Explain high finance to me.

[Bob001]

In "Social Network" (and apparently in real life), there is a point when Facebook founder Zuckerberg and original partner Severin have a falling out, and Zuckerberg reduces Severin's ownership of the company from a third to less than 1 percent by selling shares to new investors. How did this happen? If you own, say, 33 shares of a company that has issued 100 shares of stock, and the company management decides to issue, say, a million additional shares, don't you get compensated, even if it's not a stock split? Doesn't the original owner have to be a party to the decision? Or is his original share of the company suddenly devalued by a factor of 10,000? If this is legal wouldn't every potential investor fear getting ripped off? What actually occurred here?

[madurobob]

Dilution is almost always possible. Often large percentage owners are protected by clauses that ensure they have the opportunity to buy additional shares at a fixed price should the corporation decide to sell stock it owns. They are not "compensated"; they are given the opty to maintain their ownership % through purchasing more stock at an attractive price. If they don't buy that stock, for whatever reason, then their ownership is diluted with each sale of stock by the corp.

Keep in mind a corp cannot simply print more stock certificates and sell them whenever it wants. Specific volumes of stock are authorized in the articles of incorporation. Increasing that authorized volume can take a bit of wrangling.

ETA. Say we form a corp with 1M authorized shares. We each buy one share for $1, so we are 50% owners and corp has $2 to play with. If the corp decides to sell the remaining 999,998 shares and you purchase zero while I purchase the rest, then your ownership percentage has dropped to almost nothing. But, note that the value of that one share of stock you own has not decreased - its still worth $1, so you haven't lost any money in the transaction; just power.

[Mycroft]

In "Social Network" (and apparently in real life), there is a point when Facebook founder Zuckerberg and original partner Severin have a falling out, and Zuckerberg reduces Severin's ownership of the company from a third to less than 1 percent by selling shares to new investors. How did this happen? If you own, say, 33 shares of a company that has issued 100 shares of stock, and the company management decides to issue, say, a million additional shares, don't you get compensated, even if it's not a stock split? Doesn't the original owner have to be a party to the decision? Or is his original share of the company suddenly devalued by a factor of 10,000? If this is legal wouldn't every potential investor fear getting ripped off? What actually occurred here?

There are a lot of ways it could be done, but I don't know how it would happen that you could devalue one third of the company that wouldn't also devalue the other two-thirds. Unless, perhaps, Zuckerberg had additional monies he used to buy up a huge chunk of the new shares too, but then the real whine is that Severin didn't or wasn't able to take advantage of the opportunity when it presented itself.

[The Don]

ETA. Say we form a corp with 1M authorized shares. We each buy one share for $1, so we are 50% owners and corp has $2 to play with. If the corp decides to sell the remaining 999,998 shares and you purchase zero while I purchase the rest, then your ownership percentage has dropped to almost nothing. But, note that the value of that one share of stock you own has not decreased - its still worth $1, so you haven't lost any money in the transaction; just power.

Well kinda.

One of the things corporations do from time to time is a share buy-back. Say 10% of the shares are bought by the company so as to reduce the number in circulation. The market capitalisation of the company tends to stay the same and so the value of each share tends to rise.

That's certainly what happened to my Microgen shares.

On the other hand I chose not to exercise my option to buy in another company's rights issue (I think it was a buy one for each 3 shares owned). To "get the offer away", the shares were offered at a significant discount and as a result the market took it badly. The market capitalisation of the company was basically unchanged (actually it dropped slightly) so each share was worth around 25% less. My shareholding was diluted.

[Bob001]

...

ETA. Say we form a corp with 1M authorized shares. We each buy one share for $1, so we are 50% owners and corp has $2 to play with. If the corp decides to sell the remaining 999,998 shares and you purchase zero while I purchase the rest, then your ownership percentage has dropped to almost nothing. But, note that the value of that one share of stock you own has not decreased - its still worth $1, so you haven't lost any money in the transaction; just power.

I think I understand the concept. But in this example if your one out of two shares gives you 50% ownership, don't you have to agree to the sale of additional shares? Or can the board or other managers act independently of the actual owners? In the Facebook case, it looks as if Zuckerberg retained his proportion of ownership, and the new investors got shares that reduced Severin's ownership. Do we know that Zuckerberg bought enough shares to retain his ownership (and if so, with what? His only valuable property was his existing FB shares.)? And if you own 50 percent of an XX-dollar company, and overnight you own only .0001 percent, is the value of your stock really unchanged? What mechanism would have reduced Severin's ownership without reducing Zuckerberg's?

[madurobob]

On the other hand I chose not to exercise my option to buy in another company's rights issue (I think it was a buy one for each 3 shares owned). To "get the offer away", the shares were offered at a significant discount and as a result the market took it badly. The market capitalisation of the company was basically unchanged (actually it dropped slightly) so each share was worth around 25% less. My shareholding was diluted.
Yup - there are different kinds of "dilution". I was talking about ownership % only, but what most stockholders worry more about is dilution in value by the corp selling shares (or taking other actions) for less than what the stockholder paid or recently valued the stock at.

[NewtonTrino]

Just keep in mind that there is not a one-size fits all answer here. Every corp has a different set of articles although you do have to follow some broad rules. There is a huge amount of flexibility though.

[madurobob]

I think I understand the concept. But in this example if your one out of two shares gives you 50% ownership, don't you have to agree to the sale of additional shares?
Absolutely, but you don't have to have 100% agreement, you have to (generally) have a majority agreement based on common stock. In your OP you point out Severin only owned 1/3. That would make it pretty easy for Zuckerberg to marshall a majority of the rest of the stock to vote to sell more shares. Esp. if Zuckerberg owned the other 2/3 outright.

If this happened, then Zuckerberg would have to also purchase shares to maintain his ownership percentage. I don;t see why he wouldn't, since he was the one pushing for the stock sale.

And if you own 50 percent of an XX-dollar company, and overnight you own only .0001 percent, is the value of your stock really unchanged?
Its entirely possible for the value of your stock to remain unchanged. In my (overly simplified) example you still own one share that is worth $1. The only difference is you own $1 worth of a corporation worth $1M, instead of $1 worth of a corporation worth $2.

[Bob001]

...
Its entirely possible for the value of your stock to remain unchanged. In my (overly simplified) example you still own one share that is worth $1. The only difference is you own $1 worth of a corporation worth $1M, instead of $1 worth of a corporation worth $2.

This might be where the fog rolls in for me. Is the value of your stock determined by what you paid for it or by the current value of the company? If you paid $1 for one of two shares in a company that was created out of thin air on a laptop in a dorm room, and over time that company came to be valued at a billion dollars (as measured by market share, assets, revenue, prospects for growth etc.), wouldn't your one share now be worth half-a-billion dollars? How is owning half of $2 the same as owning half of a billion dollars? (Conversely, when a company like Enron goes under, the investors clutching worthless scraps of paper can't say, "But I paid $100 for it. It's worth at least that much!")

[timhau]

This might be where the fog rolls in for me. Is the value of your stock determined by what you paid for it or by the current value of the company? If you paid $1 for one of two shares in a company that was created out of thin air on a laptop in a dorm room, and over time that company came to be valued at a billion dollars (as measured by market share, assets, revenue, prospects for growth etc.), wouldn't your one share now be worth half-a-billion dollars?

Yes, assuming that no additional shares were created at any point. Then you'd have a billion-dollar company with 2 shares outstanding, both of them valued at half a billion. However, if at some point you needed additional capital for your company and decided to issue 999,999,998 shares of which you bought none, your billion-dollar company would now have a billion shares, each worth a buck, and your stake in that company would be worth $1.

[timhau]

Dilution is almost always possible. Often large percentage owners are protected by clauses that ensure they have the opportunity to buy additional shares at a fixed price should the corporation decide to sell stock it owns. They are not "compensated"; they are given the opty to maintain their ownership % through purchasing more stock at an attractive price.

That might vary from one legislation to another. By Finnish law governing joint stock companies, if a company issues new shares, it must first offer these to the existing shareholders in proportion to their ownership in the company, unless there is a compelling reason to do otherwise. Now, what constitutes a compelling reason is a matter of interpretation; most of the time when this exception is evoked, the new shares are issued to pay for a corporate acquisition by a share swap, which is a pretty straight-forward case. In the case of Facebook, by our law Z., being an absolute majority shareholder, could push through a share issue using the exception clause using whatever excuse he could come up wtih; if S. disagreed, he could have demanded his day in court.

[Bob001]

... However, if at some point you needed additional capital for your company and decided to issue 999,999,998 shares of which you bought none, your billion-dollar company would now have a billion shares, each worth a buck, and your stake in that company would be worth $1.

This leads straight back to my original question. In the movie it appeared that Severin was presented with a fait accompli. His ownership percentage was reduced suddenly, to his apparent surprise behind his back. He wasn't offered a chance to buy additional shares, and there is no indication that Zuckerberg bought more shares. The new investors got a percentage of the company that cut Severin's ownership without cutting Zuckerberg's. The Wikipedia entry says "In April 2005, Zuckerberg dropped Saverin's percentage ownership share of Facebook from 34% to 0.03%." This was the subject of legal action that resulted in a sealed settlement for Severin. So what did Zuckerberg actually do to Severin?

[madurobob]

This might be where the fog rolls in for me. Is the value of your stock determined by what you paid for it or by the current value of the company? If you paid $1 for one of two shares in a company that was created out of thin air on a laptop in a dorm room, and over time that company came to be valued at a billion dollars (as measured by market share, assets, revenue, prospects for growth etc.), wouldn't your one share now be worth half-a-billion dollars? How is owning half of $2 the same as owning half of a billion dollars? (Conversely, when a company like Enron goes under, the investors clutching worthless scraps of paper can't say, "But I paid $100 for it. It's worth at least that much!")

What timhau said. In simple terms, the worth of a corporation is the number of shares owned outside of the corporation multiplied by the current average selling price of those shares in the market. In my example we assumed the shares were priced at $1. With two shares outstanding, the value of the corp is $2. With 1M shares outstanding, the corp is worth $1M.

Now, what I think you're trying to do is assign "value" to some intangible that the corporation owns. In Zuckerberg's case its the idea for a social networking site and some basic implementation of that on a laptop. In my example, with only 2 shares for $1/ea outstanding, that idea and basic implementation is worth $2 by definition. It only becomes more valuable when others are willing to pay money to buy some portion of ownership of the idea and the revenue they expect it will generate. That is, when more people buy stock.

[timhau]

This leads straight back to my original question. In the movie it appeared that Severin was presented with a fait accompli. His ownership percentage was reduced suddenly, to his apparent surprise behind his back. He wasn't offered a chance to buy additional shares, and there is no indication that Zuckerberg bought more shares. The new investors got a percentage of the company that cut Severin's ownership without cutting Zuckerberg's

I have no idea how that could be possible legally. If S's 33% ownership share was diluted to 1%, then Z's original 67% share (assuming that was what he had) should have been diluted to 2% if he bought no additional shares.

This was the subject of legal action that resulted in a settlement for Severin. So what did Zuckerberg actually do to Severin?

The settlement suggests that everything Z did wasn't on the up-and-up. However, it's also possible that the movie took some liberties with facts (I have no idea how good it is supposed to be with them).

[madurobob]

The Wikipedia entry says "In April 2005, Zuckerberg dropped Saverin's percentage ownership share of Facebook from 34% to 0.03%." This was the subject of legal action that resulted in a sealed settlement for Severin. So what did Zuckerberg actually do to Severin?

The only way it is possible is for the corp to sell more authorized shares. Since the results are sealed, we don't know the details. But, its a reasonable assumption that Zuckerberg was authorized by the articles of incorporation to sell more shares of stock. He would have to buy some to maintain his ownership percentage. That the movie doesn't mention this is not surprising.

[timhau]

The Wikipedia entry says "In April 2005, Zuckerberg dropped Saverin's percentage ownership share of Facebook from 34% to 0.03%."

That is massive dilution. To accomplish that, Facebook would have to issue 1000 new shares for each existing one. Again, I have no idea how a majority owner could legally pull that off without the minority owner knowing about it.

[madurobob]

Here is a pretty good high level description (http://www.businessinsider.com/facebook-movie-zuckerberg-ims#im-just-going-to-cut-him-out-3) of what happened:

His plan: Reduce Eduardo's stake in TheFacebook.com by creating a new company, a Delaware corporation, to acquire the old company (the Florida LLC formed in April), and then distribute new shares in the new company to everybody but Eduardo

Might be worth reading the whole story. Neither Zuckerberg nor Severin sound like nice guys.

ETA: so, the original company, an LLC based in Florida called "TheFaceBook.com" was purchased by a newly formed C corporation based in Delaware called "Facebook.Com". The new company had no ownership by Severin; he just had his 1/3 ownership in the acquired company.

[Bob001]

Here is a pretty good high level description (http://www.businessinsider.com/facebook-movie-zuckerberg-ims#im-just-going-to-cut-him-out-3) ... so, the original company, an LLC based in Florida called "TheFaceBook.com" was purchased by a newly formed C corporation based in Delaware called "Facebook.Com". The new company had no ownership by Severin; he just had his 1/3 ownership in the acquired company.

That pretty much answers my question, and as I recall the movie touched on Severin signing papers without understanding the implications. (Essentially Zuckerberg's lawyers told him "It's better to be a corporation, sign here," and Severin said "Oh, OK.") So this wasn't a traditional stock deal at all. Zuckerberg transferred his assets to a new entity and managed to squeeze Severin out of it.

[madurobob]

That pretty much answers my question, and as I recall the movie touched on Severin signing papers without understanding the implications. (Essentially Zuckerberg's lawyers told him "It's better to be a corporation," and Severin said "Oh, OK.") So this wasn't a traditional stock deal at all. Zuckerberg transferred his assets to a new entity and managed to squeeze Severin out of it.

More or less, yes. And, as far as I can tell, Severin needed to be squeezed out. He was charged with creating the business model and raising capital, and did neither. Instead, he secretly advertised his own start-up on Thefacebook. He was clearly not interested and not a believer in the company - he was just along for the ride. Zukerberg, on the other hand, for all his character flaws, was totally committed to making it work and he knew that it would work. That's just the sort of thinking you need in a start-up (well, we could do without the backstabbing and high school drama, but the belief and commitment is commendable).

[timhau]

Neither Zuckerberg nor Severin sound like nice guys.

Where nice guys finish has been known for over 500 years.

And the manner in which we live, and that in which we ought to live, are things so wide asunder, that he who quits the one to betake himself to the other is more likely to destroy than to save himself; since any one who would act up to a perfect standard of goodness in everything, must be ruined among so many who are not good. It is essential therefore for a prince to have learnt how to be other than good and to use, or not to use, his goodness as necessity requires.

[Bob001]

... And, as far as I can tell, Severin needed to be squeezed out. ...

That's probably true, but the traditional way to do that would be for one guy to buy the other out. If Zuckerberg had paid Severin a dollar value for his shares, it might have cost him less than he ultimately had to pay in his settlement years later, especially if Severin didn't really believe in the project. Speculation is that Severin today owns 5% of Facebook, and you can be sure he and his lawyers are paying close attention to everything they sign. Stabbing your "friends" in the back has a tendency to bite you sooner or later.

[JoelKatz]

That pretty much answers my question, and as I recall the movie touched on Severin signing papers without understanding the implications. (Essentially Zuckerberg's lawyers told him "It's better to be a corporation, sign here," and Severin said "Oh, OK.") So this wasn't a traditional stock deal at all. Zuckerberg transferred his assets to a new entity and managed to squeeze Severin out of it.This is pretty clearly illegal. When Severin signed the papers, he was acquiring stock in exchange for work he had done. When you have a transaction where one entity transfers stock to another in exchange for compensation, SEC regulations require disclosure of information held by one party that is adverse to the other party that a reasonable investor would want to know. You can't bury it, an actual meeting of the minds on the information is required. And a party can't waive a claim under the law (so the contract can't say he agrees not to be told or not to sue).

This is, by the way, the way the Winklevii are trying to get out of their settlement, alleging that critical information was withheld from them during the settlement negotiations of their claim. However, their claim fails for complex reasons that surround the fact that their settlement arose out of mediation.

[JAStewart]

This thread has been very enlightening. I was also confused regarding how they reduced the shares of Eduaro without him knowing.

Man, thank the FSM that JREF exists and has so many smart people on it - I know nothing about business and you are teaching me! :D

[ZirconBlue]

That's probably true, but the traditional way to do that would be for one guy to buy the other out. If Zuckerberg had paid Severin a dollar value for his shares, it might have cost him less than he ultimately had to pay in his settlement years later, especially if Severin didn't really believe in the project. Speculation is that Severin today owns 5% of Facebook, and you can be sure he and his lawyers are paying close attention to everything they sign. Stabbing your "friends" in the back has a tendency to bite you sooner or later.

Based on the article madurobob quoted, it didn't seem to be an issue of how much to pay him, but how to get him out quickly. Zuckerberg's messages indicate that he knows that he'll be sued and end up paying a settlement, and that Severin even deserves to get that settlement.

[Soapy Sam]

I never understood finance.

Seems to me if you put cocoa beans on a boat in Africa at $10 a bag and when they reach London they are "worth" $20 a bag, then you have the same beans you had to begin with, but now $1 is worth half as many beans as before.
What is generally seen as "addition of value" looks awfully like currency inflation to me.
But this may explain why I never got rich.

[Jaggy Bunnet]

I have no idea how that could be possible legally. If S's 33% ownership share was diluted to 1%, then Z's original 67% share (assuming that was what he had) should have been diluted to 2% if he bought no additional shares.

It could be that he had a different class of shares. For example S may have owned all of the S shares and Z all of the Z shares. If the articles specify that the Z shares are entitled to 67% of the value of the company and all other share classes split the remainder, then issuing new shares would dilute S without reducing Z's holding.

This is a fairly common structure, particularly where a private equity house is involved.

[JoelKatz]

I never understood finance.

Seems to me if you put cocoa beans on a boat in Africa at $10 a bag and when they reach London they are "worth" $20 a bag, then you have the same beans you had to begin with, but now $1 is worth half as many beans as before.
What is generally seen as "addition of value" looks awfully like currency inflation to me.
But this may explain why I never got rich.If it was a change in the value of currency, it would be reflected in all commodities roughly equally. You can complete factor the currency out of the picture. Look at the value of the cocoa beans relative to wheat, sugar, leather, and so on. You would see the same change in value even if you ignore the currency.

The commodity is worth more because it is scarcer, not because the currency is worth less.

[Jaggy Bunnet]

If it was a change in the value of currency, it would be reflected in all commodities roughly equally. You can complete factor the currency out of the picture. Look at the value of the cocoa beans relative to wheat, sugar, leather, and so on. You would see the same change in value even if you ignore the currency.

The commodity is worth more because it is scarcer, not because the currency is worth less.

Or in the example given, because you no longer have to incur the cost of shipping it from Africa.

[JoelKatz]

Or in the example given, because you no longer have to incur the cost of shipping it from Africa.Well, the reason you would ship it from Africa is because it's less scarce in Africa. ;)