BONUS SHARES

July, 1918

A Deluge of Bonus Shares--The Effect on the Market--A Problem inFinancial Psychology--The Capitalisation of Reserves--The StockExchange View--The Issue of Bonus-carrying Shares--The Case of theA.B.C.--A Wiser Variation from Canada--Bonus Shares on Flotation--AnAmerican Device--Midwife or Doctor?--The Good and Bad Points of BothSystems.

Of the many kinds of Bonus shares, the one which has lately beenmost prominent in the public eye is that which is produced by thecapitalisation of a reserve fund. There has lately been a perfectepidemic of this kind of Bonus share, which is almost as plentiful asthe caterpillars in the oak trees and the green fly on the allotments.The reason for this outburst is apparently the anxiety which thedirectors of many prosperous industrial companies feel lest the highdividends which good management and sound finance in the past haveenabled them to pay should lay them open to misunderstanding andattack by well-meaning people who think that it is a crime for acompany to earn more than a certain percentage on its capital.

This explanation was very frankly given by the directors of Brunner,Mond and Company, when they lately capitalised part of their reserves.The company, they stated, has for many years paid a dividend on itsOrdinary shares of 27-1/2 per cent., and "the directors feel thatthere is a widespread impression that this is the rate of profitearned on the total of the capital invested, and consequently that thecompany is making an unfair profit out of its customers and the labourit employs. This is by no means the case." It is a lamentable proof ofthe backward state of the economic education of this country that itshould be necessary for well-financed and prosperous concerns to takesteps to make it quite clear to the public that they are not earningmore than they appear to be. In a well-educated community it wouldbe perceived at once that it is the well-financed and prosperouscompanies which improve production in the interests of theirshareholders, their workmen, and the public; that the price which thepublic pays for a commodity is ultimately the price at which the worstfinanced and worst managed companies can just manage to keep alive;that the higher profits earned by the better companies are not wrungout of the pockets of the community, or their workmen, but are theresult of good management and good finance; and that the more the goodcompanies are encouraged to go ahead and drive the bad ones out ofexistence, the better will the community be served, and the betterwill be the chance of the workmen to get good wages. These platitudesare of course, only true in a state of free competition. If there isanything like monopoly the public and the workers are fully justifiedin being suspicious and examining the source from which high dividendsare produced.

Such being the reason why this outburst of capitalisation of reservesfirst began--since in these days all capitalists and those who have tomanage capital feel that they are working under criticism, which isnot only jealous and suspicious (as it should be), but is also toooften both ignorant and prejudiced--it is interesting to note thatthe movement which was so started has been stimulated by its veryexhilarating effect on the market in the shares of the companiesconcerned. Why this should be so it is difficult at first sight tosay. What happens is merely this--that a company, let us suppose, forthe sake of simplicity, with a capital consisting wholly of 3,000,000Ordinary shares, has accumulated out of past profits, or out ofpremiums on new issues of shares, a reserve fund of L1,000,000. Itsnet profit has lately averaged L400,000, and it has, year by year,distributed L300,000 in the shape of a 10 per cent. dividend toits shareholders, and put L100,000 into its reserve fund, which isrepresented on the other side of the balance-sheet by buildingsand plant and a certain amount of first-class investments. If thedirectors now decide to capitalise that L1,000,000 of reserve fund,the only effect is that each shareholder will be given one new sharefor every three which he holds in the existing capital, the reservefund will be wiped out, and the ordinary capital will be increasedfrom L3,000,000 to L4,000,000. None of the shareholders will be inactual fact better off to the extent of one halfpenny, because allwill be in the same position with regard to one another; theirrelative shares in the enterprise will not have been altered. If weimagine, by way of simplifying the problem, that all the Ordinaryshares were in one hand, that one holder would have had in hisOrdinary shares a claim to the total assets of the company, that isto say, to its earning power as long as it is a going concern, and towhatever its assets realise if it went into liquidation; the fact thatL1,000,000 worth of the assets had been bought out of past profits orpremiums paid on new issues of shares would have already added to thevalue of the claim that he had on the property of the company, and noaddition would be made to that value by turning the reserve fund intoshares.

In other words, the reserve fund is already the property of theshareholders, and to convert it from reserve fund into capital, makingthem a present of new shares, which merely represent their claimto the assets held against the reserve fund, is as empty a gift aspresenting a man with a piece of paper informing him that he is theowner of his own hat. All this remains equally true if, besides theordinary capital, there is a considerable amount outstanding ofPreference shares and Debenture debt. In any case, the Ordinaryshareholders possess a claim to the earning power of the company whenprior charges have been satisfied, and to whatever surplus may remainon liquidation after first charges have been paid off in full. Whetherthat interest of theirs is represented by a larger or smaller numberof shares, or by shares of a larger or smaller denomination, or by areserve fund upon which they have a claim when all other claims havebeen settled makes no difference whatever as a matter of academicfact. Apart from the sentiment of the matter, there is no reason whyordinary capital should have any nominal value.

As to the earning power of the company, that, of course, is notaffected one whit by the process. The earning power of the company isall in the assets--the plant, machinery and other property--plusthe elusive qualities which are bound up in the word "goodwill,"representing the selling power, organisation, and the expectation offuture profits. The capitalisation of the reserve simply affects themanner in which the liabilities of the company are arranged, andthe existence of a reserve fund merely means that the Ordinaryshareholders have a claim to a larger amount than their nominalholding in case of liquidation. It does not matter in the leastwhether this larger claim is handed to them in the shape of acertificate, since the nominal amount of their claim has nothingwhatever to do with the amount that their claim realises to themannually in the shape of dividends, or in the event of liquidation,from the realisation of the company's assets.
In fact, the capitalisation of reserves is sometimes criticised byeconomic purists as a retrograde step because it seems likely toencourage the directors to be extravagant in the matter of dividends.In the example which we supposed above of the company with a capitalof three millions and reserve fund of one million, if the reserve fundis turned into Ordinary shares and the earning power of the companyremains the same there may obviously be a temptation to the directorsto modify the prudent policy under which they had hitherto placed onehundred thousand a year to reserve, because if they continued it theshareholders would discover they were really no better off and thatthey simply got a lower rate of dividend on the larger amount ofshares, and that their actual receipts from the company were exactlythe same as before. And if the earning power of the company remainedthe same and the directors left off placing the one hundred thousanda year to reserve, and paid away the whole of the net profit individend, it is clear that the progressive expansion of the company'sbusiness would be to that extent checked. On the other hand, there isa contrary argument that as long as the company has a large reservefund there is a possibility that dissatisfied shareholders may agitatefor a realisation of sufficient assets to enable that reserve fund tobe distributed, especially if it has been wholly acquired out of pastprofits. In this case the capitalisation of the reserve fund puts thistemptation out of their reach since, when once the reserve fund hasbeen capitalised, it can only be got at by greedy shareholders throughthe process of liquidation. Since, however, the shareholder in thesetimes is not quite so short-sighted as he used to be, there is notperhaps really very much advantage in this point.

But since, as has been shown, capitalisation of reserves has no effectupon the earning power and assets of the company, it is interesting totry and discover why the rumour and announcement of such an intentionon the part of the board of directors is nearly always accompanied bya rise in the shares of the company affected. If the shareholder ismerely to be given a larger nominal claim, which does not in the leastaffect the value of the assets which that claim concerns, and if therelative amount of his claim is exactly the same with regard to theother shareholders, it is clear that the rise in the value of theshares is based entirely either on a psychological mistake on the partof the public and its financial advisers, or on the fact that thetransaction called attention to the value of the shares which havehitherto been undervalued in the market. Probably the movement arisesfrom both these causes. A large number of people think they are betteroff if they have a larger nominal share, without considering thatall the other shareholders are at the same time having their claimincreased, that the assets to which they all have a claim are notbeing increased, and that, consequently, if a sharing-out process wereto take place they would all be exactly as they would have been ifno such capitalisation of reserves had been carried out. And if asufficient number of people think that a share or any other commodityis more valuable, it thereby becomes more valuable, because value isnothing else than the amount, whether in money or other commodities,at which a commodity can be disposed of.

But it is also true that there are, at all times, a very large numberof securities, especially in the industrial market, which wouldstand higher if their earning power and position were more closelyscrutinised. This is very clearly seen to be the case from theapparently extravagant prices at which insurance companies, forexample, sometimes buy the businesses of one another. They give aprice which is considerably above the market value of the concern asrepresented by the price of its shares. Critics say that the terms areextravagant, and yet the deal is found to be highly profitable to thebuying company. The profit of the deal, of course, may be increased bythe advantages of amalgamation, but quite apart from that it is clearthat the market price of securities very often undervalues, as italso, perhaps, still oftener overvalues, the real position of thecompanies on whose earning powers they represent claims. In any case,there is the fact that these capitalisations of reserve funds, whichmake no real difference to the actual position of the company, areuniversally regarded, in the language of the Stock Exchange, as "bullpoints." It is assumed, of course, that the directors would not carryout such an operation unless they saw their way to a higher earningpower in the future as a justification for the larger capital. In thisexpectation the directors might be right or wrong, and, even if theyare right, that prospect of higher earning power, if market pricescould be relied upon to express the true position of a company, wouldhave been "in the price."

There is another kind of Bonus share, which is not exactly a Bonusshare, but carries a bonus with it. This comes into being when thedirectors of a company sell new shares to existing shareholders at aprice below the terms which they might have obtained if they made anew issue to the general public. The classical example of this systemis the Aerated Bread Company, that concern to which City clerks andjournalists and others owe so much as pioneers of cheap and simplecatering. It will be remembered that in the palmy days of thiscompany, before it had been severely cut into by competition, its L1shares used to stand in the neighbourhood of L15. The directors usedthen to make issues of new shares to existing shareholders at theirface value, that is to say, at L1 per share, although it was obviousthat if they had made a public issue inviting all and sundry tosubscribe they could have sold their new issues at or above L14per share. This system put an enormous bonus in the pockets of theexisting shareholders at the expense of the company and its futureprospects. The directors practically gave to the existing shareholdersa present of L130,000 if they sold them 10,000 new shares for L10,000,which they and the public would have readily subscribed for atL140,000. There was nothing wicked about the process, but it wasextremely short-sighted. If the company had retained the monopolywhich its pioneer work as a cheap caterer for a long time securedit, it might have kept its prosperity unimpaired even by thisshort-sighted finance. As it was, attracted several competitors, someof which were extremely well managed and financed, and although itstill does a most useful work for the community, its earning power hassuffered considerably. But this is only an extreme example of a systemwhich is reasonable enough if it is not carried too far. The CanadianPacific Railway, for instance, has for many years adopted a verymoderate use of this system, making new issues to its shareholders onterms rather cheaper than it could have obtained by a public issue,but not giving away enough to impair its future seriously in orderto make presents to the existing stockholders by this means. By thecontinued making of small presents to their constituents the directorsof the company have obtained the support of a very loyal body ofstockholders, who feel that they are being well treated but notpampered. This system of granting a small bonus to existingshareholders on occasions when the company has to issue new capital isone which is quite unobjectionable as long as it is not abused. If,owing to the use of it, the directors are encouraged to financethemselves badly, that is to say, to pay out of new capital forimprovements and extensions which a more prudent policy would havefinanced out of earnings, just because they find that these issuescarrying a small bonus makes them popular with the stockholders, thenthe system is being abused. Otherwise there seems no reason to objectto a measure which keeps the shareholders happy and does not do anyharm to the concern so long as it is worked in moderation.

Finally, there is a Bonus share or stock which does not representaccumulation out of vast profits or issues of new shares at a premium,and does not involve a bonus by the sale to existing shareholders ata price below the terms which could be got in the market, but is atfirst sight pure water, representing merely possibilities, perhapses,and potentialities. This kind of Bonus share is chiefly known on theother side of the Atlantic, and is usually damned with bell, book andcandle by purists among English financial critics. We say on this sideof the water that every pound of an English well-financed companyrepresents a pound which has actually been spent and put into tangibleassets which help the company to earn profits. This boast is by nomeans true, since nearly all industrial companies come into being withsomething paid for in the shape of goodwill, which is of enormousimportance, but can hardly be called a tangible asset; and even in thecase of our railway companies, many millions of original capital wentinto Parliamentary and legal expenses, which have been, in one sense,dead capital ever since, though without this expenditure the railwayscould never have got to work. The American system of Common shares,representing what appears to be water, is only a modification of whatevery company has to do, in one form or another, on this side oranywhere in the world. Wherever an existing business is bought outsomething has to be given over and above the old iron value of theconcern for the value of the connection and other intangible assets.Wherever an entirely new industry is started it has to meet certaininitial expenses. It has to placate, to use the unpleasant Americanword, various interests in order to get to work, or it has to lay outmoney, in building up a concern by advertising or otherwise. It isimpossible that every penny which is put into it will go into actualbuildings, plant, machinery, and stock-in-trade.

In America the system has been preferred by which the actual tangibleassets of a new concern are financed wholly or largely by issues ofbonds or Preferred stock, and the Common stock is given away to thoseinterested in the promotion, for them either to hold or to use inorder to secure the co-operation of those who may be useful, or modifythe opposition of those who may be dangerous. The net result of it isthat the Common stock is represented in fact by goodwill or the powerto get to work. If the company prospers, then it is the business ofthose who hold these Common shares to see that assets are accumulatedout of profits, to be held against their Common stock, so squeezingthe water out of it and making it good. The system thus possesses thisvery considerable advantage, that those who promote a company areinterested in its future welfare, and watch over it and guide itthrough its subsequent existence, putting energy and good managementat its disposal in order that the paper which they hold may berepresented, not by water, but by real assets, and so may bring them atangible reward. It has thus in some ways a great advantage over theEnglish system, by which the company promoter is too often concernedmerely in the immediate success of the promotion. He is, as one of thegreatest of them described himself, a mere midwife, who brings theinteresting infant into the world, pats its little head, says good-byeto it, and leaves it to take care of itself throughout its troubledexistence. By the American system the promoter is not a midwife but adoctor who assists at the birth of the infant, and also watches overits youth and makes every effort to guide its toddling footsteps insuch a way that it may grow into lusty manhood. It is not until he hasdone so that he is enabled, by the sale of the shares which were givento him at the beginning, to realise the full profit which he expected.The profits realised by this method are in many cases enormous. Onthe other hand, the amount of work that is put in to secure them isinfinitely greater than happens in the case of the English midwifepromoter; and if the enterprise is a failure, then the promoter goeswithout his profits.

The system, like everything else, is liable to abuse, if a rascallyboard of directors, in a hurry to unload their holding of Common stockon an unsuspecting public, makes the position and prospects of thecompany look better than they are by unscrupulous bookkeeping andextravagant distribution of profits, earned or unearned. These thingshappen in a world in which the ignorance of the public about moneymatters is a constant invitation to those who are skilled in them torelieve the public of money which it would probably mis-spend; but,if well and honestly worked, the system is by no means inherentlyunsound, as some English critics too often assume, and it has beenshown that it carries with it a very great and substantial advantagein the hands of honest people who wish to conduct the business ofcompany promotion on progressive lines.