War-Time Financial Problems

by Hartley Withers

XI

BONUS SHARES

July, 1918

A Deluge of Bonus Shares—The Effect on the Market—A Problem in
Financial Psychology—The Capitalisation of Reserves—The Stock
Exchange View—The Issue of Bonus-carrying Shares—The Case of the
A.B.C.—A Wiser Variation from Canada—Bonus Shares on Flotation—An
American Device—Midwife or Doctor?—The Good and Bad Points of Both
Systems.

Of the many kinds of Bonus shares, the one which has lately been most prominent in the public eye is that which is produced by the capitalisation of a reserve fund. There has lately been a perfect epidemic of this kind of Bonus share, which is almost as plentiful as the caterpillars in the oak trees and the green fly on the allotments. The reason for this outburst is apparently the anxiety which the directors of many prosperous industrial companies feel lest the high dividends which good management and sound finance in the past have enabled them to pay should lay them open to misunderstanding and attack by well-meaning people who think that it is a crime for a company 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 its Ordinary shares of 27-1/2 per cent., and "the directors feel that there is a widespread impression that this is the rate of profit earned on the total of the capital invested, and consequently that the company is making an unfair profit out of its customers and the labour it employs. This is by no means the case." It is a lamentable proof of the backward state of the economic education of this country that it should be necessary for well-financed and prosperous concerns to take steps to make it quite clear to the public that they are not earning more than they appear to be. In a well-educated community it would be perceived at once that it is the well-financed and prosperous companies which improve production in the interests of their shareholders, their workmen, and the public; that the price which the public pays for a commodity is ultimately the price at which the worst financed and worst managed companies can just manage to keep alive; that the higher profits earned by the better companies are not wrung out of the pockets of the community, or their workmen, but are the result of good management and good finance; and that the more the good companies are encouraged to go ahead and drive the bad ones out of existence, the better will the community be served, and the better will be the chance of the workmen to get good wages. These platitudes are of course, only true in a state of free competition. If there is anything like monopoly the public and the workers are fully justified in being suspicious and examining the source from which high dividends are produced.

Such being the reason why this outburst of capitalisation of reserves first began—since in these days all capitalists and those who have to manage capital feel that they are working under criticism, which is not only jealous and suspicious (as it should be), but is also too often both ignorant and prejudiced—it is interesting to note that the movement which was so started has been stimulated by its very exhilarating effect on the market in the shares of the companies concerned. Why this should be so it is difficult at first sight to say. What happens is merely this—that a company, let us suppose, for the sake of simplicity, with a capital consisting wholly of 3,000,000 Ordinary shares, has accumulated out of past profits, or out of premiums on new issues of shares, a reserve fund of £1,000,000. Its net profit has lately averaged £400,000, and it has, year by year, distributed £300,000 in the shape of a 10 per cent. dividend to its shareholders, and put £100,000 into its reserve fund, which is represented on the other side of the balance-sheet by buildings and plant and a certain amount of first-class investments. If the directors now decide to capitalise that £1,000,000 of reserve fund, the only effect is that each shareholder will be given one new share for every three which he holds in the existing capital, the reserve fund will be wiped out, and the ordinary capital will be increased from £3,000,000 to £4,000,000. None of the shareholders will be in actual fact better off to the extent of one halfpenny, because all will be in the same position with regard to one another; their relative shares in the enterprise will not have been altered. If we imagine, by way of simplifying the problem, that all the Ordinary shares were in one hand, that one holder would have had in his Ordinary shares a claim to the total assets of the company, that is to say, to its earning power as long as it is a going concern, and to whatever its assets realise if it went into liquidation; the fact that £1,000,000 worth of the assets had been bought out of past profits or premiums paid on new issues of shares would have already added to the value of the claim that he had on the property of the company, and no addition would be made to that value by turning the reserve fund into shares.

In other words, the reserve fund is already the property of the shareholders, and to convert it from reserve fund into capital, making them a present of new shares, which merely represent their claim to the assets held against the reserve fund, is as empty a gift as presenting a man with a piece of paper informing him that he is the owner of his own hat. All this remains equally true if, besides the ordinary capital, there is a considerable amount outstanding of Preference shares and Debenture debt. In any case, the Ordinary shareholders possess a claim to the earning power of the company when prior charges have been satisfied, and to whatever surplus may remain on liquidation after first charges have been paid off in full. Whether that interest of theirs is represented by a larger or smaller number of shares, or by shares of a larger or smaller denomination, or by a reserve fund upon which they have a claim when all other claims have been settled makes no difference whatever as a matter of academic fact. Apart from the sentiment of the matter, there is no reason why ordinary capital should have any nominal value.

As to the earning power of the company, that, of course, is not affected one whit by the process. The earning power of the company is all in the assets—the plant, machinery and other property—plus the elusive qualities which are bound up in the word "goodwill," representing the selling power, organisation, and the expectation of future profits. The capitalisation of the reserve simply affects the manner in which the liabilities of the company are arranged, and the existence of a reserve fund merely means that the Ordinary shareholders have a claim to a larger amount than their nominal holding in case of liquidation. It does not matter in the least whether this larger claim is handed to them in the shape of a certificate, since the nominal amount of their claim has nothing whatever to do with the amount that their claim realises to them annually 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 by economic purists as a retrograde step because it seems likely to encourage the directors to be extravagant in the matter of dividends. In the example which we supposed above of the company with a capital of three millions and reserve fund of one million, if the reserve fund is turned into Ordinary shares and the earning power of the company remains the same there may obviously be a temptation to the directors to modify the prudent policy under which they had hitherto placed one hundred thousand a year to reserve, because if they continued it the shareholders would discover they were really no better off and that they simply got a lower rate of dividend on the larger amount of shares, and that their actual receipts from the company were exactly the same as before. And if the earning power of the company remained the same and the directors left off placing the one hundred thousand a year to reserve, and paid away the whole of the net profit in dividend, it is clear that the progressive expansion of the company's business would be to that extent checked. On the other hand, there is a contrary argument that as long as the company has a large reserve fund there is a possibility that dissatisfied shareholders may agitate for a realisation of sufficient assets to enable that reserve fund to be distributed, especially if it has been wholly acquired out of past profits. In this case the capitalisation of the reserve fund puts this temptation out of their reach since, when once the reserve fund has been capitalised, it can only be got at by greedy shareholders through the process of liquidation. Since, however, the shareholder in these times is not quite so short-sighted as he used to be, there is not perhaps really very much advantage in this point.

But since, as has been shown, capitalisation of reserves has no effect upon the earning power and assets of the company, it is interesting to try and discover why the rumour and announcement of such an intention on the part of the board of directors is nearly always accompanied by a rise in the shares of the company affected. If the shareholder is merely to be given a larger nominal claim, which does not in the least affect the value of the assets which that claim concerns, and if the relative amount of his claim is exactly the same with regard to the other shareholders, it is clear that the rise in the value of the shares is based entirely either on a psychological mistake on the part of the public and its financial advisers, or on the fact that the transaction called attention to the value of the shares which have hitherto been undervalued in the market. Probably the movement arises from both these causes. A large number of people think they are better off if they have a larger nominal share, without considering that all the other shareholders are at the same time having their claim increased, that the assets to which they all have a claim are not being increased, and that, consequently, if a sharing-out process were to take place they would all be exactly as they would have been if no such capitalisation of reserves had been carried out. And if a sufficient number of people think that a share or any other commodity is more valuable, it thereby becomes more valuable, because value is nothing 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 number of securities, especially in the industrial market, which would stand higher if their earning power and position were more closely scrutinised. This is very clearly seen to be the case from the apparently extravagant prices at which insurance companies, for example, sometimes buy the businesses of one another. They give a price which is considerably above the market value of the concern as represented by the price of its shares. Critics say that the terms are extravagant, and yet the deal is found to be highly profitable to the buying company. The profit of the deal, of course, may be increased by the advantages of amalgamation, but quite apart from that it is clear that the market price of securities very often undervalues, as it also, perhaps, still oftener overvalues, the real position of the companies on whose earning powers they represent claims. In any case, there is the fact that these capitalisations of reserve funds, which make no real difference to the actual position of the company, are universally regarded, in the language of the Stock Exchange, as "bull points." It is assumed, of course, that the directors would not carry out such an operation unless they saw their way to a higher earning power in the future as a justification for the larger capital. In this expectation the directors might be right or wrong, and, even if they are right, that prospect of higher earning power, if market prices could be relied upon to express the true position of a company, would have been "in the price."

There is another kind of Bonus share, which is not exactly a Bonus share, but carries a bonus with it. This comes into being when the directors of a company sell new shares to existing shareholders at a price below the terms which they might have obtained if they made a new issue to the general public. The classical example of this system is the Aerated Bread Company, that concern to which City clerks and journalists and others owe so much as pioneers of cheap and simple catering. It will be remembered that in the palmy days of this company, before it had been severely cut into by competition, its £1 shares used to stand in the neighbourhood of £15. The directors used then to make issues of new shares to existing shareholders at their face value, that is to say, at £1 per share, although it was obvious that if they had made a public issue inviting all and sundry to subscribe they could have sold their new issues at or above £14 per share. This system put an enormous bonus in the pockets of the existing shareholders at the expense of the company and its future prospects. The directors practically gave to the existing shareholders a present of £130,000 if they sold them 10,000 new shares for £10,000, which they and the public would have readily subscribed for at £140,000. There was nothing wicked about the process, but it was extremely short-sighted. If the company had retained the monopoly which its pioneer work as a cheap caterer for a long time secured it, it might have kept its prosperity unimpaired even by this short-sighted finance. As it was, attracted several competitors, some of which were extremely well managed and financed, and although it still does a most useful work for the community, its earning power has suffered considerably. But this is only an extreme example of a system which is reasonable enough if it is not carried too far. The Canadian Pacific Railway, for instance, has for many years adopted a very moderate use of this system, making new issues to its shareholders on terms rather cheaper than it could have obtained by a public issue, but not giving away enough to impair its future seriously in order to make presents to the existing stockholders by this means. By the continued making of small presents to their constituents the directors of the company have obtained the support of a very loyal body of stockholders, who feel that they are being well treated but not pampered. This system of granting a small bonus to existing shareholders on occasions when the company has to issue new capital is one which is quite unobjectionable as long as it is not abused. If, owing to the use of it, the directors are encouraged to finance themselves badly, that is to say, to pay out of new capital for improvements and extensions which a more prudent policy would have financed out of earnings, just because they find that these issues carrying a small bonus makes them popular with the stockholders, then the system is being abused. Otherwise there seems no reason to object to a measure which keeps the shareholders happy and does not do any harm to the concern so long as it is worked in moderation.

Finally, there is a Bonus share or stock which does not represent accumulation out of vast profits or issues of new shares at a premium, and does not involve a bonus by the sale to existing shareholders at a price below the terms which could be got in the market, but is at first sight pure water, representing merely possibilities, perhapses, and potentialities. This kind of Bonus share is chiefly known on the other side of the Atlantic, and is usually damned with bell, book and candle by purists among English financial critics. We say on this side of the water that every pound of an English well-financed company represents a pound which has actually been spent and put into tangible assets which help the company to earn profits. This boast is by no means true, since nearly all industrial companies come into being with something paid for in the shape of goodwill, which is of enormous importance, but can hardly be called a tangible asset; and even in the case of our railway companies, many millions of original capital went into Parliamentary and legal expenses, which have been, in one sense, dead capital ever since, though without this expenditure the railways could never have got to work. The American system of Common shares, representing what appears to be water, is only a modification of what every company has to do, in one form or another, on this side or anywhere in the world. Wherever an existing business is bought out something has to be given over and above the old iron value of the concern for the value of the connection and other intangible assets. Wherever an entirely new industry is started it has to meet certain initial expenses. It has to placate, to use the unpleasant American word, various interests in order to get to work, or it has to lay out money, in building up a concern by advertising or otherwise. It is impossible that every penny which is put into it will go into actual buildings, plant, machinery, and stock-in-trade.

In America the system has been preferred by which the actual tangible assets of a new concern are financed wholly or largely by issues of bonds or Preferred stock, and the Common stock is given away to those interested in the promotion, for them either to hold or to use in order to secure the co-operation of those who may be useful, or modify the opposition of those who may be dangerous. The net result of it is that the Common stock is represented in fact by goodwill or the power to get to work. If the company prospers, then it is the business of those who hold these Common shares to see that assets are accumulated out of profits, to be held against their Common stock, so squeezing the water out of it and making it good. The system thus possesses this very considerable advantage, that those who promote a company are interested in its future welfare, and watch over it and guide it through its subsequent existence, putting energy and good management at its disposal in order that the paper which they hold may be represented, not by water, but by real assets, and so may bring them a tangible reward. It has thus in some ways a great advantage over the English system, by which the company promoter is too often concerned merely in the immediate success of the promotion. He is, as one of the greatest of them described himself, a mere midwife, who brings the interesting infant into the world, pats its little head, says good-bye to it, and leaves it to take care of itself throughout its troubled existence. By the American system the promoter is not a midwife but a doctor who assists at the birth of the infant, and also watches over its youth and makes every effort to guide its toddling footsteps in such a way that it may grow into lusty manhood. It is not until he has done so that he is enabled, by the sale of the shares which were given to him at the beginning, to realise the full profit which he expected. The profits realised by this method are in many cases enormous. On the other hand, the amount of work that is put in to secure them is infinitely greater than happens in the case of the English midwife promoter; and if the enterprise is a failure, then the promoter goes without his profits.

The system, like everything else, is liable to abuse, if a rascally board of directors, in a hurry to unload their holding of Common stock on an unsuspecting public, makes the position and prospects of the company look better than they are by unscrupulous bookkeeping and extravagant distribution of profits, earned or unearned. These things happen in a world in which the ignorance of the public about money matters is a constant invitation to those who are skilled in them to relieve the public of money which it would probably mis-spend; but, if well and honestly worked, the system is by no means inherently unsound, as some English critics too often assume, and it has been shown that it carries with it a very great and substantial advantage in the hands of honest people who wish to conduct the business of company promotion on progressive lines.