JOURNEY FROM STARTUP TO IPO
In the previous lesson, we cleared some misconceptions and also learnt that over long periods of time, stock create wealth. Let’s talk about companies now. When a company needs to start, they always start small, but it needs capital. It needs capital to ...
JOURNEY FROM STARTUP TO IPO
In the previous lesson, we cleared some misconceptions and also learnt that over long periods of time, stock create wealth. Let’s talk about companies now. When a company needs to start, they always start small, but it needs capital. It needs capital to grow, capital to hire and to expand business. There are various stages of these capitals. Initially may be some friends or family get that money on and after that there are investors called Angel investors. These are private individuals willing to invest in companies showing a lot of promise. Then we have private equity, venture capitalist and finally the IPO i.e listing on the stock exchange.
An average citizen of India like you or your friend cannot invest in these companies in these stages because these companies are private but when these companies go public i.e when they list on the stock exchange, you can actually invest in them through the stock market.
Let’s get back to the basics
WHAT IS A STOCK
Basically a stock is issued by companies to the public. The public therefore buy these companies and the company raises the cash. This money is invested to grow the business.
To know what a stock is, we are going to see life of a company from start up to big business and the decision to go public.
Let’s suppose we have an individual Mr Raj. He is an entrepreneur, he wants to sell sweets and take his business to the public. He basically wants to start a sweet stand and he calls this RAJ’s sweets. We are going to guide him how to make his business a success. So first of all paper work need to be done. He calls his company Raj’s Sweets Pvt Ltd. Now he can begin his business but before setting a shop, he needs capital. For that, he has his company which is 150 shares in total. He finds an angel investor who believes in his wide vision and willing to invest. He sells 50 shares for 1000 each to this angel investor. Angel investors are wealthy individuals who are looking to invest in small start ups who have a lot of promise. Now he has 50000 rupees coming in his company as funding. Despite of selling his 50 shares, Raj is still in control as he still own 100 shares.
At this point, the company is worth 1.5 lac rupees. But then Raj comes to a realization that he still doesn’t have enough money left. He goes to the bank that gets him a loan of 1 lac rupees for his company. The bank lends this 1 lac to Raj at 10% interest annually. Now Raj gets the loan and he is ready to start business.
So there are 2 investments coming to Raj. One is the banker who lent 1 lac at 10 percent annual interest, means the bank is earning 10000 rupees, whether the company does well or not they will get that fixed returns. Banks are risk covers but they still want returns. On the other hand there is an equity investor that own 1/3rd of the company i.e 50 shares and invested 50000 rupees into Raj’s sweets. Basically has taken more risk than the banker but he also has open to much more profits. If Raj grows from 1 stall to 1000 stalls, he can pocket a huge difference. If Raj’s company is worth 600 crores by the time the angel investors will own 1/3rd of those 600 crores which is 200 crores. But the banker still gets only 10000 rupees. That is the fundamental difference between them. The angel investor believes in Raj’s business, the management, the future of how the exponential growth can go up.
In Raj’s case we have only one investor; there can be multiple investors.
Look this for Infosys
This pie chart shows different share holding patterns and this can be different in all the different companies. All owners own this share and each share has his share price. Let’s get back to Raj. He is finally starting his venture. He first needs to set up basic sweet stand and he needs to get inventory and hire one employee to help him out to make those sweets. He begins making those sweets. Let’s forward one complete year, Raj’s sweets have done really well and by the end of the year his net income after expenses and taxes is 38000 rupees which doesn’t sound a lot of money. He needs to make a decision that should he continue growing Raj sweets or not because 38000 doesn’t sound so good considering he spent entire year working full time.
Let’s calculate what the company can be after 4 years from now. Let’s make some growth assumptions.
First assumption is that Raj reinvests his profit every year. It would be nice buying a new car or house, but he decides against it. He is determined to make his company grow.
He decide that this money that he reinvest will be used to add new stalls every single year, so at the end of 5 years he will have multiple stalls in the same area or in multiple cities.
He also decides that he can charge more per sweet as the word spreads of his good sweets. It’s also safe to assume at this point, he will able to sell more sweets as the branding takes place.
The inventory cost and the employee cost remain stagnant. Now question is, what does the company do 5 years into the future? Raj has done extremely well and net income after all the taxes has now grown to 10 lac rupees. The company is now worth 7 times more then what it used to be. The per share value has increased from 1000 to 7000.
Now we are going to introduce a concept VALUE INVESTING
So how valuable is Raj’s company now? It started with 1.5 lac rupees as the value of the company. And each share was valid at 1000 but today it has risen to 7000 per share according to the balance sheet. And you can see every year it is growing.
There are famous investors like Warren Buffet who uses Value Investing. Let’s see from the value investor’s point of view that what exactly they think before they decide investing? What kind of questions does a value investor ask before investing?
What is the competition like? If Raj is doing so well, he could have competition right at his door and begin a price war. If that happens, how will Raj’s company behave in that point? Will sales go down? Will he be able to retain his customers? Ask these questions.
Now this is an important question to be asked that whether it is a growth company? Is it growing every single year? According to the balance sheet Raj’s company is growing really well.
What is unique about Raj’s sweets? Now companies like Coca Cola, it’s such a strong brand that any new cola company coming in might face difficulties to displace Coca Cola. So does Raj have something unique?
Are there any barriers to entry? Is it easy to open a sweet shop? Companies like Telecom Company like Idea, Airtel, they have barrier to entry called licences. You just can’t start Telecom Company so easily for that you need a licence from the government which is difficult. So what are the barriers to entry for a sweet shop?
How much debt does the company have? This means how much the company owe money to someone else. Sometimes during good periods when the economy is growing, lot of business coming in, companies tend to take a lot of loans. And you have to repay the loan. So every time you repay the loan it’s an expenditure from the balance sheet. Now the question is that when the economy contracts, will the business be able to pay back those loans? This can cause havoc even in best companies. Is the company in a lot of debt? Ask yourself this question.
Now this is peculiar to the stock market. We know Raj’s company is valid at 7000 rupees per share but the stock market because of sentiments, sometimes stocks can trade below book value. These are called Value buys. What would you do in this situation?
Ask these questions and you will understand, what goes in the mindset of a value investor.
Raj’s sweet has grown. In these 5 years he has grown from 1000 per share to 7000 per share. Now who do you think got the better deal? The bank that is still earning 10000 per year but if we compare to an equity investor whose investment has grown to 7 times of his initial investment, right from 50000 rupees to 3.5 lacs. So why is the equity investor allowed to earn more than the lender? At the end of the day it comes down to risk and reward.
If Raj’s sweet went bankrupt today, the lender would have first claim over the liquidation. But the equity investor on the other hand took a higher risk and in return if the business does well, he can re proportional returns.
So we can see Raj’s company has grown from nothing to high valued company. It has grown pretty well and it will continuously grow but Raj is highly ambitious. He is thinking massive. He wants pan India presence. Imagine 1000 of his sweet stalls all across the country. But there is one problem, how does he raise capital to execute this plan. He has people, he know inventory, he know how to scale the business but one thing is missing, that is the money. He has few options listed below.
– He can sell to any outright competitor. He has competitors which are much bigger than him and been around for decades but Raj loves his company and he also think it can be valued at much higher levels as years go by. So selling is not an option.
– He can sell part of his company to another investor. Now that make sense, he has 100 shares and he can share 20 out of them to an outside investor and get him on the board.
– Now this option is the bigger one. Listing on the stock exchange. By doing this, the 100 shares he owns he can actually give a small portion of it say 20 shares and release it out in the public. People from all over India even the world can invest in Raj’s company. And probably he can get much higher valuations. So that’s how small company from start up grows and then decide to go public.