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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Silicon, Semiconductor, Electrons, Holes, PN Junction, Diode, LED, Photon, 7-Segment LED and Full-Color Flat Panel LED Displays

Posted by PITHOCRATES - May 30th, 2012

Technology 101

Applying a Voltage across a PN junction to Create a Forward Bias Pushes Electrons and Holes towards the Junction

There’s gold in them thar Hills.  And silicon in the valley.  California has been a fountain of wealth.  Much of which they built from two materials located on the periodic table.  Atomic number 79.  Gold.  Or ‘Au’ as it appears on the periodic table.  And atomic number 14.  Silicon.  Or ‘Si’ as it appears on the periodic table.  Both of these metals proved to be valuable.  One by its scarcity.  One by what we could do with it.  For it was anything but scarce.  Silicon is the second most common element behind only oxygen.  But this commonly found material proved to be a greater font of wealth for California.  For it fueled the semiconductor industry.  For when we doped it with impurities we produced negatively (N-type) and positively (P-type) charged material.  Bringing the N and the P together gave us the PN junction.  Giving us the diode, transistor and integrated circuit.

The miracle of semiconductors occurs at the atomic level.  Down to the electrons orbiting the atom’s nucleus.  The nucleus contains an equal number of positively charged protons and neutrally charged neutrons.  The number of protons gives us the atomic number.  Changing the number of neutrons gives us isotopes.  Radioactive material has more protons than neutrons.  Uranium-235 is an isotope.  The stuff that made the atomic bomb dropped on Hiroshima.  Electrons orbit the nucleus.  In discrete energy levels.  The orbits closest to the nucleus have the lowest energy levels.  The orbits father away from the nucleus have higher energy levels.  Most of these orbits are ‘full’ of electrons.  The outer electron shell when ‘full’ is inert.  An outer shell that isn’t ‘full’ or has extra electrons is active.  And can chemically react.  Forming molecules.  When chemicals come into contact with each other and form molecules it is these electrons in the outer orbits (or valence electrons) that move into and out of the orbits of the different chemicals.  That is, the different elements share these valence electrons.

This is what we do when we dope silicon with impurities.  We either remove electrons from the valence shell to create a net positive charge.  Or we add electrons to the valence shell to create a net negative charge.  Giving us P-type and N-type material.  At the PN junction the N-type material loses its excess electrons to the P-type material across the junction as the empty holes in the valence shell attract the excess electrons.  As electrons leave the valence shells in the N-type material they leave holes in the valence shell where they once were.  Or, in the world of electronics, as electrons flow one way holes flow the other.  When we apply a voltage across a PN junction to create a forward bias (negative voltage applied to N-type and positive voltage applied to P-type) we push electrons and holes towards the junction.  If the forward bias is great enough they will continue all the way through the junction and into the material on the far side.  Where electrons will combine with excess holes.  And holes will combine with excess electrons.  Creating an electric current.  If we apply a voltage to create a reverse bias we will pull electrons and holes away from the PN junction.  And there will be no electrical current. We call such a PN device a diode.  A very important and indispensible device in electronics.

Placing Seven LEDs into a Figure-Eight Pattern created the Seven-Segment LED

Now back to those discrete energy levels.  There is another useful property we get when electrons move between these energy levels.  Electrons absorb energy when they move to a higher energy level.  And emit energy when they move to a lower energy level.  We make use of this property in fluorescent lighting.  A charged plasma field in a fluorescent lamp excites a small amount of mercury in the lamp.  As electrons fall into lower orbits in the mercury atoms they release invisible short-wave ultraviolet radiation.  The phosphor coating on the inside of the lamp absorbs this radiation and fluoresces.  Creating visible light.  By using different materials, though, we could see the energy (a photon) emitted by an electron falling into a lower energy level.  We have been able to move the wavelength of this photon into the visible spectrum.  The first commercial application to convert these photons into visible light was a device that gave us a red light.  That device was that important and indispensible PN-junction.  The diode.  And the use of different materials other than silicon moved these photons into the visible spectrum.  Giving us the light-emitting diode.  Or LED.

The first LEDs were only red.  Then we developed other colors using different materials.  Shifting the wavelength of the photon through all colors of the visible spectrum.  Being low-power devices, though, the intensity of light emitted was limited.  So an LED required careful mechanical construction and optics.  To direct the light out of the material forming the PN junction.  With a reflector behind the junction.  And a lens above.  To aim and diffuse the light.  And to prevent it from reflecting back into the material where it may be dissipated as heat.  Early use of LEDs was for indicator lights.  The low power consumption meant little heat was generated as with an incandescent lamp.  Which worked well in the temperature sensitive computer world.  Placing 7 LEDs into a figure-eight pattern created the seven-segment LED display.  With a rectangular shaped piece of translucent plastic above each LED you could see a bar of light for each light emitting diode.  Creating a forward bias on certain bars in the seven-segment display created the numbers we saw on our first calculators and digital watches.

An LED could produce a similar radiation like in the fluorescent lamp.  Using that radiation to fluoresce a phosphor coating inside a lamp to produce white light.  Similar to the fluorescence lamp.  Only while using less power.  Mixing the emitted light from red, green and blue (RGB) LEDs also produced white light.  Further improvements allowed us to emit whiter and brighter lights.  Allowing brighter lamps that consumed less power than the compact fluorescent lamps which were energy saving alternatives to the incandescent lamps.  With the lower power consumption of LEDs creating less heat we expanded the lifespan of lighting sources made from LEDs.  Using them to increase the service life in lamps inconvenient to change.  Like in traffic signal lights over busy intersections.  To the taillights in tractor trailers.  Where anytime spent not hauling freight was lost revenue.

We made Full-Color Flat Panel Displays from LEDs by combining Red, Green and Blue LEDs into Full-Color Pixel Clusters

The market didn’t demand these developments in semiconductors or LEDs.  For the most part the market didn’t even know this technology existed.  But the entrepreneurs gathering in Silicon Valley did.  They had some great ideas of what they could do with this new technology.  All they needed was the capital to bring these ideas to market.  It was risky.  The technology was good.  But could they use it to make useful things at affordable prices?  And would the people be so enamored with the things they built that they would buy them?  There were just too many unknowns for conservative bankers to take a risk.  But thanks to venture capitalists those entrepreneurs got the capital they needed.  Brought their ideas to market.  Created Silicon Valley.  And the modern world we now take for granted.

They continue to advance this technology.  Creating full-color flat panel displays.  By combining red, green and blue LEDs into full-color pixel clusters.  Which, unlike an LCD flat panel display, does not need a backlight as they produce their own light.  So these panels are thinner and use less power than LCD displays.  Making them ideal for the displays in our cellular devices for they allow more battery life between charges.  They also have wide viewing angles.  People looking at these displays from near perpendicular viewing angles see nearly the same quality of picture as those viewing directly in front.  Making them ideal for use in stadiums.  The video replays you see on that mammoth flat panel display in the new Dallas Cowboy stadium is an LED flat panel display.

All of this from joining two differently-charged semiconductor materials together.  Creating that all important and indispensible PN junction.  The foundation for every electronic device.  And of Silicon Valley itself.

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LESSONS LEARNED #11: “Before you condemn capitalism, imagine a world without professional sports, movies, cell phones and tampons.” -Old Pithy

Posted by PITHOCRATES - April 29th, 2010

AT THE END of the American Revolution the world said, “Okay.  Now what?”  We were a joke.  We were broke.  We were weak.  And now that the common enemy was no more, we weren’t very united any more.  Most assumed we would end up back with Great Britain.  And because of that many thought there was no sense rushing in to make treaties that will just have to be unmade.

It was complicated dealing with us.  In a confederacy of strong states, it was not easy making trade or treaties.  Multiple currencies, tariffs, laws, etc.  To enter the world of the European powers, America needed to put on her big boy pants and speak with one voice.  Some Founding Fathers saw this.  That’s why they met in Philadelphia and drafted the Constitution.  And with ratification, we had one voice.

ALEXANDER HAMILTON WAS a capitalist.  Thomas Jefferson was not.  Hamilton understood money and finance.  Jefferson did not.  Hamilton liked manufacturing and commerce.  Jefferson did not.  He thought everyone should be a simple farmer.  Everyone, that is, but him.

When elected president, people hailed Jefferson as the people’s president.  Simple, unassuming, the epitome of egalitarian republicanism.  Only thing was, there wasn’t anything simple, unassuming or egalitarian about him.  He attacked the nobility, the corruption of big cities and the evils of commerce and the ‘money’ men.  Yet he indulged in the good life like no other American.  He always lived beyond his means.  He lavished himself in the finest luxuries of the time.  And he absolutely loved Paris though it was everything he said he hated.

Hamilton put America’s financial house in order.  He helped give the new nation legitimacy.  He opened European credit to us.  Problem was that, in Jefferson’s eyes, America was becoming too much like Great Britain.  And worse, it was becoming less Virginian.  So they squared off and fought each other.  Tooth and nail.  They gave birth to America’s first political parties (Federalists and Republicans).  They viciously attacked each other in the press.  Yes, politics were nasty right from the beginning.

Then something happened that caused Jefferson to embrace much of what Hamilton did.  He fell ass-backwards into the Louisiana Purchase.

THERE WERE DREAMS of a French empire in North America.  But the slave uprising in Saint-Domingue (present day Haiti) put the kibosh on that.  With Saint-Domingue lost, there was no point in France keeping New Orleans or the Louisiana territory beyond.  And Napoleon needed money.  He was at war.  And that war was about to expand to include Great Britain.  So he offered it all to the Americans for about 15 million dollars.  Though a steal, 15 million was still a lot of money.  And then Jefferson embraced what that capitalistic bastard (we can call him that for Hamilton was the fruit of unmarried loins) created. 

(This sale was also strategic.  By expanding America’s western border, it kept that land from falling to the British.  America would grow and, in time, a stronger America would challenge Great Britain for all that sea-going commerce in the Atlantic.  If it couldn’t go to the French, better it go to the Americans.  And, in the process, it would really piss off the British.  Like I said, strategic.)

The deal included gold, bonds and some debt assumption.  Jefferson was adamantly opposed to Hamilton’s assumption of states’ debt back in Washington’s administration for it only aggrandized the central government.  And Jefferson absolutely hated banking (probably because he was forever in debt).  And though he was brilliant, he was not so brilliant when you put dollar signs in front of things.  Jefferson made the purchase, but the bond deal put together was pure Hamiltonian. 

France wanted cash.  We didn’t have it.  But we now had established credit in Europe.  We could issue bonds.  Because of our credit worthiness, the Dutch were willing to buy those bonds from France at a discount and give France the cash Napoleon wanted.  And, voilà, Hamilton’s capitalism allowed Jefferson to double the size of the United States while reducing the threat in North America from the competing European powers (Great Britain, France and Spain).  It also enabled Napoleon to cause further mischief in Europe (an unfortunate side affect).  Sorry about that, Europe.  It was an unintended consequence.

THE FREE FLOW of ideas and capital can define capitalism.  Some people have great ideas.  Others have lots of money and are willing to take a risk.  Separately, these two don’t do much to make life better.  But bring them together, though, and let the good times roll.

Venture capitalists are rich.  And they’re looking to get richer.  It’s what they’re good at.  They look for talent.  New start-up companies with a good idea.  An idea that may change the world.  They may not have that creative spark to create something new, but they can recognize that spark when they see it.  And when they see it, they want to finance it.  If they pick a winner, we may get that something that changes the world.  And they may make a dump truck full of money.  Everyone wins.

Venture capitalists bring in money.  And talent.  The entrepreneur spends his or her time creating.  The venture capitalist helps build the business.  Kind of like a mentor.  They can be demanding, though.  And impatient.  They expect a big profit on their investment.  And they don’t want to wait around forever to get it.  When things work, they can work well.  Very well.  The entrepreneurs create something new and remarkable that everyone must have.  They then take their company public.  Their initial public offering brings in gazillions.  And those initial investors (the entrepreneurs and the venture capitalists) get incredibly rich.

IN 1976, THREE guys had an idea.  They made an electronic device in a garage that they thought people would want to buy.  It was crude and ‘some’ assembly was required.  And by ‘some’ I mean a lot.  Initial financing was limited.  A car and a scientific calculator just didn’t sell for a lot.  Two of them (one had since left the company) approached a couple of venture capitalists who introduced them to a man by the name of Armas Clifford (Mike) Markkula Jr.  He, too, was a venture capitalist.  And an engineer to boot.

Markkula joined the company.  He was one of the driving forces behind a new product introduced in 1984.  Their Super Bowl ad was, is, a classic.  That product was the Macintosh computer.  Those two men introduced to Markkula were Steve Jobs and Stephen Wozniak.  That company is, of course, Apple.  Today, Apple’s iPhone dominates the market.  And they’re still innovating.  Thanks to a venture capitalist willing to take a risk.

CAPITALISM CAN DO remarkable things.  It can build a nation.  Or change a world.

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