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12/26/12

[Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel Investor, Jun

[Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel
Investor, Junk Bonds, Bearer Bonds, Gilt Edged securities: Meaning, Explained
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How To get the cash to start my company?


Problems in above options
Financing my company: Debt OR Equity
#1: Debt: Bonds
Junk Bonds vs Gilt Edged Security
Bearer Bonds
#2: Equity Shares
Shareholders and Board of Directors
What is IPO?
Venture Capitalist and Angel Investors
What is Venture Capital?
Who is Angel Investor?
Who is Underwriter?
Debt vs Equity : good and Bad things
Upcoming articles

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I want to start an Ice cream company, what will I need?


Land

To build a factory.

Labor

Workers to run the machines.

Capital

Money to buy Freezers, mixers and packing machines to make ice-cream.

Entrepreneurship To take the risk and do above three things.


These are called the four factors of production.
I already have the entrepreneurship in my heart and mind.
But it requires truckload of cash to arrange for the other three items: Land, Labour and Capital.

How To get the cash to start my company?


I can rob a bank
Or I can just start my own IIT Bombay, sell its application forms for 5,000 rupees and then declare cut off 99.99% and thus
earning truckload of cash without actually wasting a single rupee in arranging the admission interviews.
Or I can join politics.

Problems in above options


Cant rob a rob a bank because this too requires Labour (gangsters) and guns, masks, vehicles and Entrepreneurship (to take
the risk of going to jail).
Cant start my own IIT Bombay would again require those four factors of production (Land, Labour, Capital,
Entrepreneurship)+Permissions from UGC/AICTE.
Cant join politics because Only ministers can make huge money, MPs/MLAs dont. And Unfortunately Im not a son or
daughter of some big politician so I cant become minister @ young age (Agatha Sangma, Sachin Pilot, Naveen Jindal et
al) So even If I join politics right now, Ill have to do bootlicking of Party high command until I get 60 years old, only then
I can become minister and break the records set by A.Raja and Madhu Koda.
Now, There are two ways to (legally) arrange money for starting a company or to expand a company. First is Debt and Second
Equity. See this chart

Financing my company: Debt OR Equity

#1: Debt- bond


The word debt is self-explanatory. You borrow money from someone: It can be a bank, it can be a friend, it can be a

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[Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel Investor, Jun

The word debt is self-explanatory. You borrow money from someone: It can be a bank, it can be a friend, it can be a
stranger.
I write on a piece of paper: To whoever pays me Rs.1000, Ill pay annual 10% interest rate (Rs.100). And after 5 years, Ill
also repay the principle amount Rs.1000. No ifs and buts.
This is one type of security paper. We call it BOND.
IF you hold my bonds, Im liable to pay you money no matter what happens. Whether my ice-cream company actually
makes profit or goes Kingfisher. I have to keep paying fixed money to you, every year.
Junk Bonds vs Gilt Edged Security
In above case I offered you 10% interest rate. But in real life, there are credit rating companies like CRISIL, S&P, Moodys
etc. Theyll give credit ratings to a bond. (i.e. Am I capable enough to actually pay you?).
Based on that, they give ratings example AA,A, BBB, BB,C,D etc.
I had talked about them in my previous article. Go through the Archive on www.mrunal.org/economy
Junk Bonds
If my Bond gets C or D rating, it means Im not creditworthy, I may default on this loan, I may run away. So my bond
is as junk as Ra.One movie. A wise man will not invest in it.
So, how can I seduce you into purchasing my bonds? How can I convenience you to take the higher risk, in buying my junk
bond?
How about Free caller Tunes or a scratch-card that offers you a chance to dine with Sachin or Katrina?
Or How about Higher Interest rates: If you give me Rs.1000, Ill give you 25% interest rate per year!
This is also known as High Yield Bond, because youre getting higher profit.
Gilt Edged Securities
Like an ice cream company, Government also needs finance- at times when tax collection is low and they need some
temporary funds.
They issues treasury bonds. RBI sells these treasury bonds on Governments behalf.
But Governments generally have the aukaat to repay the principle and interest rates. Hence Government bonds have higher
credit ratings (AA). So, they dont need to seduce you, theyll offer very low rate, say 4%.
Similarly, well known companies with high credit ratings (AA) also issue bonds but pay low rates.
If you dont like to take risks, youll invest in such bonds. These are called gilt-edged securities.
Bearer Bonds (and Bad Guys)
In Bollywood movies, Kidnapper demands ransom of Rs.10 lakhs but he wants the money in the denomination of
Rs.5/10/50 Rupee notes. Why? Because it is easy to circulate these notes and harder for police or banks to keep track of this
money.
Same way, in Hollywood Spy-thriller movies, the Villain will ask you to pay 10 million dollars in Bearer bonds.
Bearer bonds are same as regular bonds, but they dont have Holders Name on them. These bearer bonds have coupons
attached with them. So, if you dont want to withdraw the whole money, you can cut a few coupons and sell them to a
broker to withdraw partial amount.
E.g. Rs.100 interest is to be paid on 1st April 2012, But even on December-2011 you can sell the coupon to a Broker.
Although hell not give you Rs.100 but something like Rs.95 or 90. (Why so? Think about it!)
Anyways, the point is, Noone can keep a track of who withdrew the money, whos buying, whos selling Because there are
no names, addresses or records. Bad guys like it, because this ensures anonymity.
See the following example photograph of a Bearer bond of Government of Palestine. Notice that it doesnt have space for
Owners names and there are three coupons attached at the bottom.

Question: Why would Government issue bearer bonds? Because when theyre in dire need of money, there is emergency,
there is war going on, they cannot waste time in checking the lengthy registration forms. So, Better just sell the bonds to any
swinging dude that comes, without asking his name, address, mobile number or email id.
Although, in real life, it is hard to find Bearer bonds. Because most of the bonds now, exist in Electronic (DEMAT) format
and youve to give your pan card number (or other similar personal information in foreign countries) to buy or sell
bonds/shares or any similar security papers. So, now bad guys want payment in gold, diamond or other precious metals
instead of bearer bonds.

#2: Equity: IPOs and Shares


So far, we saw that first option is to borrow money and pay regular interest rate. (Debt ->Bonds). Now continuing this not
so technically correct article,
Second option is, I take money from you and in return I offer you partnership. This is called Equity.
Assuming that I need 1 crore rupees to start my company and Ive 30 lakhs in my savings. So, I write on a piece of paper:
Ill give 0.0001% ownership of my company to whoever gives me Rs.1000.

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[Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel Investor, Jun

Ill give 0.0001% ownership of my company to whoever gives me Rs.1000.


This is again a type of security-paper. But since Im sharing a part of ownership with you, in crude terms, well call it
Share.
Then I print 10,000 such papers. Whats the value of these papers?
10,000 Papers multiplied with Rs.1000 each =1 crore. Voila thats total money I need.
And since I already have Rs.30 lakhs, I can purchase 3000 shares. (because 3000 papers x Rs. 1000 each = 30 lakhs)
So out of the Total 10,000 shares that I printed, I will own 3,000 shares, so percentage wise I own 30% of this companys
equity.
Related to this: How do they Calculated SENSEX? Click Me to Read it

Shareholders and Board of Directors


Since Im issuing the shares (Equities), under the Company law, Ive to Constitute a board of directors and hold
annual general meeting of the shareholders.
For important policy decision, Ill have to take votes of the shareholders, the Board of Directors will supervise over my
activities. In short I cannot run the company as I please, Ive to give answers to those people.
On the first year, I make profit of Rs.25 lakhs. The board of directors will meet and decide

distribute Rs. 10 lakhs as Dividend among the shareholders. Now about the remaining 15
lakhs, invest them back in the company to expand our production-capacity , buy bigger
machines and install new factories in Pakistan and Somalia.
Here is the cool part, I can become CEO of my own company and say Ill take salary of Rs.1 only! And still, I will earn Rs.3
lakhs.
How? Because I own 30% of shares in this company, so when that Rs.10 lakh Dividend is shared among the shareholders, I
get 30% of it = 3 lakhs, apart from my Rs.1 salary as an employee of this company.
Here is a demo photograph, of Creek Mining Companys shares.

The owner Mr. George own 200 shares of this company. And in the small fonts, it is mentioned that total 30,00,000 shares of $1
each. Meaning Mr. George owns (200/30 lakh) x100 =0.0067 % stocks of this Creek Mining Company.
But in real life, nowadays, when you purchase shares , you dont get such cool looking colorful paper certificates. You get the
shares in electronic dematerialized format. They get transferred in your demat account. (already discussed in QFI vs FII article.)

What is IPO?
Mithun Chokrobarthys Son Mimoh Chakrabarthy was launched in the first film Jimmy. That year he got Best
Newcomer award. Movie was flop, then Mimoh decided that changing his name, would bring him some luck.
So he became Mahaakshay Chkarbarty and yet gave a few more flop films.
Now people dont call him Newcomer, they call him flop hero.
Moral of the story: When you act in your first film, youre called a newcomer. Then in your subsequent movies, youre
called a flop actor, although youre the same human being from your daddys eyes.
Same way, When I sell my share papers for the first time, to the public, it is called IPO (initial public offer)
Then you (the buyers of these IPOs), sell these papers to each other, the same paper is called Share or Equities.
From Daddys point of view (Mine), its the same. If someone has one paper, he gets 0.0001% from the dividends.
Primary vs Secondary Market
Primary market = this is the Place where IPOs are sold,
Secondary Market= this is the place where IPOs are re-sold as shares.
Physically both things are done in the same place e.g. BSE (Bombay Stock Exchange) but this virtual classification helps in
keeping track of things, making statistical analysis etc.

Venture Capitalist and Angel Investors


Now Two more sub-types of Equity financers

What is Venture Capital?


Venture Capital is a company that gives you money, to start your company or to expand your company but in return they
demand part of ownership.
They deal with only big things, big projects, big investments. They wont help me to open an ice-cream parlour in
Gujarat University despite the fact that its monthly revenue will be higher than SBI General Managers salary.
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[Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel Investor, Jun

Gujarat University despite the fact that its monthly revenue will be higher than SBI General Managers salary.
Copy pasting example of Ojasventure, India
We invest in technology based businesses in sectors such as Mobile technology, Telecom, Software.
We make an initial investment of US $ 250,000 to US $ 1.5 million.
How do they get money?
Ofcourse money doesnt fall from sky, these Venture Capitalist companies themselves borrow money from other companies
like mutual funds, pension funds or they may be issuing their own bonds to get money.
How do they operate?
Theyve their own team of Management experts, corporate lawyers, chartered accountant, and business consultants. They
study your business plan, approve the money.
Theyll demand seats in your companys board of directors to Influence the Decision Making in your company, according
to their requirement and so on

Who is Angel Investor?


These are rich gentlemen. They finance startup companies for getting partial ownership and or assured returns on investment,
after few years.They can give debt (i.e. just like moneylenders and banks) or Equity (i.e. partial ownership). But mostly they
play in the equity field.
What is the need of Angel Investors?
You can get money from Banks / Bonds (Debt) or IPO/Venture Capitalist (Equity), if your business project is likely to bear
success based on previous experiance.
For example: Pharmaceuticals, Dairy, Engineering instruments, Mining, Telecom, Textiles, Oil Refinery etc.
But they may not get interested in you, if you talk about untried and untested business plans / product or fields.
Imagine Steve Jobs requesting SBI Bank Manager to give him business loan in 1970s to start Apple Computers,
or Same Steve Jobs launching IPO of Apple in NewYork Stock exchange during that time!
But there was an angel investor Mike Markkula, who actually believed in his plan and gave him some money and got 1/3rd
ownership in the company in 1977.
Angel investor doesnt mind taking huge risk by helping even small timers with totally unique and untested idea, if he think
that itll grow up huge success in future.
Similarly, Amazon online shopping website and Starbucks coffee chain also started with Angel Investors.

Capital Gain Tax Revisited


Recall the argument given by Mr.Vodafone in Capital Gains tax?

An individual who owns 45 per cent share capital does not own 45 of that companys
assets. There is a difference between the sale of shares in a company and the sale of assets
of that company.
Why is it so?
Because most of the company dont directly start with IPO / Shares. First the entrepreneur starts a small company using
money from his own savings, borrowing from friends, relatives and banks or from an Angel Investor.
Once the business starts booming, hell launch an IPO to get extra funds from public, to expand his business.
So, He already has some building, machinery, vehicles etc assets in his small company before launching his IPO.
Take a really crude example
I have Rs.30 in savings, I borrow Rs.20 (Debt) and thus start a company for Rs.50
After few years, I need another Rs.50 to expand business, so I launch an IPO: Total 50 share papers worth Rs. 1 each
(Equity)
You buy 10 shares for 10 rupees. Means you own 10/50th =20% of my shares/stocks/equity/ IPO whatever you want to call
it.
But the total assets of my company are= From Rs. 50 I had already + Rs. 50 from IPO = Total Rs.100
So, You dont own 20% assets of my company, because youve given me only Rs.10! and my total assets are financed
from both Debt + Equity.
Same way, if you purchase 10% shares of Jet Airways, doesnt mean you own 10% of their airplanes and buildings.

Who is Underwriter?
So far weve seen that
To arrange money I can either borrow (debt, Bond) or I can give shares (equity, IPOs/shares).
Here is the problem: I cannot print those security papers on my own Home PCs cheap-printer.
First, A lengthy legal and accounting paper-work has to be done, itll require chartered accountants, Corporate Lawyers
experts in these matters.
So, I goto an underwriter, he charges Commission but he promises to cover all the technically things, paperwork, SEBI
regulations, selling, accepting money for IPO/Bonds sale etc.etc.etc.

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[Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel Investor, Jun

regulations, selling, accepting money for IPO/Bonds sale etc.etc.etc.


Same underwriter also offers a kinda insurance, that hell buy the IPO/Bonds if others dont buy it.
Kotak Mahindra, ICICI offer such underwriting services.

Debt vs Equity : good and Bad things


In real life, companies dont rely on single source to finance their adventure. Theyll arrange part of the cash from Debt
(Borrowing) and part of the cash by issuing IPOs (Equity).
Each has its own advantage and disadvantage. Lets check
Good things: bonds vs shares
Debt (Bond)

Equity (IPO/Shares)

I have complete ownership and control over the company.


Im accountable to nobody just like UPA-II.
I dont have to share my profit with anyone. I get to eat
the whole cake.
I can claim income tax deduction for paying the loan.
It require less paperwork and time to borrow from bank /
friend than via sharemarket (SEBI permission, board of
directors etc)

If the company makes loss, I dont have to share any


money with the shareholder, just like Kingfisher.
So there is no regular interest payment, as we do in
the loan. Meaning Ive less tension compared to bank
loan/ bonds.

Bad things: bonds vs shares


Debt (Bond)

Equity (IPO/Shares)

Even if I dont make profit, Ive to pay interest


rate, because basically this is a loan just like home
loan or car loan. Whether you earn or not, youve
to pay the EMI.
I may have to mortgage something (machinery,
building) to get the loan. So in case I default on the
loan, the bank/financer can take it away from me.

I dont get complete ownership and control over the


company.
Ive to constitute a board of directors, hold general meetings
of shareholders, Im accountable to them. The board of
directors can throw me out of CEO job, if I donot deliver
results, unlike Mohan.
It requires heavy paperwork and time to initiate IPO,
sharemarket thing (SEBI permission, underwriting etc)

So, itd be better if I finance a part from debt and a part from equity. That leads us to the discussion about Debt to Equity
Ratio. (to be continued)

Upcoming articles
All my articles on economy, are archived at Mrunal.org/economy
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Previous Posts
1. [Economy] SARFAESI Act, Asset Reconstruction Company (ARC), Security Receipts (SR), QIB, DRT, Central Registry
2. [Economy] Banking Amendment Bill: Issues, Features, Problems, Reforms meaning explained
3. [Economy] Capital Goods and Capital Gains: Meaning, Difference Explained
4. [Economy] GMR-Maldives Airport Controversy, IFC, AAI: Meaning, Reason, Implications, Explained
5. [Economy] Infrastructure Debt Funds (IDF), Withholding Tax, EPFO Angle: Meaning, Concept, Explained
6. [Economy] Fiscal Cliff: Meaning, Reasons, Implications on US and Indian Economy explained
7. [Economy] National Investment Board (NIB): Meaning, Functions, Anti-Arguments
8. [Economy] 2G scam, Spectrum refarming, Sistema controversy, Allocation of Natural Resources explained
9. [Economy] Collective Investment Scheme (CIS) and Multi-Layer Marketing Frauds
M arch 29th, 2012 | Category: Economy

10 comments to [Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel Investor, Junk Bonds, Bearer
Bonds, Gilt Edged securities: Meaning, Explained

Abhishek
mrunal.org/2012/03/econ-debt-equity.html

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Abhishek

[Economy] Bonds vs Shares, Debt vs Equity, IPO, Underwriter, Venture Capital, Angel Investor, Jun

August 29, 2012 at 9:57 AM Reply


The Securities and Exchange Board of India (SEBI) has allowed partial fungibility of Indian Depository Receipts
(IDRs) redemption or conversion of IDRs into underlying equity shares in a financial year to the extent of 25 per
cent of the IDRs originally issued.
This has been decided to retain the domestic liquidity, said SEBI in a circular to stock exchanges, depositories and
other market participants. An article in Hindu (28th August)
Can u plz explain what is IDR.. and how it is converted into Equity shares and how it affects liquidity thanks in advance

Abhishek
October 7, 2012 at 2:14 PM Reply
please mrunal do explain what is IDR

ADARSH
October 7, 2012 at 3:47 PM Reply
sir,the links in the page for other pages are not working,they divert me to home pageplz do something

Mrunal
October 7, 2012 at 4:03 PM Reply
sorry for the inconvenience. Ever since I move from blogspot, many the links were broken. Anyways go to
mrunal.org/economy
youll find all the articles.

utkarsh
November 27, 2012 at 12:05 PM Reply
sir ,m a fan of urs, can u plz explain the income tax deduction ??

krishna
November 27, 2012 at 2:36 PM Reply
thank u sir..

utkarsh
December 2, 2012 at 1:36 AM Reply
sir plz explain EARNINGS PER SHARE AND ITS CALCULATION

Rajndra
December 10, 2012 at 10:33 AM Reply
Good Article

hitaish
December 11, 2012 at 11:46 PM Reply
Thank u very much sirthese topics used to haunt me in my dreams. .now many of the things are clear. Sir please explain if the
credit rating agency gives a bad credit rating to any countrydoes it include the private investors of that country as well

MUKUND SINGH
December 17, 2012 at 11:27 PM Reply
AWESOME , SIR U R GREAT . I READ MANY BOOKS TO GET CLEAR CONCEPTS OF THESE TOPICS UT TO NO AVAIL. BUT U
MADE ME LEARN THESE TOPICS IN SUCH WAY THAT ONCE A MOMENT I THOUGT I WAS LEARING A FOR APPLE LIKE THING.

[Tips] "One-Word Approach" to master Indian Polity from


M.Laxmikanth (TMH Publication)

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Questions for CSAT Environment and Biodiversity topic

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