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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LESSONS LEARNED #34: “Sure, until you win the lotto you’re all for sticking it to the rich.” -Old Pithy

Posted by PITHOCRATES - October 7th, 2010

Buddy Can You Spare a Dime

In the old days, we used to jail people who didn’t pay their debts.  Even in the United States.  A couple of signers of the Declaration of Independence even served time in a debtors’ prison.  We took it seriously.  Honoring your debts.  For those who didn’t, they found themselves inside a jail until they did.  Or until they died.

We jailed some people over small sums.  The severity of the punishment (broken families, disease, starvation, privation, physical abuse, etc.) was often extreme in comparison to the size of the debt owed.  In time we would move away from such barbaric justice.  No, in the modern, caring world, we don’t torment those who are down on their luck and find themselves penniless.  You see, the modern world is a caring world.  We abhor the sufferings of our fellow man.  So we show them kindness.  Charity.  We forgive them their debts and help them rebuild their lives.  Well, most of us do.

If you find yourself owing the IRS, you better pay up.  For they will send you to prison.  And take whatever you have.  They will destroy your life.  And your family.  Because they want to make something perfectly clear.  You don’t f*ck with the IRS.  They play to keep.  All the time.

The War on Alcohol

The 18th Amendment prohibited “the manufacture, sale, or transportation of intoxicating liquors within, the importation thereof into, or the exportation thereof from the United States and all territory subject to the jurisdiction thereof for beverage purposes.”  The government may have shut down supply, but the market remained.  Enter criminal gangs.  Who furnished the supply to meet the demand.

None did it better than Al Capone.  His gang ruled Chicago.  People admired him.  After all, he wasn’t hurting anyone.  He was just giving the people what they wanted.  A way to relax and blow off steam.  Like we do today when we enjoy an alcoholic beverage with our friends.  But the gang violence grew.  The pictures following the Saint Valentine’s Day Massacre were just too gruesome.  Soon thereafter the FBI branded Scarface as public enemy #1.

Bootlegging, prostitution, murder, extortion…Capone broke a lot of laws.  But he crossed the line.  He committed a crime that was so heinous that it would land him ultimately in Alcatraz, America’s most secured federal prison.  That crime?  Income tax evasion.

On the Road Again

Willie Nelson is a big time Democrat.  He’s into saving the environment.  Animal rights.  Legalizing marijuana.  Helping the farmers.  And he’s a regular peacenik.  So you’d think he’d be a big fan of Big Government.  Well, yes and no. 

He became very wealthy by the 1980s.  And like a good Democrat, he tried to shield some of that wealth from the IRS.  He parked some of it in some talk shelters.  Then came along Ronald Reagan.  He understood what Andrew Mellon understood (Secretary of the Treasury for Warren G. Harding).  High tax rates made rich people hide their money.  Lower tax rates encouraged rich people to invest their money.  When Mellon cut the tax rates wealthy people paid more taxes and less wealthy people paid fewer taxes.  The progressive tax system worked even better at lower tax rates.  Tax revenue increased as the wealthy invested their money instead of finding creative ways to hide it.  It worked for Reagan, too.  He even closed tax shelters as a further incentive for the wealthy to invest their money to grow the economy and create jobs.  That worked, too.  Savvy wealthy people everywhere were putting Americans back to work.  Only one small problem.  The not so savvy wealthy were caught unawares.

Willie Nelson didn’t move his money from his tax shelters.  When Reagan disallowed those shelters, his money sat there accruing federal taxes.  And interest and penalties.  He blamed and sued his accountants.  The accountants countered that they only did the accounting and taxes.  They were not investment advisors.  Anyway, the IRS seized his assets.  He went on the road again and often to pay off his tax bill.  His total bill came to about 16 million in back taxes, interest and penalties.  Which he paid.  As he no doubt would have from the get-go if he had sought appropriate counsel to help him negotiate the 1,000+ page U.S. tax code.

Easy Money – For the IRS

There are many stories like Willie Nelson’s.  Even Treasury Secretary Timothy Geithner, the smartest man in America, couldn’t figure out his own taxes.  (But we were to excuse him for this because no one else was as qualified as he was to write and administer the U.S. tax code).  But it’s not only the not-so-savvy celebrity rich and the intellectually challenged intellectuals who have trouble with the U.S. tax code.  The poorest of the poor who never had money can sometimes run afoul of the IRS.

Playing the lotto.  Millions do.  Most lose.  And they’re lucky that they do.  Many lotto winners have their lives take a turn for the worse.  Friends and relatives you don’t know are reacquainting themselves with you.  Well, not you so much as your new found wealth.  Con men target you.  Charities.  Neighbors.  Some spend the money fast.  Or recklessly.  Develop drug addictions.  Get robbed.  Even murdered.  There are a lot of stories out there.  Just search the Internet.

When you win the lotto, you can take a lump-sum payment.  Or you can take a series of payments.  Either way the IRS taxes this as income.  And the amount of these payouts will most probably push you in the highest income tax bracket during the period of these payouts.  So the IRS likes lotto winners.  Your odds of winning are slim to none but someone always wins.  And that’s a tax bonanza for the IRS.  Not-so-savvy people who become rich overnight.  The full force and power of the U.S. government falling on some poor schmuck who probably never had a tax liability in his or her life.  Money just doesn’t get any easier. 

Capital Gain or Income?

Some may sell the rights to their future payments.  It’s sort of like selling a rental property.  For example, take a house that rents for $1,000 per month and sells for $150,000.   The buyer gets those future rent payments.  The seller gets the money back that they paid for the house and, hopefully, a capital gain (i.e., they sell the house for more than they paid for it).  The seller pays a capital gains tax on their capital gain.  They do not pay any further income tax on the rental income that the buyer now collects.

Some lotto winners see selling their rights to future payments in the same light.  And that they should only pay a one-time capitals gain tax (at a lower capital gains tax rate) in lieu of the higher income tax rate.  The IRS begs to differ.  And they usually get their way.

Sadly, some buyers advised those selling their rights that they could pay the lower capital gains tax rate.  Which they did.  And faced heavy tax bills for back taxes, interest and penalties as a consequence.  Once again, easy money for the IRS.  You can search the Internet for stories like these, too.

Pay or Else

Whether a gangster, a celebrity, a Democrat brainiac or a low-income lotto winner, we all share something in common.  Whatever our politics, when it comes to our money, we all try to avoid paying our ‘fair share’ of taxes.  We may demand that other rich people pay their taxes, but we will do everything we can to avoid paying our taxes.  But we play a dangerous game when we do.  For those who do and lose, they learn a painful lesson.

You don’t f*ck with the IRS.

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