operations? Will the teacher’s receive a good return on their investment? Will we ever discover why Mercy likes pilchards and Weetabix so much? Check back here on Tuesday for the exciting conclusion to “What is a Stock, Really?”