Capital Markets, IPO, Bubbles and Stock Market Crashes

Posted by PITHOCRATES - April 22nd, 2013

Economics 101

Entrepreneurs turn to Venture Capitalists because they Need a Lot of Money Fast

It takes money to make money.  Anyone who ever started a business knows this only too well.  For starting a money-making business takes money.  A lot of it.  New business owners will use their lifesavings.  Mortgage their home.  Borrow from their parents.  Or if they have a really good business plan and own a house with a lot of equity built up in it they may be able to get a loan from a bank.  Or find a cosigner who is willing to pledge some collateral to secure a loan.

Once the business is up and running they depend on business profits to pay the bills.  And service their debt.  If the business struggles they turn to other sources of financing.  They pay their bills slower.  They use credit cards.  They draw down their line of credit at their bank.  They go back to a parent and borrow more money.  A lot of businesses fail at this point.  But some survive.  And their profits not only pay their bills and service their debt.  But these profits can sustain growth.

This is one path.  Entrepreneurs with a brilliant new invention may need a lot of money fast.  To pay for land, a large building for manufacturing, equipment and tooling, energy, waste disposal, packaging, distribution and sales.  And all the people in production and management.  This is just too much money for someone’s lifesavings or a home mortgage to pay for.  So they turn to venture capital.  Investors who will take a huge risk and pay these costs in return for a share of the profits.  And the huge windfall when taking the company public.  If the company doesn’t fail before going public.

The Common Stockholders take the Biggest Risk of All who Finance a Business

As a company grows they need more financing.  And they turn to the capital markets.  To issue bonds.  A large loan broken up into smaller pieces that many bond purchasers can buy.  Each bond paying a fixed interest rate in return for these buyers (i.e., creditors) taking a risk.  Businesses have to redeem their bonds one day (i.e., repay this loan).  Which they don’t have to do with stocks.  The other way businesses raise money in the capital markets.   When owners take their business public they are selling it to investors.  This initial public offering (IPO) of stock brings in money to the business that they don’t have to pay back.  What they give up for this wealth of funding is some control of their business.  The investors who buy this stock get dividends (similar to interest) and voting rights in exchange for taking this risk.  And the chance to reap huge capital gains.

The common stockholders take the biggest risk in financing a business.  (Preferred stockholders fall between bondholders and common stockholders in terms of risk, get a fixed dividend but no voting rights.)  In exchange for that risk they get voting rights.  They elect the board of directors.  Who hire the company’s officers.  So they have the largest say in how the business does its business.  Because they have the largest stake in the company.  After all, they own it.  Which is why businesses work hard to please their common stockholders.  For if they don’t they can lose their job.

During profitable times the board of directors may vote to increase the dividend on the common stock.  But if the business is not doing well they may vote to reduce the dividend.  Or suspend it entirely.  What will worry stockholders, though, more than a reduced dividend is a falling stock price.  For stockholders make a lot of money by buying and selling their shares of stock.  And if the price of their stock falls while they’re holding it they will not be able to sell it without taking a loss on their investment.  So a reduced dividend may be the least of their worries.  As they are far more concerned about what is causing the value of their stock to fall.

Investors make Money by Buying and Selling Stocks based on this Simple Adage, “Buy Low, Sell High.”

A business only gets money from investors from the IPO.  Once investors buy this stock they can sell it in the secondary market.  This is what drives the Dow Jones Industrial Average.  This buying and selling of stocks between investors on the secondary market.  A business gets no additional funding from these transactions.  But they watch the price of their stock very closely.  For it can affect their ability to get new financing.  Creditors don’t want to take all of the risk.  Neither do investors. They want to see a mix of debt (bonds) and equity (stocks).  And if the stock price falls it will be difficult for them to raise money by issuing more stock.  Forcing them to issue more bonds.  Increasing the risk of the creditors.  Which raises the bond interest rate they must pay to attract creditors.  Which makes it hard for the business to raise money to finance operations when their stock price falls.  Not to mention putting the jobs of executive management at risk.

Why?  Because this is not why venture capitalists risk their money.  It is not why investors buy stock in an IPO.  They take these great risks to make money.  Not to lose money.  And the way they expect to get rich is with a rising stock price.  Business owners and their early financers get a share of the stock at the IPO.  For their risk-taking.  And the higher the stock trades for after the IPO the richer they get.  When the stock price settles down after a meteoric rise following the IPO the entrepreneurs and their venture capitalists can sell their stock at the prevailing market price and become incredibly rich.  Thanks to a huge capital gain in the price of the stock.  At least, that is the plan.

But what causes this huge capital gain?  The expectations of future profitability of the new public company.  It’s not about what it is doing today.  But what investors think they will be doing tomorrow.  If they believe that their new product will be the next thing everyone must have investors will want to own that stock before everyone starts buying those things.  So they can take that meteoric rise along with the stock price.  As this new product produces record profits for this business.  So everyone will bid up the price because the investors must have this stock.  Just as they are sure consumers will feel they must have what this business sells.  When there are a lot of companies competing in the same technology market all of these tech stock prices can rise to great heights.  As everyone is taking a big bet that the company they’re buying into will make that next big thing everyone must have.  Causing these stocks to become overvalued.  As these investors’ enthusiasm gets the better of them.  And when reality sets in it can be devastating.

Investors make money by buying and selling stocks.  The key to making wealth is this simple adage, “Buy low, sell high.”  Which means you don’t want to be holding a stock when its price is falling.  So what is an investor to do?  Sell when it could only be a momentary correction before continuing its meteoric rise?  Missing out on a huge capital gain?  Or hold on to it waiting for it to continue its meteoric rise?  Only to see the bottom fall out causing a great financial loss?  The kind of loss that has made investors jump out of a window?  Tough decision.  With painful consequences if an investor decides wrong.  Sometimes it’s just not one individual investor.  If a group of stocks are overvalued.  If there is a bubble in the stock market.  And it bursts.  Look out.  The losses will be huge as many overvalued stocks come crashing down.  Causing a stock market crash.  A recession.  A Great Recession.  Even a Great Depression.

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