Finance and capital markets
Public vs. Private Equity. Why people buy equity to begin with. Created by Sal Khan.
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- Say, we have issued 10M shares during IPO. Later point in time a VC who invested in firm wants to sell a portion of his/her share in Secondary market. My question is, If the VC sells his/her share in secondary market does it gonna add up to the 10M shares what we issued during the IPO?(1 vote)
- In the example from the video, there are 5 million shares before they go public. Then they issue 10 million to the public. That means there are now 15 million shares - the 10 mill they 'created' for the IPO and the 5 mill that already existed (that the founders and VCs owned). So now the founders and VCs are really on par with the public in the sense that they own shares that are equivalent. If a member of the public wants to take control of the company, they can buy up 7,500,001 shares on the open market and install their own board of directors. VCs and the founders like having the IPO (in general) because they can sell their shares in the market and see a return on their investment.(2 votes)
- when company enters into public offering.. who decides on share value ? and how do they divide assets into X number of shares and where does X comes from?(1 vote)
- The price is ultimately driven by demand, and after the first second of trading it's the market that sets the price. As to how they decide on where to price them originally- it's usually done by a bunch of investment bankers with spreadsheets comparing the company to other companies that have recently done an IPO as well as other publicly traded companies. The company decides how many shares they want to offer (the number of which can be somewhat arbitrary - Google famously used the square root of 2 times 10 million) in order to raise the desired amount of money.
A simplified example: Say I'm the sole owner of a company and I think it's worth $100 (it's a fancy lemonade stand in a high-traffic part of town). But I want to raise $100. If I want to attract neighbourhood kids to be owners, I could say that I own 100 shares, and then sell an additional $100 shares for $1 each. If I wanted parents to invest, I could say that I own 10 shares, and sell an additional 10 shares at $10 each. If I only wanted my own parents to invest, I could say that I own 2 shares, and sell an additional 2 shares for $50 each. In every example I still raise $100 and retain 50% of the company.(1 vote)
- Please clarify the following two items:
1. Only the the shares issued under the IPO and not the total shares are traded/sold to the general public correct? To explain using your previous example, there were 4M shares prior to the IPO held by the founders, angel, and VC investors. Then, the company issued an additional 10M shares to the public via an IPO. That means only the 10M shares are being traded on the public/exchange market and are "liquid". The other 4M are not being traded on the exchange and are not "liquid". Correct?
2. If I'm correct on number one above, that also means that none of the original shareholders including the founders, angel, and VCs are able to benefit from any share price increases in the exchange of public shares correct? Again, to explain using your example, none of the original shareholders own any of the 10M shares being issued to the public via the IPO. They only own the 4M shares that are not public. Therefore they cannot benefit from the increase in market value of those publicly traded shares. Correct?(1 vote)
- If the investment banker/lead underwriter's commission is tied to amount of offering. Then what keeps them from driving the pre-money offering up to increase their commission?(1 vote)
- You're absolutely right that investment bankers have a short-term economic incentive to drive up the pre-money valuation so that their 7% slice of the money raised in the IPO is larger. However, they also have a long-term disincentive to drive the valuation too high.
Let me explain the long-term incentives. If investment banks drive up the pre-money valuation too high, the price of the company's stock won't increase over time after the IPO. If investors who just bought the company's stock in the IPO, see that their stock is losing value in the days and weeks after the IPO, these investors will be angry. They will therefore be skeptical of future IPOs as well as distrust the information they received from the investment banks. If the investors don't like future IPOs and don't like the investment banks, the investment banks will lose their ability to reach the 7% profits if IPOs as a whole become less attractive and less successful.(1 vote)
- How can you just add 2 million shares without diluting the other shareholders equity? Is it just because you are getting a cash value for that which is now added to the companies bank account and eventually turned into equipment or goods?(1 vote)
- Yes, you get cash in exchange for those shares. If the company is worth $100 and has 10 shares outstanding, each share is worth $10. If they now sell another share for $10, then the company is worth $110 and there are 11 shares out, so each share is still worth $10.
In reality the people who own a stock often own it because they think it is undervalued. In the previous example it would be as though the people who own the company think it is worth $200 even though everyone else thinks it is worth $100. If they think it is worth $200 then they think the shares are worth $20 each and they don't want one to be sold for $10, because then the company will be worth $210 and there will be 11 shares and each share will only be worth $19.09 and they will think they were diluted. But more likely they were deluded.
In practice, when a company wants to sell a lot of shares, simple supply and demand tells you that the additional shares are going to have to be sold at a discount to whatever the current quoted market value is, just because you are trying to dump a whole bunch of shares into the market at once.
During an IPO, the same thing is going on except there is no current quoted market price. So part of the job of the bankers who get the IPO done is to get people excited about the company so they will imagine that if there was a quoted price it would be very high, and then you sell it to them at a discount to that price they are imagining. Very often the excitement of that carries over into the first few days and weeks of trading, so the stock trades above the IPO price. The bankers could stop that from happening by trying to get an even better price at the IPO but the "pop" is supposed to be the reward to the people who are willing to participate in the IPO this time so that they will also participate in other IPOs that might not be so exciting. The track record of IPOs returns 1 year after issuance is not good, for these reasons. If you ever get a chance to get in on an IPO at the offering price, the right strategy is to take the shares you can get and then flip them on the pop. If you want to hold that company long term, wait until a year after the IPO - you will probably have a chance to buy it cheaper.
Better yet, don't mess around with individual stocks at all. Put your money in diversified low-cost index funds and leave it there.(1 vote)
- At 8.05, when an IPO is first marketed by the investment bankers, will the price of the share fluctuate? Assuming it could fluctuate, could the value of the whole equity of the angel investors/inital owners/VCs potentially go down due to the lack of interest from the public, making the share prices drop below 10 dollars/share to maybe 8 dollars per share?(1 vote)
- Absolutely. Obviously the owners hope that the price goes up, but it's no guarantee. Often companies will decline to go public if they don't think there is good appetite for their IPO at the moment. It's kind of like how blockbusters get released in the summer. In the late 90s there was huge investor demand for internet-related investment, so there were lots of internet IPOs. When investor demand dropped, so did the number of IPOs.(1 vote)
- Let's say my company has 1 Million shares outstanding at $1 per share so I have a $1 Million company. If an investor comes and offers to invest $5 Million into my company, but I want to hold at least a 50% market share, is my only option to only accept $1 Million? Is there a way to take in a $5 Million investment for a less market share for the investor?(1 vote)
- Nope, the only thing I COULD SEE WOULD MAY BE TO TELL the guy that hey, all the shares have to be five dollars. That means that you will still have a million shares and so will the vc. But I 'm not sure they can do that. You'd have to be a very, very, very good arguer to convinvce the vc to only get a million shares. So normally the VC would say, I need two million or three million or what not amount of shares priced at 5/2 or 5/3 dollars respectively.(1 vote)
- Sal, what if an investor believes in a company's prospects but knows the company isn't likely to make a traditional exit through a sale or IPO? Do angels ever arrange to receive a percentage of net profits?(1 vote)
- By definition, the equity stakeholders of a company are entitled to the earnings/net profit of a company either in the form of dividends or if none are declared then their equity stake just increases in value.(1 vote)
I think a little bit of a review is in order now and maybe just taking a little bit of a step back to say well, why does a company even raise equity? And why do the people who buy the equity even do it in the first place? So the whole idea of what we were doing in the last several videos is that a company wants to raise money to start a website, or build a factory, or do whatever else-- kind of invest in the world and in its kind of productive capacity, so it can build the things that the company is meant to build. And in every example so far-- we have the example where me and my buddies, we have just a business plan, that's the asset. And then we own all the equity. We're the board of directors initially. So that's all the equity. So let's call this the assets right now. This is the equity. And we could go to a venture capitalist-- it could have been an angel investor. It could have been-- we talked about Series A, Series B, all of that. And we could say OK, we need to raise x million dollars. What percentage of your company do we have to give away for that? And it'll say OK, well we'll value what you have right now-- I'll do a different number than what I did in the past-- we'll value what you have right now as $1 million. And so, if you need another $2 million-- so let's say we value what you have right now as $1 million. Let's say right now you have one million shares. So the company's pre-money valuation is $1 million. So you are essentially saying that the company right now is worth a dollar per share. There's $1 million worth of assets, and there's a million shares, so a million divided by a million is $1 per share. So they're valuing it at $1 per share. And essentially they're saying that we're willing to give you, or we're willing to buy more shares from you at $1. So, if we give you-- let me see, let me do green, I'll do a different color, I'll do purple-- we'll give you-- draw the box-- we'll give you, I don't know, $2 million. And since we're buying it at $1 per share, we get two million shares for that. And now all of this is the equity. This is what the founders had, and this is all the equity. And so now the company has what we say was worth a million dollars. And this is kind of an arbitrary thing, and we'll talk more about how you can actually value these intangible assets and things. But now they had that, and now they have another $2 million. So the post-money valuation-- pre-money was $1 million-- post-money is now $2 million. And now, we had one million shares, now we have three million shares. So essentially, for giving $2 million, these venture capitalists, or whoever-- so these shares go to some VC or angel investor-- they have now 2/3 of the company. They have two out of three million shares, or 66% of the company for giving the $2 million. So that was kind of a private raise of capital. And so you've probably heard the words private company and public company. A private company is one whose shares are not traded on a public exchange. So if this company wants to raise money by selling equity, the only place it can do it is to venture capitalists or to private equity firms. And we'll talk a little bit more about kind of the difference. A venture capitalist really is a private equity firm because it's buying private equity. But private equity tends to invest in more established business, when people just talk about private equity by itself. But we'll do several videos on that. So this is, essentially, this company is a private company raising private equity. Now, the example we did in the last video is, let's say this company grows to a certain size. Let me just do another company so it's clean. Let's say I have another company, these are its assets. And this is its-- let me draw its current equity base right there. They should be the same size, but you get the idea-- and these assets, it could be it has some cash. It has some factories or land. It could have a bunch of stuff. It could have some technology, or we could have some intellectual property. Maybe it's a drug company, or maybe it's a technology company. It has a bunch of patents and stuff. And then it has some intangibles-- a brand-- who knows what it has. These are the assets of the firm. This is the equity of the firm. So this company right now has no debt. And we'll talk about that in a second, what it means to have debt. And this is its current shareholder base, maybe some of these are some VCs who invested in the company when it was private. Maybe the founder has these shares. But this is the equity base right here. And let's say this company wants to raise a lot of money, and as just kind of a review of the last video, it can do an initial public offering. So right now it's private. All of these shares right now that are owned by the VCs and the initial founders of the company, they are not traded on a public exchange. This VC can't go to the NASDAQ and sell their shares. They can't go to the broker and say hey, sell my million shares I have in Company X. They have to just sit on them. Maybe they can find another private equity investor to buy their shares, or maybe these founders-- there's no liquidity here. There's no other person they can sell the shares to. And also, if this company wants to raise money right now it has to kind of go to a VC and do the whole process where you negotiate what this value is-- what the pre-money value is. And they have to come up with all these legal documents, and all of these stipulations around, we'll give you this money, but if this happens, then you have to give us this interest rate. And just all these type of things. So, what they might want to say is, we need to raise a lot of money. All of these guys want a way for them to be able to sell their shares easily if they need to. And this company says well, we need to raise a ton of money. Let's say we want to raise $100 million. And that's hard to raise from just any one individual investor, even if they are a big institution. So they'll do an initial public offering, and that really just means and-- the IPO, and this is review of the last one-- is that for the first time this company is going to register its shares with the SEC, and because it does, it's going to list its shares on an exchange. It will get a ticker symbol, it will maybe be company-- this'll be its ticker, T-I-C-K, or in the last video could be SOCKS, because it's going to sell socks. And then people can trade these shares on that exchange. It could be on the NASDAQ or something. And I think some of you all have had experience doing that where you go on your Charles Schwab account and you say I'm going to sell SOCK. Well, that company that you're selling, at some point, did an initial public offering, and registered with the SEC, and got listed on an exchange. And the way it really works is, it's fundamentally the same as when you raise money from a VC. But now, instead of raising money from a VC, all the money comes from, essentially, the public. It goes through these banks and brokerages, but it's coming from a bunch of small-- I'm just divvying it up right here. It could be coming from millions and millions of people. But the same process kind of holds. In order to see what price these shares are bought at, someone has to say well, what is the company worth before it gets the money? What is the company worth before it gets this money? Kind of a pre-money valuation. That still has to happen, and that's what the investment bank does. The investment bank will essentially do a model and they'll say oh, this is worth-- the company beforehand was worth $50 million. They'll kind of go out into the market to say well, our-- and let's say the company right now has five million shares. So that this piece right here is five million. So if the banks value the company at $50 million, and it has five million shares, they'll say OK, right now, the pre-money valuation is $10 a share. And the bank will go out there. It'll kind of gauge interest and say well, does it seem like the market's willing to pay $10 a share for a company like this? Or give this company a $50 million pre-money valuation? And if so, they'll move forth with the IPO. And, hopefully, the market actually wants to not pay $10 per share. The market maybe wants to pay $20 a share. So all of these guys, let's say they'll pay $10 a share, so let's say that they sell 10 million shares at $10 a share. So the company is able to raise $100 million. 10 times $10, $100 million. Then they can do big ads and all of that. And what the bank hopes is by selling these shares at $10 a share-- so let's say this is days, and this is price. Let me change colors-- so what the investment bank wants to hope is that, on day one, you sell it at $10 a share, and then the price moves up. That the demand was actually to sell it for much more. And there's a bit of a balancing act, because if they sell for too little, then the company won't get as much money as it deserves. But if they sell for too much, then the stock price goes down, then you kind of have a stigma associated with the IPO. But anyway, this begs the question of sure, I understand why the company is selling shares. It needs money. It needs to operate. It needs to build factories or put out advertising, and all that. But why are people buying shares to begin with? Why do people buy shares in the stock market? And frankly, there's two answers. And one is kind of the obvious one, because they think the shares will go up. But to some degree, that's speculation. If I'm buying a share at $10, just because I'm hoping that there's some other dude out there who, maybe a few weeks later, is going to pay $15, I'm just speculating. I'm just saying oh, IPOs go up so let me buy it. But, economically, why was this even worth $10 to begin with? How do we even think about that valuation, at a very even high level, why is this even worth $10 a share to begin with? And the idea is that these assets-- assets are nothing but claims on future benefits, right? A house is an asset because you get the future benefit of getting to live in it, right? Or the future benefit of not having to pay rent. So, the future benefit of these is, they'll hopefully, at some point in the future, generate an income stream. And even more, they'll generate cash. And at some point in the future, and a lot of companies don't do it right now, they'll actually dividend out that cash. So there's a couple of things that will make this equity have kind of an economic-- it'll ground it economically. And it could be these assets starting to pump out cash, and then each of the shareholders will get a dividend. A dividend is just cash that is given to the shareholders. So let's say that this is a stock certificate in SOCK. So at some point when the assets of this company start generating cash, each of the shareholders might be getting a dividend. Or maybe a large company, at some future date, says wow, this is an awesome technology. It'll complement what we already have. And maybe they'll buy out the company. Maybe they'll pay $300 million for this company. And then, essentially, they're paying $300 million-- and there's, what, fifteen million shares? So they're paying $20 a share. So those are the economic kind of grounding points that why these shares even have a value. And I'll go into a lot more detail, I'll do a whole playlist on how do you even think about whether this is worth $50 million, or is it worth $5 million, or is it worth $500 million. And it's kind of an art, more than a science, because you're going to make tons of assumptions in terms of how fast the company grows, what's the risk free rate of return that you could get on other assets? Essentially, where else you could you put your money? When does the company dividend out its-- there's so many assumptions, so it's more of an art. So it's really kind of you try to get a handle on things. But there's no real right answer. The real right answer is kind of what someone's willing to pay for it. But anyway, I'll see you in the next video.