Companies need money to get new equipment, develop better products,and expand their operations.
One way to get money is to ask a bank for a loan. However many companies when they start are small and not established. Therefore banks are wary of giving them loans. Even if the banks give them a loan, often the interest rate is high to offset the risk of giving them a loan. The high interest rates pull down the growth and earnings of the business and lead to failure of the business.
Another option is to sell shares of the business. By selling shares, the people who buy the shares will own a piece of the business itself. The company raises money and does not have to pay interest to anybody. If the business succeeds, the people who bought the shares also gain a lot of money. If the business fails, the people who bought the shares lose a lot of money.
Initially a company might sell shares of the business to a few investors. These investors are the first to invest in the business hoping to profit. Hence they are called venture capitalists. If the business succeeds they make a lot of money. If the business fails, they lose a lot of money.
Once the business succeeds initially, the venture capitalist makes a lot of money. How does this happen?
Let me explain it with an example:
I decide to start a business selling rare books. I need Rs. 1000 to start the business. I have only Rs. 600. My friend, Raj, gives me Rs. 400. I say to him the business consists of 10 shares. Since I put Rs. 600 I own 6 shares and since Raj invested Rs. 400, Raj owns 4 shares.
One year later, the business is successful. We think the business is worth Rs. 5000 now and financial experts agree with us.
So in 1 year we have gained: 5000-1000/1000 x 100= 400%. An absurdly high return. This is how the venture capitalist makes a high return. However he took a high risk as well, because if my business had failed, he would have lost 100% of his money. High risk, high potential return.
However, now, I want to expand the business. I need more money. Raj does not want to invest more money in the same business.
So I decide to sell shares to the public. The following things have to happen for me to sell shares to the public:
- The stock market should accept my business to be listed on their exchange.
- An investment banker should be ready to help me. Say I wanted to sell 1,00,000 shares at Rs. 1 each which make up say 40% of the company. The investment banker does all the leg work to sell it to the public. If the public does not buy it, the investment banker buys it. But he will a take a small amount of profit per share say 1 paisa per share for the risk that he is taking in case the public does not buy the shares. The investment banker first sells a portion of the shared to the primary market( preferred clients which are usually institutions and high networth people). Then he sells the rest in the secondary market(people like you and me).
- Once the above things are done, the exchange lists the stock and the stock starts trading on the market. The price of the stock varies depending on what the market thinks the price of the share should be. The company does not profit anymore from the 40% of the shares it has sold. Whoever has bought the shares profit or lose depending on the price they buy and the price they sell.
- If I want to raise more money, then I can make what is called a secondary offering. The price of shares offered during the secondary offering will depend on the market price. Companies want their stock price to be high because they can then quote a high price for their secondary offerings.
This is how shares are sold to the public
Practically, what is the use of knowing this:
- A share/stock is a part ownership in a business. It is not some number on a ticker like what happens when gambling.
- A business has a value. The value of the business is different from the price at which the business is quoted for. Usually values and prices are close. From time to time mispricings occur and shares may become overvalued or undervalued.
- Buying something that is of good quality and fair to undervalued is the basis of success in all investing.
- In the short run, the market is a voting machine. In the long run, it is a weighing machine. It prices the share based on the profitability of the company now and in the future.
- The market just gives you prices. It is upto you to accept them or reject them.
There are many more lessons that can be learnt from understanding the process of why and how companies sell shares. Understanding them will make you a better investor.