Welcome. In this video,

we're going to discuss the economics of firms interacting with their owners.

That's what accountants call shareholders equity,

but we're not going to talk about accounting in this video.

I'll cover that in some future videos.

At it's most simple level,

when firms interact with their owners, owners contribute capital.

The firm takes that capital,

they invest it to create value.

After creating some value,

they'll return a portion of that created value to the shareholders.

And this cycle will just continue again and again,

maybe with some new investments or contributions from other shareholders and eventually,

the firms lived it's useful life,

it gets liquidated and all the remaining value goes to the shareholders.

Now, that's a simple way to look at,

it but it's worth thinking a little more carefully about how a few of

these transactions impact the firm and its shareholders.

So, let's start at the very beginning.

An outsider provides something of value to the firm,

usually money, but it could be some other form of capital.

And in return, they're going to get some rights back from the firm.

Usually, those rights relate to future cash flows some sort of say,

about the governance of the firm or decision power.

These people have become partial owners in

the firm and they're going to get the rights related to that.

Now, maybe it'll be clear if we give you an example.

So, let's think of two people Kim and Scott.

Kim and Scott have a friend who wants to start a firm.

That firm is going to need a $100000 to get started.

Kim has 60000 in her bank account and Scott has 40000 in his bank account.

They're going to make an investment to the firm for that.

What they get back are these rights,

the rights to future cash flows from the firm and the decision rights.

Since Kim put in $60000,

she'll get 60 percent of these rights and Scott will get 40 percent.

Now, that's not always the case.

Sometimes, stocks will be issued that

don't have exactly a proportional share of those rights.

Maybe they'll have more cash flow rights and less decision rights or vice versa.

You'll know that when you buy the stock,

it's important to take a look and see exactly what comes with it.

But usually it is proportional and for the rest of this video,

we're going to assume that that's the case.

So now, the firm has $100000,

they can go along and start creating capital and Kim and Scott can go about their lives.

That takes us to the next step.

As the firm has created capital now,

it's going to want to distribute some of that cash back to its owners.

The first way that we're going to think about that is where firms give

a proportional distribution of that cash

back so that there's no change in the ownership structure,

but rather there's just a return of cash.

Let's go back to Kim and Scott and take another look at

what's going on with their company to get a better sense of this.

So the company has been operating for a while.

It's now created 50000 worth of value.

So, the company is worth $150000.

That means that Kim's share that 60 percent is $90000 and Scott's share is worth $60000.

The firms now decided that it's okay for it to distribute some of this cash

back to those shareholders and so it's going to give

$30000 of that back to the shareholders.

And that $30000 is going to be split based on their ownership.

So, Kim's going to get 18000 in cash which is

60 percent of the value and Scott's going to get 12000 in cash,

which is 40 percent of the 30000.

Now, if you take a look at this what you see,

look at Scott for example,

is he now has 12000 in cash and he also has 48000 in value still in the company.

That's the value of his 40 percent share.

Kim has 18000 in cash and $72000 dollars worth of value in her stock.

If you add up Scott's 12000 and 48000,

you'll see it adds back up to that 60000 that he had before this transfer took place.

And Kim's assets add up to the 90000 she had before the dividend transfer took place.

What this is showing us is that value wasn't created or destroyed,

it was just moved between the two accounts that the owners have,

into their bank account and out of the company.

Now, there would be another way to make this distribution.

Instead of making that distribution proportionally where they

both continue to own the same amount of the company,

you also can make this distribution where you give one of

the owners some cash in return for some of their ownership in the company.

Maybe all of it, maybe just a portion of it.

So if we go back to our friends Scott and Kim,

and we say the company is worth that 150000 we talked about before and it's

decided to distribute 30000 but

it's going to distribute that 30000 differently this time.

Scott's going to get all 30000 in the cash.

So, his bank account goes up by 30000.

But what he gives up is a proportion of the company.

So now, he's only going to own 25 percent of the company,

which turns out to be 30000 of value itself, as well.

So he still has 60000 worth of value but part of that is in

cash and part of it now is in a smaller proportion of the company,

which is also a smaller company since we've taken 30000 out of it.

Kim didn't get any cash,

so her bank account didn't change at all.

But what she now has is 75 percent of the company.

Since the company is worth 120000,

that means Kim's shares is worth 90000,

which is exactly the value she had before.

So once again, we see that cash has been moved out of one account- the company,

and into another account without value having really been changed.

The difference here is that,

Scott got all the cash and in return what he did give up is future rights in the company.

And Kim, she's taken part of a smaller company

now but she owns a larger proportion of it going forward.

Now, what should be clear in all of these transactions is,

as the owners interact with the firm,

value is transferred out of their bank account into the firm,

out of the firm back into their bank accounts but

it's not created or destroyed in these transactions.

Transactions with owners are never going to impact

the income statement because they're not creating or destroying value.

That happens when you interact with your customers,

when you interact with your employees and

other stakeholders that are outside of the firm.

Now, this can get tricky at times because the firm

sometimes deals with owners who also have other roles with the firm.

For example, the owner may be

a large customer of the firm or even more frequently, an employee.

In those sorts of interactions,

what we'll have to figure out was in this interaction,

was that person acting in the role as an employee?

Or were they acting as the role of an owner?

If they're an employee or a customer,

then that will impact value creation or destruction and show up on the income statement.

But if they're acting as an owner,

we're never going to see that impact in the income statement.

In the next video,

I'll talk to you more about how to do the accounting for some of these transactions.

The Economics of Interacting with Owners

Accounting for Decision Making

Meet the Instructors