15/11/2016

MrunalExplained:DebtvsEquity,SharesvsBonds,IPOs,Angelinvestor

Mrunalhttp://mrunal.org

[Economy]BondsvsShares,DebtvsEquity,IPO,
Underwriter,VentureCapital,AngelInvestor,Junk
Bonds,BearerBonds,GiltEdgedsecurities:Meaning,
Explained
PostedByMrunalOn29/03/2012@12:00amInEconomy|114Comments

Howtoarrangebusinessfinance?
Financemethods:DebtOREquity
#1:Debt:Bonds
JunkBondsvsGiltEdgedSecurity
BearerBonds
#2:EquityShares
ShareholdersandBoardofDirectors
VentureCapitalistandAngelInvestors
WhatisVentureCapital?
WhoisAngelInvestor?
WhoisUnderwriter?
DebtvsEquity:Pros&Cons
IwanttostartanIcecreamcompany,whatwillIneed?
Land

Tobuildafactory.

Labor

Workerstorunthemachines.

Capital

MoneytobuyFreezers,mixersandpackingmachinestomakeicecream.

Entrepreneurship Totaketheriskanddoabovethreethings.
Thesearecalledthefourfactorsofproduction.
Ialreadyhavetheentrepreneurshipinmyheartandmind.
Butitrequirestruckloadofcashtoarrangefortheotherthreeitems:Land,LabourandCapital.

HowTogetthecashtostartmycompany?
Icanrobabank
OrIcanjuststartmyownIITBombay,sellitsapplicationformsfor5,000rupeesandthen
declarecutoff99.99%andthusearningtruckloadofcashwithoutactuallywastingasingle
rupeeinarrangingtheadmissioninterviews.
OrIcanjoinpolitics.

Problemsinaboveoptions
CantrobarobabankbecausethistoorequiresLabour(gangsters)andguns,masks,vehicles
andEntrepreneurship(totaketheriskofgoingtojail).
CantstartmyownIITBombaywouldagainrequirethosefourfactorsofproduction(Land,
Labour,Capital,Entrepreneurship)+PermissionsfromUGC/AICTE.
CantjoinpoliticsbecauseOnlyministerscanmakehugemoney,MPs/MLAsdont.And
UnfortunatelyImnotasonordaughterofsomebigpoliticiansoIcantbecomeminister@
youngage(AgathaSangma,SachinPilot,NaveenJindaletal)SoevenIfIjoinpoliticsrightnow,
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IllhavetodobootlickingofPartyhighcommanduntilIget60yearsold,onlythenIcan
becomeministerandbreaktherecordssetbyA.RajaandMadhuKoda.
Now,Therearetwowaysto(legally)arrangemoneyforstartingacompanyortoexpanda
company.FirstisDebtandSecondEquity.Seethischart

Financingmycompany:DebtOREquity
Withinthat,twomajortypes:Gildedgedsecurities,junkBondsandCouponbonds.

#1:Debtbond
Theworddebtisselfexplanatory.Youborrowmoneyfromsomeone:Itcanbeabank,itcanbe
afriend,itcanbeastranger.
Iwriteonapieceofpaper:TowhoeverpaysmeRs.1000,Illpayannual10%interestrate
(Rs.100).Andafter5years,IllalsorepaytheprincipleamountRs.1000.Noifsandbuts.
Thisisonetypeofsecuritypaper.WecallitBOND.
IFyouholdmybonds,Imliabletopayyoumoneynomatterwhathappens.Whethermyice
creamcompanyactuallymakesprofitorgoesKingfisher.Ihavetokeeppayingfixedmoneyto
you,everyyear.

JunkBondsvsGiltEdgedSecurity
InabovecaseIofferedyou10%interestrate.Butinreallife,therearecreditratingcompanies
likeCRISIL,S&P,Moodysetc.Theyllgivecreditratingstoabond.(i.e.AmIcapableenoughto
actuallypayyou?).
Basedonthat,theygiveratingsexampleAA,A,BBB,BB,C,Detc.
Ihadtalkedabouttheminmypreviousarticle.GothroughtheArchiveon
www.mrunal.org/economy

JunkBonds

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IfmyBondgetsCorDrating,itmeansImnotcreditworthy,Imaydefaultonthisloan,I
mayrunaway.SomybondisasjunkasRa.Onemovie.Awisemanwillnotinvestinit.
So,howcanIseduceyouintopurchasingmybonds?HowcanIconvenienceyoutotakethe
higherrisk,inbuyingmyjunkbond?
HowaboutFreecallerTunesorascratchcardthatoffersyouachancetodinewithSachinor
Katrina?
OrHowaboutHigherInterestrates:IfyougivemeRs.1000,Illgiveyou25%interestrateper
year!
ThisisalsoknownasHighYieldBond,becauseyouregettinghigherprofit.

GiltEdgedSecurities
Likeanicecreamcompany,Governmentalsoneedsfinanceattimeswhentaxcollectionislow
andtheyneedsometemporaryfunds.
Theyissuestreasurybonds.RBIsellsthesetreasurybondsonGovernmentsbehalf.
ButGovernmentsgenerallyhavetheaukaattorepaytheprincipleandinterestrates.Hence
Governmentbondshavehighercreditratings(AA).So,theydontneedtoseduceyou,theyll
offerverylowrate,say4%.
Similarly,wellknowncompanieswithhighcreditratings(AA)alsoissuebondsbutpaylowrates.
Ifyoudontliketotakerisks,youllinvestinsuchbonds.Thesearecalledgiltedgedsecurities.

BearerBonds(andBadGuys)
InBollywoodmovies,KidnapperdemandsransomofRs.10lakhsbuthewantsthemoneyinthe
denominationofRs.5/10/50Rupeenotes.Why?Becauseitiseasytocirculatethesenotesand
harderforpoliceorbankstokeeptrackofthismoney.
Sameway,inHollywoodSpythrillermovies,theVillainwillaskyoutopay10milliondollarsin
Bearerbonds.
Bearerbondsaresameasregularbonds,buttheydonthaveHoldersNameonthem.These
bearerbondshavecouponsattachedwiththem.So,ifyoudontwanttowithdrawthewhole
money,youcancutafewcouponsandsellthemtoabrokertowithdrawpartialamount.
E.g.Rs.100interestistobepaidon1stApril2012,ButevenonDecember2011youcansell
thecoupontoaBroker.AlthoughhellnotgiveyouRs.100butsomethinglikeRs.95or90.(Why
so?Thinkaboutit!)
Anyways,thepointis,Noonecankeepatrackofwhowithdrewthemoney,whosbuying,whos
sellingBecausetherearenonames,addressesorrecords.Badguyslikeit,becausethis
ensuresanonymity.
SeethefollowingexamplephotographofaBearerbondofGovernmentofPalestine.Noticethat
itdoesnthavespaceforOwnersnamesandtherearethreecouponsattachedatthebottom.

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Question:WhywouldGovernmentissuebearerbonds?Becausewhentheyreindireneedof
money,thereisemergency,thereiswargoingon,theycannotwastetimeincheckingthe
lengthyregistrationforms.So,Betterjustsellthebondstoanyswingingdudethatcomes,
withoutaskinghisname,address,mobilenumberoremailid.
Although,inreallife,itishardtofindBearerbonds.Becausemostofthebondsnow,existin
Electronic(DEMAT)formatandyouvetogiveyourpancardnumber(orothersimilarpersonal
informationinforeigncountries)tobuyorsellbonds/sharesoranysimilarsecuritypapers.So,
nowbadguyswantpaymentingold,diamondorotherpreciousmetalsinsteadofbearerbonds.

#2:Equity:IPOsandShares
Sofar,wesawthatfirstoptionistoborrowmoneyandpayregularinterestrate.(Debt
>Bonds).Nowcontinuingthisnotsotechnicallycorrectarticle,
Secondoptionis,ItakemoneyfromyouandinreturnIofferyoupartnership.Thisiscalled
Equity.
AssumingthatIneed1crorerupeestostartmycompanyandIve30lakhsinmysavings.So,I
writeonapieceofpaper:Illgive0.0001%ownershipofmycompanytowhoevergivesme
Rs.1000.
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Thisisagainatypeofsecuritypaper.ButsinceImsharingapartofownershipwithyou,in
crudeterms,wellcallitShare.
ThenIprint10,000suchpapers.Whatsthevalueofthesepapers?
10,000PapersmultipliedwithRs.1000each=1crore.VoilathatstotalmoneyIneed.
AndsinceIalreadyhaveRs.30lakhs,Icanpurchase3000shares.(because3000papersxRs.
1000each=30lakhs)
SooutoftheTotal10,000sharesthatIprinted,Iwillown3,000shares,sopercentagewiseI
own30%ofthiscompanysequity.

ShareholdersandBoardofDirectors
SinceImissuingtheshares(Equities),undertheCompanylaw,IvetoConstituteaboardof
directorsandholdannualgeneralmeetingoftheshareholders.
Forimportantpolicydecision,Illhavetotakevotesoftheshareholders,theBoardofDirectors
willsuperviseovermyactivities.InshortIcannotrunthecompanyasIplease,Ivetogive
answerstothosepeople.
Onthefirstyear,ImakeprofitofRs.25lakhs.Theboardofdirectorswillmeetanddecide
distributeRs.10lakhsasDividendamongtheshareholders.Nowabouttheremaining15lakhs,
investthembackinthecompanytoexpandourproductioncapacity,buybiggermachinesand
installnewfactoriesinPakistanandSomalia.
Hereisthecoolpart,IcanbecomeCEOofmyowncompanyandsayIlltakesalaryofRs.1only!
Andstill,IwillearnRs.3lakhs.
How?BecauseIown30%ofsharesinthiscompany,sowhenthatRs.10lakhDividendisshared
amongtheshareholders,Iget30%ofit=3lakhs,apartfrommyRs.1salaryasanemployee
ofthiscompany.
Hereisademophotograph,ofCreekMiningCompanysshares.

TheownerMr.Georgeown200sharesofthiscompany.Andinthesmallfonts,itismentioned
thattotal30,00,000sharesof$1each.MeaningMr.Georgeowns(200/30lakh)x100=0.0067
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%stocksofthisCreekMiningCompany.
Butinreallife,nowadays,whenyoupurchaseshares,youdontgetsuchcoollookingcolorful
papercertificates.Yougetthesharesinelectronicdematerializedformat.Theygettransferredin
yourdemataccount.

PrimaryvsSecondaryMarket
Primarymarket=thisisthePlacewhereIPOsaresold,
SecondaryMarket=thisistheplacewhereIPOsareresoldasshares.
Physicallyboththingsaredoneinthesameplacee.g.BSE(BombayStockExchange)butthis
virtualclassificationhelpsinkeepingtrackofthings,makingstatisticalanalysisetc.

VentureCapitalistandAngelInvestors
NowTwomoresubtypesofEquityfinancers
WhatisVentureCapital?
VentureCapitalisacompanythatgivesyoumoney,tostartyourcompanyortoexpandyour
companybutinreturntheydemandpartofownership.
Theydealwithonlybigthings,bigprojects,biginvestments.Theywonthelpmetoopenan
icecreamparlourinGujaratUniversitydespitethefactthatitsmonthlyrevenuewillbehigher
thanSBIGeneralManagerssalary.
CopypastingexampleofOjasventure,India
WeinvestintechnologybasedbusinessesinsectorssuchasMobiletechnology,Telecom,
Software.
WemakeaninitialinvestmentofUS$250,000toUS$1.5million.
Howdotheygetmoney?
Ofcoursemoneydoesntfallfromsky,theseVentureCapitalistcompaniesthemselvesborrow
moneyfromothercompanieslikemutualfunds,pensionfundsortheymaybeissuingtheirown
bondstogetmoney.
Howdotheyoperate?
TheyvetheirownteamofManagementexperts,corporatelawyers,charteredaccountant,and
businessconsultants.Theystudyyourbusinessplan,approvethemoney.
TheylldemandseatsinyourcompanysboardofdirectorstoInfluencetheDecisionMakingin
yourcompany,accordingtotheirrequirementandsoon

WhoisAngelInvestor?
Thesearerichgentlemen.Theyfinancestartupcompaniesforgettingpartialownershipandor
assuredreturnsoninvestment,afterfewyears.Theycangivedebt(i.e.justlikemoneylenders
andbanks)orEquity(i.e.partialownership).Butmostlytheyplayintheequityfield.
WhatistheneedofAngelInvestors?
YoucangetmoneyfromBanks/Bonds(Debt)orIPO/VentureCapitalist(Equity),ifyour
businessprojectislikelytobearsuccessbasedonpreviousexperiance.
Forexample:Pharmaceuticals,Dairy,Engineeringinstruments,Mining,Telecom,Textiles,Oil
Refineryetc.
Buttheymaynotgetinterestedinyou,ifyoutalkaboutuntriedanduntestedbusinessplans/
productorfields.

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ImagineSteveJobsrequestingSBIBankManagertogivehimbusinessloanin1970stostart
AppleComputers,
orSameSteveJobslaunchingIPOofAppleinNewYorkStockexchangeduringthattime!
ButtherewasanangelinvestorMikeMarkkula,whoactuallybelievedinhisplanandgavehim
somemoneyandgot1/3rdownershipinthecompanyin1977.
Angelinvestordoesntmindtakinghugeriskbyhelpingevensmalltimerswithtotallyunique
anduntestedidea,ifhethinkthatitllgrowuphugesuccessinfuture.
Similarly,AmazononlineshoppingwebsiteandStarbuckscoffeechainalsostartedwithAngel
Investors.

CapitalGainTaxRevisited
RecalltheargumentgivenbyMr.VodafoneinCapitalGainstax?
Anindividualwhoowns45percentsharecapitaldoesnotown45ofthatcompanysassets.
Thereisadifferencebetweenthesaleofsharesinacompanyandthesaleofassetsofthat
company.
Whyisitso?
BecausemostofthecompanydontdirectlystartwithIPO/Shares.Firsttheentrepreneurstarts
asmallcompanyusingmoneyfromhisownsavings,borrowingfromfriends,relativesandbanks
orfromanAngelInvestor.
Oncethebusinessstartsbooming,helllaunchanIPOtogetextrafundsfrompublic,toexpand
hisbusiness.
So,Healreadyhassomebuilding,machinery,vehiclesetcassetsinhissmallcompanybefore
launchinghisIPO.

Takeareallycrudeexample
IhaveRs.30insavings,IborrowRs.20(Debt)andthusstartacompanyforRs.50
Afterfewyears,IneedanotherRs.50toexpandbusiness,soIlaunchanIPO:Total50share
papersworthRs.1each(Equity)
Youbuy10sharesfor10rupees.Meansyouown10/50th=20%ofmyshares/stocks/equity/IPO
whateveryouwanttocallit.
Butthetotalassetsofmycompanyare=FromRs.50Ihadalready+Rs.50fromIPO=Total
Rs.100
So,Youdontown20%assetsofmycompany,becauseyouvegivenmeonlyRs.10!andmy
totalassetsarefinancedfrombothDebt+Equity.
Sameway,ifyoupurchase10%sharesofJetAirways,doesntmeanyouown10%oftheir
airplanesandbuildings.

WhoisUnderwriter?
Sofarweveseenthat
ToarrangemoneyIcaneitherborrow(debt,Bond)orIcangiveshares(equity,IPOs/shares).
Hereistheproblem:IcannotprintthosesecuritypapersonmyownHomePCscheapprinter.
First,Alengthylegalandaccountingpaperworkhastobedone,itllrequirechartered
accountants,CorporateLawyersexpertsinthesematters.
So,Igotoanunderwriter,hechargesCommissionbuthepromisestocoverallthetechnically
things,paperwork,SEBIregulations,selling,acceptingmoneyforIPO/Bondssaleetc.etc.etc.
Sameunderwriteralsooffersakindainsurance,thathellbuytheIPO/Bondsifothersdontbuy
it.
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KotakMahindra,ICICIoffersuchunderwritingservices.

DebtvsEquity:ProsandCons
Inreallife,companiesdontrelyonsinglesourcetofinancetheiradventure.Theyllarrangepart
ofthecashfromDebt(Borrowing)andpartofthecashbyissuingIPOs(Equity).
Eachhasitsownadvantageanddisadvantage.Letscheck
Goodthings:bondsvsshares
Debt(Bond)

Equity(IPO/Shares)

Ihavecompleteownershipandcontroloverthe
company.Imaccountabletonobodyjustlike
UPAII.

Ifthecompanymakesloss,Idonthaveto

Idonthavetosharemyprofitwithanyone.I

shareanymoneywiththeshareholder,just

gettoeatthewholecake.

likeKingfisher.

Icanclaimincometaxdeductionforpayingthe Sothereisnoregularinterestpayment,as
loan.

wedointheloan.MeaningIvelesstension

Itrequirelesspaperworkandtimetoborrow

comparedtobankloan/bonds.

frombank/friendthanviasharemarket(SEBI
permission,boardofdirectorsetc)

Badthings:bondsvsshares
Debt(Bond)

Equity(IPO/Shares)

EvenifIdontmakeprofit,Ivetopay

Idontgetcompleteownershipandcontrolover

interestrate,becausebasicallythisisa

thecompany.

loanjustlikehomeloanorcarloan.

Ivetoconstituteaboardofdirectors,holdgeneral

Whetheryouearnornot,youvetopaythe meetingsofshareholders,Imaccountabletothem.
EMI.

TheboardofdirectorscanthrowmeoutofCEO

Imayhavetomortgagesomething

job,ifIdonotdeliverresults,unlikeMohan.

(machinery,building)togettheloan.So

Itrequiresheavypaperworkandtimetoinitiate

incaseIdefaultontheloan,the

IPO,sharemarketthing(SEBIpermission,

bank/financercantakeitawayfromme.

underwritingetc)

So,itdbebetterifIfinanceapartfromdebtandapartfromequity.Thatleadsustothe
discussionaboutDebttoEquityRatio.(tobecontinued),Allmyarticlesoneconomy,are
archivedatMrunal.org/economy

ArticleprintedfromMrunal:http://mrunal.org
URLtoarticle:http://mrunal.org/2012/03/economyfinancecapitaldebtequity
bonds.html
Copyright2014Mrunal.Allrightsreserved.

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