[economy] bonds vs shares, debt vs equity, ipo, underwriter, venture capital, angel investor, junk...

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[Economy] 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: BondsJunk Bonds vs Gilt Edged Security

Bearer Bonds

5. #2: Equity SharesShareholders and Board of Directors

What is IPO?

6. Venture Capitalist and Angel InvestorsWhat is Venture Capital?

Who is Angel Investor?

7. Who is Underwriter?

8. Debt vs Equity : good and Bad things

9. Upcoming articles

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.

Theseare called the fourfactors 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.

How To get the cash to start my company?

I can rob a bankOr I can just start my own IIT Bombay, sell its application forms for 5,000 rupees and then declare cut off 99.99% and thusearning truckload of cash without actually wasting a single rupee in arranging the admission interviews.Or I can join politics.

Problems in above options

Cant 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).Cant start my own IIT Bombay would again require those four factors of production (Land, Labour, Capital,Entrepreneurship)+Permissions from UGC/AICTE.Cant join politics because Only ministers can make huge money, MPs/MLAs dont. And Unfortunately Im not a son or

daughter of some big politician so I cant become minister @ young age (Agatha Sangma, Sachin Pilot, Naveen Jindal etal) So even If I join politics right now, Ill have to do bootlicking of Party high command until I get 60 years old, only thenI 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 SecondEquity. See this chart

Financing my company: Debt OR Equity

#1: Debt- bond
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e wor e s se -exp ana ory. ou orrow money rom someone: can e a an , can e a r en , can e astranger.I write on a piece of paper: To whoever pays me Rs.1000, Ill pay annual 10% interest rate (Rs.100). And after 5 years, Illalso 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, Im liable to pay you money no matter what happens. Whether my ice-cream company actuallymakes profit or goesKingfisher. I have to keep paying fixed money to you, every year.

Junk Bonds vs Gilt Edged Security

In above case I offered you 10% interest rate. But in real life, there are credit rating companies like CRISIL, S&P, Moodys

etc. Theyll 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 Im not creditworthy, I may default on this loan, I may run away. So my bondis 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, Ill give you 25% interest rate per year!

This is also known as High Yield Bond, because youre 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 sometemporary funds.They issues treasury bonds. RBI sells these treasury bonds on Governments behalf.But Governments generally have the aukaat to repay the principle and interest rates. Hence Government bonds have highercredit ratings (AA). So, they dont need to seduce you, theyll offer very low rate, say 4%.Similarly, well known companies with high credit ratings (AA) also issue bonds but pay low rates.If you dont like to take risks, youll invest in such bonds. These are called gilt-edged securities.

Bearer Bonds (and Bad Guys)

In Bollywood movies, Kidnapper demands ransom of Rs.10 lakhs but he wants the money in the denomination ofRs.5/10/50 Rupee notes. Why? Because it is easy to circulate these notes and harder for police or banks to keep track of thismoney.

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 dont have Holders Name on them. These bearer bonds have couponsattached with them. So, if you dont 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 hell 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, whos buying, whos selling Because there areno names, addresses or records. Bad guys like it, because this ensures anonymity.See the following example photograph of a Bearer bond of Government of Palestine. Notice that it doesnt have space forOwners names and there are three coupons attached at the bottom.

Question: Why would Government issue bearer bonds? Because when theyre 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 anyswinging 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) formatand youve 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 metalsinstead of bearer bonds.

#2: Equity: IPOs and Shares

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 Ive 30 lakhs in my savings. So, I write on a piece of paper:
http://img403.imageshack.us/img403/4152/bearerbonds.png


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Ill give 0.0001% ownership of my company to whoever gives me Rs.1000.This is again a type of security-paper. But since Im sharing a part of ownership with you, in crude terms, well call itShare.Then I print 10,000 such papers. Whats the value of these papers?10,000 Papers multiplied with Rs.1000 each =1 crore. Voila thats 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 companysequity.

Related to this: How do they Calculated SENSEX? Click Me to Read it

Shareholders and Board of Directors

Since Im issuing the shares (Equities), under the Company law, Ive to Constitute a board of directors and holdannual general meeting of the shareholders.For important policy decision, Ill have to take votes of the shareholders, the Board of Directors will supervise over myactivities. In short I cannot run the company as I please, Ive to give answers to those people.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 15lakhs, invest them back in the company to expand our production-capacity , buy biggermachines and install new factories in Pakistan and Somalia.

Here is the cool part, I can become CEO of my own company and say Ill take salary of Rs.1 only! And still, I will earn Rs.3lakhs.How? Because I own 30% of shares in this company, so when that Rs.10 lakh Dividend is shared among the shareholders, Iget 30% of it = 3 lakhs, apart from my Rs.1 salary as an employee of this company.Here is a demo photograph, of Creek Mining Companys shares.

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 $1each. 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 dont get such cool looking colorful paper certificates. You get theshares in electronic dematerialized format. They get transferred in your demat account. (already discussed in QFI vs FII article.)

What is IPO?

Mithun Chokrobarthys Son Mimoh Chakrabarthy was launched in the first film Jimmy. That year he got BestNewcomer award. Movie was flop, then Mimoh decided that changing his name, would bring him some luck.So he becameMahaakshay Chkarbartyand yet gave a few more flop films.

Now people dont call himNewcomer, they call himflop hero.

Moral of the story: When you act in your first film, youre called a newcomer. Then in your subsequent movies, youre

called a flop actor, although youre the same human beingfrom your daddys 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 Daddys point of view (Mine), its 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 inkeeping track of things, making statistical analysis etc.

Venture Capitalist and Angel Investors

Now Two more sub-types of Equity financers

What is Venture Capital?

Venture Capital is a company that gives you money, to start your company or to expand your company but in return theydemand part of ownership.They deal with only big things, big projects, big investments. They wont help me to open an ice-cream parlour inGu arat Universit des ite the fact that its monthl revenue will be hi her than SBI General Mana ers salar .
http://mrunal.org/2012/03/economy-qfi-qualified-foreign-investor.htmlhttp://img23.imageshack.us/img23/3020/shareslooklikethis.png


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.Copy pasting example of Ojasventure, IndiaWe 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 doesnt fall from sky, these Venture Capitalist companies themselves borrow money from other companieslike mutual funds, pension funds or they may be issuing their own bondsto get money.

How do they operate?

Theyve their own team of Management experts, corporate lawyers, chartered accountant, and business consultants. They

study your business plan, approve the money.Theyll demand seats in your companys board of directors to Influence the Decision Making in your company, accordingto their requirement and so on

Who is Angel Investor?

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 bearsuccess 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 1/3rdownership in the company in 1977.Angel investor doesnt mind taking huge risk by helping even small timers with totally unique and untested idea, if he thinkthat itll grow up huge success in future.Similarly, Amazon online shopping website and Starbucks coffee chain also started with Angel Investors.

Capital Gain Tax Revisited

Recall the argument given by Mr.Vodafone in Capital Gains tax?

An individual who owns 45 per cent share capital does not own45 of that companysassets. There is a difference between the sale of shares in a company and the sale of assetsof that company.

Why is it so?Because most of the company dont directly start with IPO / Shares. First the entrepreneur starts a small company usingmoney from his own savings, borrowing from friends, relatives and banks or from an Angel Investor.Once the business starts booming, hell 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.50After 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 callit.But the total assets of my company are= From Rs. 50 I had already + Rs. 50 from IPO = Total Rs.100So, You dont own 20% assets of my company, because youve 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, doesnt mean you own 10% of their airplanes and buildings.

Who is Underwriter?So far weve seen thatTo 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 PCs cheap-printer.First, A lengthy legal and accounting paper-work has to be done, itll require chartered accountants, Corporate Lawyersexperts in these matters.So, I goto an underwriter, he charges Commission but he promises to cover all the technically things, paperwork, SEBI
http://mrunal.org/economy/vodafone-essar-case


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reguat ons, se ng, accept ng money or IPO Bon s sa e etc.etc.etc.Same underwriter also offers a kinda insurance, that hell buy the IPO/Bonds if others dont buy it.

Kotak Mahindra, ICICIoffer such underwriting services.

Debt vs Equity : good and Bad things

In real life, companies dont rely on single source to finance their adventure. Theyll arrange part of the cash from Debt(Borrowing) and part of the cash by issuing IPOs (Equity).Each has its own advantage and disadvantage. Lets check

Good things: bonds vs shares

Debt (Bond) Equity (IPO/Shares)

I have complete ownership and control over the company.Im accountable to nobody just like UPA-II.I dont have to sharemy profit with anyone. I get to eatthe whole cake.I can claim income tax deduction for paying the loan.It require less paperwork and time to borrow from bank /friend than via sharemarket (SEBI permission, board ofdirectors etc)

If the company makes loss, I dont have to share anymoney with the shareholder, just like Kingfisher.So there is no regular interest payment, as we do inthe loan. Meaning Ive less tension compared to bankloan/ bonds.

Bad things: bonds vs shares

Debt (Bond) Equity (IPO/Shares)

Even if I dont make profit, Ive to pay interestrate, because basically this is a loan just like homeloan or car loan. Whether you earn or not, youveto pay the EMI.I may have to mortgage something (machinery,

building) to get the loan. So in case I default on the

loan, the bank/financer can take it away from me.

I dont get complete ownership and control over thecompany.Ive to constitute a board of directors, hold general meetingsof shareholders, Im accountable to them. The board ofdirectors can throw me out of CEO job, if I donot deliverresults, unlike Mohan.

It requires heavy paperwork and time to initiate IPO,sharemarket thing (SEBI permission, underwriting etc)

So, itd be better if I finance a part from debt and a part from equity. That leads us to the discussion about Debt to EquityRatio. (to be continued)

Upcoming articles

All my articles on economy, are archived at Mrunal.org/economy

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Previous Posts

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2. [Economy] Banking Amendment Bill: Issues, Features, Problems, Reforms meaning explained

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4. [Economy] GMR-Maldives Airport Controversy, IFC, AAI: Meaning, Reason, Implications, Explained

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6. [Economy] Fiscal Cliff: Meaning, Reasons, Implications on US and Indian Economy explained

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8. [Economy] 2G scam, Spectrum refarming, Sistema controversy, Allocation of Natural Resources explained

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March 29th, 2012 | Category: Economy

10 comments to [Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel Investor, Junk Bonds, Bearer

Bonds, Gilt Edged securities: Meaning, Explained

Abhishek
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[Tips] "One-Word Approach" to master Indian Polity from

[EnB] Biodiversity: Meaning and Types of Species+ Moc

August 29, 2012 at 9:57 AM Reply

The Securities and Exchange Board of India (SEBI) has allowed partial fungibility of Indian Depository Receipts(IDRs) redemption or conversion of IDRs into underlying equity shares in a financial year to the extent of 25 percent of the IDRs originally issued.This has been decided to retain the domestic liquidity, said SEBI in a circular to stock exchanges, depositories andother market participants. An article in Hindu (28th August)

Can u plz explain what is IDR.. and how it is converted into Equity shares and how it affects liquidity thanks in advance

Abhishek

October 7, 2012 at 2:14 PM Reply

please mrunal do explain what is IDR

ADARSHOctober 7, 2012 at 3:47 PM Reply

sir,the links in the page for other pages are not working,they divert me to home pageplz do something

MrunalOctober 7, 2012 at 4:03 PM Reply

sorry for the inconvenience. Ever since I move from blogspot, many the links were broken. Anyways go tomrunal.org/economyyoull find all the articles.

utkarshNovember 27, 2012 at 12:05 PM Reply

sir ,m a fan of urs, can u plz explain the income tax deduction ??

krishnaNovember 27, 2012 at 2:36 PM Reply

thank u sir..

utkarshDecember 2, 2012 at 1:36 AM Reply

sir plz explain EARNINGS PER SHARE AND ITS CALCULATION

RajndraDecember 10, 2012 at 10:33 AM Reply

Good Article

hitaishDecember 11, 2012 at 11:46 PM Reply

Thank u very much sirthese topics used to haunt me in my dreams. .now many of the things are clear. Sir please explain if thecredit rating agency gives a bad credit rating to any countrydoes it include the private investors of that country as well

MUKUND SINGHDecember 17, 2012 at 11:27 PM Reply

AWESOME , SIR U R GREAT . I READ MANY BOOKS TO GET CLEAR CONCEPTS OF THESE TOPICS UT TO NO AVAIL. BUT UMADE ME LEARN THESE TOPICS IN SUCH WAY THAT ONCE A MOMENT I THOUGT I WAS LEARING A FOR APPLE LIKE THING.
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