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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Singapore going ‘Solyndra’ to find the next Mark Zuckerberg?

Posted by PITHOCRATES - January 26th, 2013

Week in Review

While public education teaches kids the fear of global warming, the evils of capitalism and the goodness of government Singapore is having their schools teach business and entrepreneurial skills.  The U.S. is suffering through the worst economic recovery since the Great Depression.  While Singapore is doing quite well.  And should continue to do well because they don’t teach kids the evils of capitalism in school (see Singapore Hunts for New Zuckerberg With Stanford-Style Dorm by Sharon Chen posted 1/25/13 on Bloomberg).

Singapore became Southeast Asia’s only advanced economy by moving up the technology ladder, turning a trading port into the region’s biggest banking center and a manufacturer of electronics, petrochemicals and pharmaceuticals. Now, the nation is looking to gain a bigger share of a software industry that raised $28 billion in initial share sales last year.

N-House, which opened in August 2011, is one strand of a five-year plan by the government that includes offering new technology companies grants of as much as S$500,000, supporting venture capital funds, and encouraging high schools to teach business and entrepreneurial skills, in an effort to groom the next Mark Zuckerberg, co-founder of Facebook Inc…

The island of 5 million people, ranked the easiest place to do business for seven straight years by the World Bank, is the second-easiest place in Asia after Hong Kong for entrepreneurs to gain access to capital, according to a study by the Milken Institute published in 2010.

Singapore is a success story because it’s an easy place to do business in.  Businesses like that.  So businesses do business in Singapore.  This is a lesson the United States could learn.  Making it easy for businesses to do business.  Detroit, the Motor City, birthplace of the automated assembly line, is a horrible place to do business.  Being the home of the Big Three (General Motors, Ford and Chrysler) you’d think they’d have an edge on manufacturing automobiles.  Yet not one new auto manufacturer has chosen Detroit.  Honda, Toyota, Nissan, Mercedes, BMW, Volkswagen, Hyundai, and Kia all built assembly plants in the United States.  But not one of them picked Detroit.  Because Detroit, the Motor City, is not an easy city to make automobiles in.

So Singapore knows a thing or two about how to do business.  Which, for the most part, is just leaving business the hell alone.  For a business is a lot like a dog having puppies.  They can do it without any help.  In fact, trying to help can actually do more harm to a business than good.  For when the government steps in and provides money the private sector won’t supply you can pretty much guarantee that the government is backing a bad investment.  Think Solyndra in the U.S.  And all those jobs of the future we were supposed to get with all those investments into green energy.  President Obama begins his second term with the worst recovery since the Great Depression.  Despite all that spending to invest into the jobs of the future.  Here’s a lesson Singapore can learn from the U.S.  Creating a business-friendly environment is good.  But trying to influence things in that environment, well, that rarely ends well.  Again, think Solyndra.

“Singapore has done the best job of any government to spawn an entrepreneurial ecosystem,” said Ressi, who travels to the city about three times a year to meet with government officials. “However, I think they’ve gone a little bit too far in making it easy. If they can’t actually raise money from people privately, they probably aren’t worthy of being in existence.”

There are venture capitalists out there with money burning holes in their pocket.  They want to invest it.  They want to groom the next Mark Zuckerberg.  And if these greedy bastards are NOT willing to bet their money on someone there’s a reason for it.  These people are in the business of finding entrepreneurs to back and groom.  And if they don’t invest in an entrepreneur they must have determined that the entrepreneur just doesn’t have what it takes.  So they keep looking for one who does have what it takes.  And if that person is out there the free market will find that entrepreneur.  While governments pour millions into other Solyndras.

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Bill Gates, Microsoft, Dot-Com Companies, Dot-Com Bubble, Green Energy and Green Energy Companies

Posted by PITHOCRATES - December 18th, 2012

History 101

Investors poured Money into Dot-Com IPOs to get in on the Ground Floor of the next BIG Thing

Cash is king.  It is the lifeblood of a business.  The most serious business issues are discussed in blood metaphors.  When a company’s operations are losing money the company is ‘in the red’.  When the company’s losses are so great that there is a high probability of bankruptcy business analysts may say the company is ‘bleeding (or hemorrhaging) red ink all over their balance sheet’.  Indicating the death of the business is imminent.  For if the company is bleeding too much cash it simply won’t have the cash to pay its people, its vendors, its taxes, etc.  And it will cease to be.  Like any living organism that loses too much blood.

Healthy cash flows in a business are so important that analysts, investors, bankers, etc., will review one particular financial statement, the statement of cash flows, for an immediate assessment of a business’ health.  This statement shows the three sources of cash a business has.  Operating activities, investing activities and financing activities.  A successful business can generate all the cash they need from their operating activities.  To get there, though, they need startup capital.  Which comes from their financing activities.  The companies that are preparing for a surge in growth will look for venture capital.  And the inevitable initial public offering (i.e., going public).  For many companies the IPO is the measure of success.  Because going public is what makes these entrepreneurs millionaires.  And billionaires.

In the Eighties one such entrepreneur that became a billionaire is Bill Gates.  Mr. Microsoft himself.  Who made a fortune.  And is now working to give it away.  Just like Andrew Carnegie.  And John D. Rockefeller.  This geek made so much money with his software company that he made a lot of people wealthy who were smart enough to buy Microsoft stock early.  How these stockholders loved Bill Gates.  And every investor since has been waiting for the next Bill Gates to come along.  So they can get in on the ground floor of the next BIG thing.  And they thought they found him.  Rather, they thought they found a whole bunch of him.  Pouring their money into IPO after IPO.  Just waiting for the nascent dot-com companies to take off and soar into the stratosphere of profits.  For the Internet had arrived.  Few knew what it did.  But everyone knew it was the next BIG thing.

The Dot-Coms survived on Venture Capital and the Proceeds from their IPOs as they had no Sales Revenue

And these dot-coms took their money and spent it.  They hired programmers like there was no tomorrow.  They built office buildings.  Cities even offered lucrative incentives to attract these dot-coms to tech corridors they were building in their cities.  And splurged on infrastructure to support them.  The dot-coms bought advertising.  They spent a fortune to develop their brand identity.  Making them common place names in the new high-tech economy.  There was only one thing they didn’t do.  Develop something they could actually sell.

Those on the Left keep talking about how great the Clinton economy was in the Nineties.  Despite higher marginal tax rates than we have now.  These people who don’t even like Wall Street say the stock market did better under Clinton.  Apparently getting rich in the stock market was okay in the Nineties.  Today it only attracts occupy movements to protest the evil that stock profits now are.  But there was one subtle difference between the economy in the Nineties and the boom of the Eighties.  Most of the Nineties was a bubble.  A dot-com bubble.  It wasn’t real.  It was all paper profits that sent stock prices of companies that had nothing to sell soaring.  As all those stockholders sat and waited for these companies to sell the next BIG thing.  Taking them on a whirlwind ride to riches that never came.  Because once that startup capital petered out so did these dot-coms.  Leaving George W. Bush to deal with the resulting Clinton recession.

A review of their statement of cash flows for all of these failed dot-coms would show the same thing.  They would show tremendous flows of cash.  But it all flowed from their financing activities to their operating activities.  Which was nothing but a black hole for that startup capital.  All of these companies survived on venture capital and the proceeds from their IPOs.  They paid all their programmers, bought their buildings, paid for advertising and developed their brand with money from investors.  A healthy business eventually has to replace that startup capital with money from their operating activities.  Businesses that don’t fail.  Because even the most diehard of investors will stop investing in a company that can’t do anything but bleed red ink all over their balance sheet.

Instead of Investors taking the Loss on Green Energy Investments it’s the American Taxpayer taking the Loss

Bill Clinton had his dot-coms.  While President Obama has his green energy companies.  Which are similar to the dot-coms but with one major difference.  Instead of investors pouring money into these companies for a whirlwind ride to riches they’re sitting out the green energy industry.  Because it is a bad investment.  There will be no Microsoft in green energy.  Because it is a horrible business model.  The cost to harness the free energy out of wind and solar is just prohibitive.  The amount of infrastructure required is so costly that there can never be a return on investment.  Like there can be for a coal-fired power plant.  Which is something investors will invest their money in.

Green energy cannot compete in the marketplace unless the government subsidizes it with tax dollars.  Green industries cannot even build a factory.  While they have some private investors it is never enough.  Most green investors typically support these companies with a token investment.  But the real investors who expect a return on investment look at a green energy prospectus and say, “Thank you but no.  It is a horrible investment.”  And the people who want to build these plants know they’re horrible investments as they want to risk other people’s money.  Not theirs.  Which leaves but one source for startup capital.  A source that is so inept about business that they will pour money into a horrible investment.  The government.

The Energy Department invested heavily into these bad investments.  And a lot of them ended the same.  Just like the dot-coms.  The cash on their statement of cash flows went from financing activity to operating activities.  Another black hole for investment capital.  They spent that startup capital on plants and buildings.  Hired people.  And paid themselves very well.  But eventually they ran through that startup capital.  And were unable to get any more.  And with their operating activities unable to generate cash like in a healthy business many of the green energy companies went the way of the dot-coms.  Only instead of investors taking the loss it’s the American taxpayer taking the loss.  As it is their money that is bleeding out in red ink all over these green energy balance sheets.

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Jessica Alba is a Movie Star, Mother and Small Business Owner who uses Venture Capital

Posted by PITHOCRATES - September 15th, 2012

Week in Review

Jessica Alba is a movie star.  Mother.  Small business owner.  And Democrat.  She and her husband hosted the closing party at the recent Democrat National Convention in Charlotte.  So she’s pretty active in supporting her political party.  And she’s probably not a fan of Republican candidate Mitt Romney.  Probably a good thing, then, that she didn’t go to Bain Capital to raise her venture capital (see Jessica Alba: Running A Startup Is Really Hard, You Have To Be Passionate About What You Do by Sarah Perez posted 9/10/2012 on TechCrunch).

Kicking off the TechCrunch Disrupt SF 2012 sessions were The Honest Company co-founders, actress Jessica Alba and Brian Lee, also of ShoeDazzle, Teeology and LegalZoom. The two teamed up to launch Honest, an e-commerce startup offering a line of eco-friendly products for baby, family, and home. The company raised a $27 million Series A from General Catalyst, Lightspeed Venture Partners, and Institutional Venture Partners in March this year, and first experimented with the trendy subscription-based service model for selling products, later opening up to offer the ability to directly buy from the website.

Given that Honest isn’t really a “tech” startup — Lee described it as a “mission-based company” — it faces different sorts of challenges than some of the other startups in the industry. But one thing that’s not different from the rest? According to Alba, “it’s really, really, really hard” to do a startup.

“It’s so hard,” Alba said, “you’re working day and night. It actually never stops. If you’re not so passionate and working day and night, it’s not going to happen.”

She no doubt will support her party in their attacks on the evils of venture capital firms like Bain Capital even while using venture capital herself to launch a startup business.  So venture capital is bad.  Unless you need some yourself.  Then of course it’s okay.  Just hope that her venture capital firm doesn’t bankrupt her business.  And throw all of her employees out of a job.  Putting them on the streets with no health care.  For if you listen to the Democrat campaign ads that is a very real possibility.

She probably should be more careful in her remarks, too.  For she did not credit the role of government or their roads and bridges in the making of her business.  She seems be taking full credit for working day and night.  And being passionate.  Almost as if she’s building this business herself.  If she’s not careful her party may reprimand her for suggesting that small business owners build their own businesses without the help of government.  Or by winning life’s lottery.  Which of course is preposterous according to the Democrat Party.

Jessica Alba is now a small business owner.  The backbone of this county.  Let’s wish her nothing but success so her business grows and creates jobs.  Lots of them.  So she can experience the joy of complying with some regulatory policy like Obamacare.  Boy, will that be an eye opener for her.  It could very well change her political affiliation.  As most small business owners tend to vote Republican.  Even the ones who start out as Democrats.  Because once they experience what it’s like doing business under the anti-business policies of the Democrat Party they tend to have a political realignment.

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