Old MacDonald had a cap table

For some readers a little background may be helpful before I talk about commercial banks and deposit accounts. Others may prefer this over the use of pharmaceutical sleeping aids or alcohol.  I’ll try to keep it short.

Ownership, broadly understood, is simply to have a legitimate claim staked in some actual property.  There are many different forms of ownership.

Suppose we have a farm which is owned by a group of investors.  In anticipation of future discussions I’ll sometimes out of habit refer to the collected assets of the farm as the balance sheet of the farm; in fact the balance sheet more strictly speaking includes not just the assets (inventory of what is owned) but also an inventory of what is owed (liabilities + equity), that is, what the farm “owes” to various parties (workers, investors, customers, suppliers, etc).  These always ‘balance out’ to zero[3]; thus the name ‘balance sheet'[1].

The farm is not a person, of course, so to say that it ‘owes’ something to Bob is simply to say that Bob is entitled to that something to the extent that it can be recovered from the operations and assets of the farm.  I’ll sometimes habitually refer to things that the farm ‘owes’ to various parties as ‘claims against the balance sheet’ or the like.

These various claims come in two flavors.  The operating flavor is what the investor/creditor is entitled to while the farm is up and running, producing crops and making profits (or incurring losses).  The liquidation flavor is what the investor/creditor is entitled to when the farm is being liquidated, that is, when the farm itself or its assets are being sold off.

A capitalization table (cap table) is just an inventory of the investors and their claims.  The claims each has depends upon the kind(s) of security (investment contract with the farm) he owns.  Securities come in all sorts of flavors and a virtually infinite variety of contract terms, but for the sake of simplicity we can speak of two basic kinds: equity (stock) and debt (bonds)[2].

Debt is entitled to repayment of principal and a fixed rate of interest on a predetermined schedule, and has liquidation preference over equity. That is to say, if the farm is in liquidation the principal and accrued interest on the debt are fully paid from the assets before the equity holders get anything at all.  Debt is obviously lower risk than equity.

Equity gets whatever is left over after all other claims have been satisfied.  Equity has more profit potential than debt, but is much riskier.  While the business is operating equity gets all of the profit in excess of expenses (including, in the expenses which have to be paid first, payments on outstanding debt).  When the business is liquidated equity gets everything that is left over after all of the ‘fixed’ claims have been paid.  So the profit potential for equity has no theoretical maximum; but misfortune can easily reduce its value to nothing.

Notice that nowhere in this basic capital structure has any person made a personal guarantee of repayment.

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[1] The reason a balance sheet balances out to zero – that the sum of what is owned is equal to the sum of what is owed – is because once all of the creditors of various sorts have been paid what they are owed, any left over assets belong to the holders of equity.  Equity is often itself referred to as ‘ownership’, although this is obviously a more narrow category which simply means ‘entitled to whatever is left over after everyone else has been paid’.  There are kinds of equity which do not involve any formal ‘say’ in how the company is run, and the market does take that difference into consideration: a contemporary example is the difference between GOOG and GOOGL.

[2] I’m ignoring matters of operating control for present purposes.  Usually debt investors are passive, whereas equity investors are active – that is, equity investors elect the board of directors.

[3] Assuming that no claims extend beyond the assets of the farm-as-actual-property to personal guarantees: that is, assuming no usurious contracts.