Someone in the village proposes building a ship to trade with other islands. A ship costs 100 portions of grain, more than any household can afford. A ship at sea has a thirty per cent chance of sinking, and no household could bear such a loss either. Borrowing to build the ship does not work: if it sinks, the borrower cannot repay and the lender loses anyway, and the interest rate a lender would demand for that is prohibitively high. And so shares appear: many households put in money together and share success and failure in proportion to their holdings. Each household puts a little grain into many ships, so that one sinking does not cripple it. Limited liability means investors can lose at most what they put in, and shares can therefore be transferred without worry. When a ship returns, debts are paid first and what remains goes to the shareholders: debt and equity are two ways of dividing the same proceeds.
The households on the island have grown more prosperous and have more spare grain, but the most profitable trade lies across the sea. Build a ship, carry grain to other islands, and bring back salt and cloth; on its return, the cargo is worth two and a half times what the ship cost to build. But building a ship takes 100 portions of grain. A household can spare no more than 5 portions, and even the richest household in the village has only 20. Even if the grain could be found, a ship at sea has a thirty per cent chance of sinking. A household that staked everything it owned would be ruined by a single wreck.
The problem has two layers: no household can put up that much money, and no household can bear that much risk.
Today's counterpart. Building a railway, building a factory or developing a new drug requires capital and carries risks far beyond what any family can manage.
Could one household take the lead and borrow from the whole village to build the ship? A loan agreement requires repayment of principal and interest when due, whether or not the ship returns. If the ship returns, the borrower repays principal and interest and keeps everything else; if it sinks, the borrower cannot repay, and the lender's grain goes down with the ship. Knowing there is a thirty per cent chance of losing everything, a lender needs an interest rate of at least about 43% just to break even. Even then, the lender bears the entire loss from a sinking, while most of the gain when the ship returns goes to the borrower, so few lenders are willing to take the risk. Lending suits uses whose outcomes are fairly certain, not ventures where success and failure lie far apart.
Today's counterpart. Start-ups find it hard to get going on bank loans; most of their money comes from investors willing to share in success and failure.
Try a different agreement: twenty households each put in 5 portions to build one ship together, each owning one twentieth. If the ship returns, the cargo is divided among the households by their holdings; if it sinks, each household loses its 5 portions. The investment no longer requires a fixed return; gains and losses are shared in proportion to holdings. This is a share.
Shares also make diversification possible. Rather than putting all 5 portions into one ship, a household can put half a portion into each of ten ships: if one sinks, it loses only half a portion. If whether each ship sinks is unrelated to the others, the more ships a household invests in, the steadier its returns. The reasoning is the same as for mutual insurance; only what is being shared changes, from bad luck to the success or failure of ventures.
Today's counterpart. A stock is a share in a company; hold the stocks of many companies, and the failure of one has little effect on the whole portfolio.
When a ship sinks, more than the ship is lost: the crew's wages and the goods bought on credit from others must still be paid. If the ship's investors had to answer for these debts with everything they owned, a well-off household that put half a portion into an unfamiliar ship could lose everything in a single wreck. Nor would it be willing to invest alongside households of slender means, because creditors would turn to the wealthier households to collect.
Limited liability changes this: investors can lose at most what they put in, and the ship's debts are limited to the ship's own assets. The worst outcome is known in advance. Well-off households no longer need to keep watching whether the captain is running up debts, nor to find out how much their fellow investors own, so they can safely put a small amount into each of many ships. Someone who buys a share likewise need not care how much the other investors own. The same share is worth the same in anyone's hands, so shares can be transferred, and their price depends only on the ship itself. The cost is that part of the loss is shifted to creditors, who therefore demand higher interest or collateral.
Today's counterpart. Shareholders of limited liability companies and joint-stock companies are liable only up to their capital contribution; banks lending to a company therefore look at the company's own assets and cash flow.
A ship can also borrow and issue shares at the same time. When it returns, debts are repaid first as agreed, and only what remains is divided among the shareholders. Debt pays a fixed return and carries less risk; equity has no ceiling on its return but comes last and carries more risk. Shareholders are therefore called residual claimants.
Dividing the proceeds into debt and equity does not change what the ship itself is worth. How much cargo the ship brings back depends on the winds and on trade, not on how the proceeds were divided in advance. Imagine two identical ships, one financed only with shares, the other with both debt and shares. If the debt and shares of the second together sold for more, an investor could sell their stake in the second, buy shares in the first, and personally borrow grain in the same proportion. They would get exactly the same harvest as before and pocket the price difference for nothing. When everyone does this, the difference soon disappears. So, as long as there are no taxes, a sinking brings no extra losses, everyone sees the same information, and investors and the ship can borrow grain on the same terms, the ship's total value does not depend on how its proceeds are divided.
Today's counterpart. A company's capital consists of liabilities and shareholders' equity; in bankruptcy and liquidation, creditors are paid first and shareholders come last.
Early seafaring partnerships were often set up for a single voyage: the ship returned, the cargo was counted and divided, and the partnership dissolved. The Dutch East India Company, founded in 1602, went further. Its capital was originally to be liquidated after ten years, but it was later kept in the company for the long term. Investors who wanted to leave could only sell their shares to someone else, and an active trade in shares grew up in Amsterdam as a result. Gelderblom, de Jong and Jonker (2013) point out that this corporate form was not designed from the outset but took shape step by step as defects were repaired; even the limited liability of its managers was established only after years of trial and error.
Only when capital stays in the company for the long term can the company take on undertakings that span many years; only when shares can be transferred do investors avoid being locked in for those years.
Today's counterpart. The capital of a listed company stays in the company for the long term, and shareholders enter or leave by buying and selling shares on an exchange.
The simulator unlocks the "Shares" rule. Each year twenty households set aside part of their grain to invest in building ships, and each ship has a thirty per cent chance of sinking. You can choose to build ships alone, have a few households build one together, or have every household hold a small share in every ship, and switch limited liability on or off. Then watch each household's wealth and the number of households ruined over twenty years.
With shares, large projects can be carried by many people together, but new problems follow:
Stocks, bonds and the funds built from them all rest on the mechanisms of this chapter. Three implications follow. First, equity and debt are two ways of dividing the same proceeds: equity shares in success and failure and carries more risk; debt pays a fixed return and is paid first. A product's risk depends on which layer it holds. Second, the risk of shares can be greatly reduced by diversification; staking everything on one company means bearing risk that could have been avoided. Third, limited liability and transferable shares are what allow ordinary people to take part in large undertakings. They also shift part of the risk to creditors and separate investing from managing; the latter is where the problem of delegation begins.
Ventures whose outcomes lie far apart do not suit lending; they suit many people investing together and sharing the losses.
The average gain is unchanged and volatility falls sharply; staking everything on one ship means bearing avoidable risk.
Investors need not care about others’ wealth, and shares can be transferred; part of the risk is shifted to creditors.
Debts are paid first and the rest goes to shareholders; the split does not change what the ship itself is worth.