Cisco CK'd at $86

by Rob Landley

Austin, TX (June 23, 1998) -- Just after noon today, Tom flipped a dime in the air in the luxurious Fool Studios offices (home to The Motley Fool Radio Show, coming to stations near you in the months ahead). The dime landed heads up. So we went out onto the public markets and picked up 23 shares of Cisco Systems (Nasdaq: CSCO) at $86 per share. Go Cisco!

Having made our final stock purchase (before adding the new $2,000 every six months), I'd like to get back to basics for a moment to ensure that we're all on the same page (or in the same book), as we dream about accumulating wealth over the long-term through stock investments. I mean, this whole "investing in publicly-traded stocks" thing is a great deal. We're sharing in the success of enormous companies, some of which have been in business long before we were born. We profit, while they work.

Now, why exactly are they letting us do this? Why are public corporations organized in such a way that we can literally buy tiny pieces of them -- and even possibly have a say in their development? Jeez, what exactly is a corporation? And what are some of the alternatives to a corporation?

Well, there are three main ways that a for-profit business can be legally organized: 1) Sole Proprietorship, 2) Partnership, and 3) Corporation. There are a few variants of each, but today we're just going to talk about the plain vanilla form of each.

What everyone should know is that the way a business is organized doesn't restrict the type or the size of its activities. There are sole proprietorships that manufacture millions of dollars worth of goods and sell them internationally. And there are corporations organized for the purpose of owning the contents of a safety deposit box. Each way to organize a business has its advantages and its disadvantages. Let's walk through them:

1. Sole Proprietorship

The simplest type of business organization is the Sole Proprietorship. This is a structure that allows one person to go into business for themselves. They directly own and are totally responsible for the entire business. The sole proprietor receives the money whenever anything is sold and writes the checks to buy more supplies.

Most things that a sole proprietorship does, such as renting office space, are done in the name of the sole proprietor, not in the name of the business. Because of this, there's no paperwork to file to become a sole proprietor; it pretty much happens by default.

This very simplicity is the main advantage of the sole proprietorship. The entrepreneur has the option to file a "Doing Business As" certificate to legally protect her company name a bit, and there's a lot of tax paperwork involved in hiring employees. But overall, if you're making money on your own, without being someone else's employee or boss, you're a sole proprietor (unless you've made other arrangements).

There are many downsides to the sole proprietorship, and they all boil down to the fact that there's no financial separation between the individual and the business. The sole proprietor takes on all the risks of running the business themselves. The business's debts are personal debts owed by the individual. If calamity strikes and the business goes under, guess who else goes under!

Legally, the individual is also responsible for the actions of their company, which is nasty if you run a pizza delivery place and you run somebody over on your bicycle. You would get sued as an individual for that -- with all of your assets, inside and outside of the business, available to the claim.

And finally, banks are going to be less likely to help finance a one-person business for all the reasons above, and others. When approached for a loan to expand that business, a bank will probably only see a single overworked person who could get hit by a bus or die in the throes of a Viagrian event. And the sole proprietor can't delegate too much responsibility to other people -- all decisions have to flow through them. Not the best management style, in any business.

2. Partnership

If you bring other people on board, to co-own the business, it becomes a Partnership. Legally, an oral agreement ("We're partners") is enough to form a partnership, although in reality you really, really, really want to put something on paper whenever there's money involved between two people. Partners can bring in resources (like money or office space), expertise, or just be an extra body to help run the thing without having to be paid a fixed salary like employees.

The downside of a partnership is a little legal thing called "Joint and Several Liability" -- meaning that each and every partner can be held totally responsible for the actions of any of the other partners.

In fact, in most ways, partnerships are actually a greater legal risk than sole proprietorships because the individual is responsible for the behavior of all the partners. If anybody tries to collect money from the company for a debt or a lawsuit, they can legally go after all of the partners (and, generally the richest one) for the entire amount. Any of the partners can sign checks or contracts that are binding to all of the partners. And if any of the partners leaves or dies, or new partners are added, technically you have a whole new company. That makes it extremely difficult to retire, pass on your part of the business to your kids, or sell it to a third party.

3. Corporation

The Corporation was invented to solve the problems of sole proprietorships and partnerships. Legally, a corporation is an individual entity, capable of owning and owing money and property. The corporation is legally responsible for its own actions and can have any number of owners. If it sounds like it was designed to facilitate a business owned and managed by large numbers of people, you're catching on.

The corporation can hire and fire people, buy property, take on debt, and do just about anything a person legally can short of (The Truman Show notwithstanding) adopt babies. Of course people have to actually do all this -- meaning that the owners, managers and employees have to arrive at some sort of consensus as they go (a strategy designed differently at literally every corporation in existence today). However as long as the leaders of each corporation are duly appointed by and acting in the best interests of the corporation (which they may have to prove in court if they get sued), no individual at the corporation is legally responsible for their actions as a representative of the corporation.

In fact, the owners of the corporation aren't responsible either; the corporation itself is. This is why when a Microsoft product eats your hard drive, you can't sue Bill Gates either as an owner of Microsoft stock or as the CEO of Microsoft. You have to sue Microsoft itself -- the whole big monstrosity of it. (Oh, and, good luck with that -- the line forms way over there.) This protection of the owners and management of a corporation from liability is called the "Corporate Veil," and is one of the main reasons for the existence of corporations.

Another reason is that corporations are "continuous" -- meaning that the corporation can continue to do business regardless of what happens to any individual. If the business loses a manager, it can just hire somebody else. If it loses an owner, somebody will inherit that stock (or buy the shares at the estate auction). This is why Coca-Cola, Johnson & Johnson, IBM, and AT&T have been around so long -- for decades... long after their founders have passed on.

Stock is the bookkeeping method by which ownership of a corporation is determined -- and it's what we can buy and sell everyday via the mechanisms of our public marketplace. Each share of stock is a fraction of the deed of ownership of the corporation, and the total number of "outstanding shares" that have been issued and remain in circulation always add up to 100% of the ownership of the corporation.

Thus, if Microsoft has 2.5 billion shares outstanding and is trading at $100 per share, the total company is worth $250 billion. If Microsoft decided to split its stock, it would have 5 billion shares outstanding trading at $50 per share. And the company would still be valued at $250 billion. That's a simple illustration which explains why it seems that everyone on The Motley Fool's editorial staff has, at one point or another, posted a note talking down the importance of stock splits. Same pie, same value to the corporation -- stock splits are fundamentally irrelevant.

Anyway, now you know where those shares of Cisco that we bought today came from. The people who founded the business sold part of it, first privately to venture capitalists, and then publicly to the open markets. They did so to raise money to build the business. Later, the owners of the company sold more shares (usually far more valuable now in the public markets) to put their kids through college or buy a new house or gift the shares to charities. And the people they sold those shares to may just have sold some of them to us. It's a rolling process. That said, we hope to hold these Cisco shares for decades to come.

Now, it only takes around $2,000 and a few hours of paperwork to form a corporation. But there's a lot involved in running and growing a successful one. Tomorrow, I'm going to talk about that.

Until then... Fool on!

Rob Landley

06/23/98 Close

Stock  Change    Bid 
 AXP   +  3/8   105.88 
 CHV   +2 5/16  84.06 
 CSCO  +2 1/4   86.88 
 KO    +1 7/16  82.56 
 GPS   +  1/4   59.13 
 EK    -  1/16  67.19 
 XON   +1       71.63 
 GM    -  1/16  68.00 
 INTC  +1 3/8   75.25 
 MSFT  +4 7/8   100.69 
 PFE   -1 5/16  110.13 
 TROW  -  1/8   35.00 
                  Day   Month    Year  History 
         C-K      +1.06%   4.11%  10.10%  10.10% 
         S&P:     +1.48%   2.63%  11.80%  11.80% 
         NASDAQ:  +2.15%   3.69%  11.60%  11.60% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   22 Pfizer        82.30    110.13    33.81% 
     2/3/98   24 Microsoft     78.27    100.69    28.64% 
    2/27/98   27 Coca-Cola     69.11     82.56    19.47% 
     5/1/98   37 Gap Inc.      51.09     59.13    15.73% 
     2/6/98   56 T. Rowe Pr    33.67     35.00     3.94% 
    5/26/98   18 American E   104.07    105.88     1.74% 
    6/23/98   23 Cisco Syst    86.00     86.88     1.02% 
    2/13/98   22 Intel         84.67     75.25   -11.13% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Exxon         64.34     71.63    11.33% 
    3/12/98   20 Eastman Ko    63.15     67.19     6.40% 
    3/12/98   15 Chevron       83.34     84.06     0.86% 
    3/12/98   17 General Mo    72.41     68.00    -6.08% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
    5/26/98   18 American E  1873.20   1905.75    $32.55 
     2/3/98   22 Pfizer      1810.58   2422.75   $612.17 
     2/3/98   24 Microsoft   1878.45   2416.50   $538.05 
    2/27/98   27 Coca-Cola   1865.89   2229.19   $363.30 
     5/1/98   37 Gap Inc.    1890.33   2187.63   $297.30 
     2/6/98   56 T. Rowe Pr  1885.70   1960.00    $74.30 
    6/23/98   23Cisco Syste  1985.95   1998.13    $12.18 
    2/13/98   22 Intel       1862.83   1655.50  -$207.33 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   15 Chevron     1250.14   1260.94    $10.80 
    3/12/98   20 Exxon       1286.70   1432.50   $145.80 
    3/12/98   20 Eastman Ko  1262.95   1343.75    $80.80 
    3/12/98   17 General Mo  1230.89   1156.00   -$74.89 
                               CASH     $51.68 
                              TOTAL  $22020.31 
 *The year for the S&P and Nasdaq will be as of 02/03/98