Bonds vs Shares, Debt vs Equity, IPO,
Underwriter, Venture Capital, Angel Investor, Junk Bonds, Bearer Bonds, Gilt
Edged securities: Meaning, Explained
1.
How To get the cash to start my company?
2.
Problems in above options
3.
Financing my company: Debt OR Equity
4.
#1: Debt: Bonds
o Junk Bonds vs Gilt
Edged Security
o Bearer Bonds
5.
#2: Equity –Shares
o Shareholders and Board
of Directors
o What is IPO?
6.
Venture Capitalist and Angel Investors
o What is Venture
Capital?
o Who is Angel Investor?
I want to start an Ice
cream company, what will I need?
Land
|
To
build a factory.
|
Labor
|
Workers
to run the machines.
|
Capital
|
Money
to buy Freezers, mixers and packing machines to make ice-cream.
|
Entrepreneurship
|
To
take the risk and do above three things.
|
·
These
are called the four factors of production.
·
I
already have the entrepreneurship in my heart and mind.
·
But
it requires truckload of cash to arrange for the other three items: Land,
Labour and Capital.
·
I
can rob a bank
·
Or
I can just start my own IIT Bombay, sell its application forms for 5,000 rupees
and then declare cut off 99.99% and thus earning truckload of cash without
actually wasting a single rupee in arranging the admission interviews.
·
Or
I can join politics.
·
Can’t
rob a rob a bank because this too requires Labour (gangsters) and guns, masks,
vehicles and Entrepreneurship (to take the risk of going to jail).
·
Can’t
start my own IIT Bombay would again require those four factors of production
(Land, Labour, Capital, Entrepreneurship)+Permissions from UGC/AICTE.
·
Can’t
join politics because Only ministers can make huge money, MPs/MLAs don’t. And
Unfortunately I’m not a son or daughter of some big politician so I can’t
become minister @ young age (Agatha Sangma, Sachin Pilot, Naveen
Jindal et al) So even If I join politics right now, I’ll have to do
bootlicking of ‘Party high command’ until I get 60 years old, only then I can
become minister and break the records set by A.Raja and Madhu Koda.
Now, There are two ways
to (legally) arrange money for starting a company or to expand a company. First
is Debt and Second Equity.
·
The
word debt is self-explanatory. You borrow money from someone: It can be a bank,
it can be a friend, it can be a stranger.
·
I
write on a piece of paper: “To whoever pays me Rs.1000, I’ll pay annual 10%
interest rate (Rs.100). And after 5 years, I’ll also repay the principle amount
Rs.1000. No “ifs” and “buts”.
·
This
is one type of security paper. We call it “BOND”.
·
IF
you hold my bonds, I’m liable to pay you money no matter what happens. Whether
my ice-cream company actually makes profit or goes Kingfisher. I
have to keep paying fixed money to you, every year.
·
In
above case I offered you 10% interest rate. But in real life, there are credit
rating companies like CRISIL, S&P, Moody’s etc. They’ll give credit ratings
to a bond. (i.e. Am I capable enough to actually pay you?).
·
Based
on that, they give ratings example AA,A, BBB, BB,C,D etc.
·
I
had talked about them in my previous article. Go through the Archive on
www.mrunal.org/economy
Junk Bonds
·
If
my Bond gets “C” or “D” rating, it means I’m not creditworthy, I may default on
this loan, I may run away. So my bond is as junk as Ra.One movie. A wise man
will not invest in it.
·
So,
how can I seduce you into purchasing my bonds? How can I convenience you
to take the higher risk, in buying my junk bond?
·
How
about Free caller Tunes or a scratch-card that offers you a chance to dine with
Sachin or Katrina?
·
Or
How about Higher Interest rates: “If you give me Rs.1000, I’ll give you 25%
interest rate per year!”
·
This
is also known as “High Yield Bond”, because you’re getting higher profit.
Gilt Edged Securities
·
Like
an ice cream company, Government also needs finance- at times when tax
collection is low and they need some temporary funds.
·
They
issues treasury bonds. RBI sells these treasury bonds on Government’s behalf.
·
But
Governments generally have the “aukaat” to repay the principle and
interest rates. Hence Government bonds have higher credit ratings (AA). So,
they don’t need to seduce you, they’ll offer very low rate, say 4%.
·
Similarly,
well known companies with high credit ratings (AA) also issue bonds but pay
low rates.
·
If
you don’t like to take risks, you’ll invest in such bonds. These are called ‘gilt-edged
securities’.
·
In
Bollywood movies, Kidnapper demands ransom of Rs.10 lakhs but he wants the
money in the denomination of Rs.5/10/50 Rupee notes. Why? Because it is easy to
circulate these notes and harder for police or banks to keep track of this
money.
·
Same
way, in Hollywood Spy-thriller movies, the Villain will ask you to pay 10
million dollars in Bearer bonds.
·
Bearer
bonds are same as regular bonds, but they don’t have “Holder’s Name” on them.
These bearer bonds have coupons attached with them. So, if you don’t want to withdraw
the whole money, you can cut a few coupons and sell them to a broker to
withdraw partial amount.
·
E.g.
Rs.100 interest is to be paid on 1st April 2012, But even on December-2011 you
can sell the coupon to a Broker. Although he’ll not give you Rs.100 but
something like Rs.95 or 90. (Why so? Think about it!)
·
Anyways,
the point is, Noone can keep a track of who withdrew the money, who’s buying,
who’s selling Because there are no “names”, addresses or records. Bad guys like
it, because this ensures anonymity.
·
Question:
Why would Government issue bearer bonds? Because when they’re in dire need of
money, there is emergency, there is war going on, they cannot waste time in
checking the lengthy registration forms. So, Better just sell the bonds to any
swinging dude that comes, without asking his name, address, mobile number or
email id.
·
Although,
in real life, it is hard to find Bearer bonds. Because most of the bonds now,
exist in Electronic (DEMAT) format and you’ve to give your pan card number (or
other similar personal information in foreign countries) to buy or sell
bonds/shares or any similar security papers. So, now bad guys want payment in
gold, diamond or other precious metals instead of bearer bonds.
·
So
far, we saw that first option is to ‘borrow’ money and pay regular interest
rate. (Debt ->Bonds). Now continuing this not so technically correct article,
·
Second
option is, I take money from you and in return I offer you partnership. This is
called Equity.
·
Assuming
that I need 1 crore rupees to start my company and I’ve 30 lakhs in my savings.
So, I write on a piece of paper: “ I’ll give 0.0001% ownership of my
company to whoever gives me Rs.1000”.
·
This
is again a type of ‘security-paper’. But since I’m sharing a part of ownership
with you, in crude terms, we’ll call it “Share”.
·
Then
I print 10,000 such papers. What’s the value of these papers?
·
10,000
Papers multiplied with Rs.1000 each =1 crore. Voila that’s total money I need.
·
And
since I already have Rs.30 lakhs, I can purchase 3000 shares. (because 3000
papers x Rs. 1000 each = 30 lakhs)
·
So
out of the Total 10,000 shares that I printed, I will own 3,000 shares, so
percentage wise I own 30% of this company’s equity.
o Since I’m issuing the
‘shares’ (Equities), under the Company law, I’ve to Constitute a board of
directors and hold annual general meeting of the shareholders.
o For important policy
decision, I’ll have to take votes of the shareholders, the Board of Directors
will supervise over my activities. In short I cannot run the company as I
please, I’ve to give answers to those people.
o On the first year, I
make profit of Rs.25 lakhs. The board of directors will meet and decide
distribute Rs. 10
lakhs as Dividend among the shareholders. Now about the remaining 15 lakhs,
invest them back in the company to expand our production-capacity , buy bigger
machines and install new factories in Pakistan and Somalia.
·
Here
is the cool part, I can become CEO of my own company and say I’ll take salary
of Rs.1 only! And still, I will earn Rs.3 lakhs.
·
How?
Because I own 30% of shares in this company, so when that Rs.10 lakh Dividend
is shared among the shareholders, I get 30% of it = 3 lakhs, apart from my Rs.1
salary as an ‘employee’ of this company.
The owner Mr. George own
200 shares of this company. And in the small fonts, it is mentioned that total
30,00,000 shares of $1 each. Meaning Mr. George owns (200/30 lakh) x100 =0.0067
% stocks of this Creek Mining Company.
But in real life,
nowadays, when you purchase shares , you don’t get such cool looking colorful
paper certificates. You get the shares in electronic dematerialized
format. They get transferred in your demat account
·
Mithun
Chokrobarthy’s Son Mimoh Chakrabarthy was launched in the first film “Jimmy”.
That year he got Best “Newcomer” award. Movie was flop, then Mimoh
decided that changing his name, would bring him some luck.
·
So
he became Mahaakshay Chkarbarty and yet gave a few more flop
films.
·
Now
people don’t call him Newcomer, they call him flop hero.
·
Moral of the story: When you act in your
first film, you’re called a ‘newcomer’. Then in your subsequent movies, you’re
called a flop actor, although you’re the same human being from
your daddy’s eyes.
·
Same
way, When I sell my share papers for the first time, to the public, it is
called IPO (initial public offer)
·
Then
you (the buyers of these IPOs), sell these papers to each other, the same paper
is called “Share” or “Equities”.
·
From
Daddy’s point of view (Mine), it’s the same. If someone has one paper, he gets
0.0001% from the dividends.
Primary vs Secondary
Market
·
Primary
market = this is the Place where IPOs are sold,
·
Secondary
Market= this is the place where IPOs are re-sold as shares.
·
Physically
both things are done in the same place e.g. BSE (Bombay Stock Exchange) but
this virtual classification helps in keeping track of things, making
statistical analysis etc.
Now Two more sub-types
of Equity financers
·
Venture
Capital is a company that gives you money, to start your company or to expand
your company but in return they demand part of ownership.
·
They
deal with only ‘big’ things, ‘big’ projects, ‘big’ investments. They won’t help
me to open an ice-cream parlour in Gujarat University despite the fact that its
monthly revenue will be higher than SBI General Manager’s salary.
·
Copy
pasting example of Ojasventure, India
·
We
invest in technology based businesses in sectors such as Mobile technology,
Telecom, Software.
·
We
make an initial investment of US $ 250,000 to US $ 1.5 million.
How do they get money?
·
Ofcourse
money doesn’t fall from sky, these Venture Capitalist companies themselves
borrow money from other companies like mutual funds, pension funds or they may
be issuing their own ‘bonds’ to get money.
How do they operate?
·
They’ve
their own team of Management experts, corporate lawyers, chartered accountant,
and business consultants. They study your business plan, approve the money.
·
They’ll
demand seats in your company’s board of directors to Influence the Decision
Making in your company, according to their requirement and so on…
·
These
are rich gentlemen. They finance startup companies for getting partial
ownership and or assured returns on investment, after few years.They can give
debt (i.e. just like moneylenders and banks) or Equity (i.e. partial
ownership). But mostly they play in the equity field.
What is the need of
Angel Investors?
·
You
can get money from Banks / Bonds (Debt) or IPO/Venture Capitalist (Equity), if
your business project is likely to bear success based on previous experiance.
·
For
example: Pharmaceuticals, Dairy, Engineering instruments, Mining, Telecom,
Textiles, Oil Refinery etc.
·
But
they may not get interested in you, if you talk about untried and untested
business plans / product or fields.
·
Imagine
Steve Jobs requesting SBI Bank Manager to give him business loan in 1970s to
start Apple Computers,
·
or
Same Steve Jobs launching IPO of Apple in NewYork Stock exchange during that
time!
·
But
there was an angel investor Mike Markkula, who actually believed in his plan
and gave him some money and got 1/3rd ownership in the company in 1977.
·
Angel
investor doesn’t mind taking huge risk by helping even small timers with
totally unique and untested idea, if he think that it’ll grow up huge success
in future.
·
Similarly,
Amazon online shopping website and Starbucks coffee chain also started with
Angel Investors.
Capital
Gain Tax Revisited
An individual who owns
45 per cent share capital does not own 45 of that
company’s assets. There is a difference between the sale of shares in a company
and the sale of assets of that company.
·
Why
is it so?
·
Because
most of the company don’t directly start with IPO / Shares. First the
entrepreneur starts a small company using money from his own savings, borrowing
from friends, relatives and banks or from an Angel Investor.
·
Once
the business starts booming, he’ll launch an IPO to get extra funds from
public, to expand his business.
·
So,
He already has some building, machinery, vehicles etc assets in his small
company before launching his IPO.
Take a really crude
example
·
I
have Rs.30 in savings, I borrow Rs.20 (Debt) and thus start a
company for Rs.50
·
After
few years, I need another Rs.50 to expand business, so I launch an IPO: Total
50 share papers worth Rs. 1 each (Equity)
·
You
buy 10 shares for 10 rupees. Means you own 10/50th =20%
of my shares/stocks/equity/ IPO whatever you want to call it.
·
But
the total assets of my company are= From Rs. 50 I had already + Rs. 50 from IPO
= Total Rs.100
·
So,
You don’t own 20% assets of my company, because you’ve given me only Rs.10! and
my total assets are financed from both Debt + Equity.
·
Same
way, if you purchase 10% shares of Jet Airways, doesn’t mean you own 10% of
their airplanes and buildings.
·
So
far we’ve seen that
·
To
arrange money I can either borrow (debt, Bond) or I can give shares (equity,
IPOs/shares).
·
Here
is the problem: I cannot print those security papers on my own Home PC’s
cheap-printer.
·
First,
A lengthy legal and accounting paper-work has to be done, it’ll require
chartered accountants, Corporate Lawyers experts in these matters.
·
So,
I goto an underwriter, he charges Commission but he promises to cover all the
technically things, paperwork, SEBI regulations, selling, accepting money for
IPO/Bonds sale etc.etc.etc.
·
Same
underwriter also offers a kinda insurance, that he’ll buy the IPO/Bonds if
others don’t buy it.
·
Kotak Mahindra, ICICI offer such
underwriting services.
·
In
real life, companies don’t rely on single source to finance their adventure.
They’ll arrange part of the cash from Debt (Borrowing) and part of the cash by
issuing IPOs (Equity).
·
Each
has its own advantage and disadvantage. Let’s check
Good things: bonds vs
shares
Debt
(Bond)
|
Equity
(IPO/Shares)
|
|
|
Bad things: bonds vs
shares
Debt
(Bond)
|
Equity
(IPO/Shares)
|
|
|
·
So,
it’d be better if I finance a part from debt and a part from equity.
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