Tuesday, September 14, 2010

Why Companies Enter The Stock Market

Before we get to stock analysis and what makes a stock go up or down in price, let's look at why a company would want to be traded in the first place. There must be a reason if thousands of companies want a piece of the daily action.

The way it normally begins is that someone owns a business that is well off financially, either at the moment or is setting up good returns in the near future. The company's doing ok, but more money is needed to take it to the next level.

The amount of money that the owner wants to raise is far above what regular people like you and me could offer. This is where Venture Capitalists (VCs) come in. VCs earn their living exactly fronting money (capital) to young and upcoming companies (ventures) in exchange for part ownership. Don't be fooled though, it is hardly a friendly donation. Further down the line, VCs expect their stake in the company they financed to be worth more than what they paid for it. If the owner of the company is in it for the enterprise, VCs are in it for the payoff.

There might be a second round of financing from other, publicly traded companies, maybe companies that work in the same field as the business being financed. The point is, most if not all of these organizations will want a chunk of the company they put their money in. Up until now, this was all in the hands of the founders: they went around making the presentations and phone calls to look for outside investors.

To mediate the distribution of ownership that's part of the deal, an investment firm will come in and help in a process called IPO (initial public offering). The firm will look at the company's finances, the outside financing it received and the general interest it could drum up once it goes public (that is, starts trading in the market). Once the value of the company is estimated, it is divided among an arbitrary amount of shares, normally in the millions.

So, for example, someone at Company XYZ has received money from VCs and another company that's already trading publicly. XYZ hires Goldman Sachs to overlook their IPO. GS decides, after doing their research, that XYZ is worth $250M, and decides that ownership will be divided among 20M shares at $12.50 each. However, there is no reason why they shouldn't pick 50M shares at $5 or 250M at $1. That's just part of the analysis. Furthermore, it is decided how many of the total shares are for the original investors, and how many will 'float' to the public and will be available for trading the moment XYZ hits the Stock Exchange. With 20M total shares, this might be in the ratio of 15M private and 5M floating. Once again, no reason why these ratios shouldn't be different. It is normal, however, to see the bigger chunk go to the original investors.

Let's keep with the 20M shares at $12.50 each. Company XYZ, at this point, needs to slice up the private 15M among the founders and the investors that asked for a piece of the company back when they financed operations. Based on the money that was fronted to value the company at $250M, the process of subdivision starts with 100% of the ownership split equally among founders, who then have to give up a proportionate amount to the VCs and other investors. This normally causes the founders to end up with a stake that's about 10-20% of the total, which might not seem like much, but value wise it is more than what they started with.

The last step is for the investment firm to fly around and stir up demand on this new, upcoming stock. This entails writing up what the company does and how well off it is doing financially. Sometimes the company is already well known and demand will already be high without the need of a prospect, but it is required by law along with a long list of disclaimers as to why you shouldn't buy the company. Pretty crazy, I know, but that's just how it is.

A second pricing is set after demand has been generated, and once the shares go public, the company has little to do with the shares for the rest of its existence. The original investors must wait 18 months before they can start selling the shares they had since day 1, and little by little (due to limitations on how much you can sell at once), the founders, VCs and other investors will be putting back their shares into the market, hopefully for a hefty profit.

19 comments:

  1. Very helpful, keep em coming :D

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  2. thanks for sharing this! i enjoyed reading it

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  3. followin 'n' supportin bro :)

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  4. i've stude it at school a few years ago

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  5. interesting blog, supporting here :)

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  6. Very informative. I know next to nothing about stocks, but this helped a bit. Most of it still went over my head though.

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  7. This post has piqued my interests

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  8. I know absolutely nothing about the market, but I've always wanted to invest in something. You never know when some get rich quick thing will sky rocket lol. This post gave me some info. Thanks man, supported hard!

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  9. Good info, I might try investing next year

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  10. I gotta disagree with you about tech stocks. They fluctuate way too much. Stick to natural stuff like corn ;-D

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