What are stocks and bonds? Equity vs. Debt?

Companies use two sources to obtain funding for various uses such as initial investment, expansion, and supplementing operating income. The two sources available to a company are borrowing money (bonds) or selling equity (stocks).

Let’s break this down even further by asking what is equity?

If I were to start a gardening shop that sells only Tulip bulbs I would need a few things to start with. First, I would need money to pay rent for the place I am selling the Tulip bulbs out of, second I would need money to buy the Tulip bulbs from a whole sale retailer, third I may need to pay for an employee who will sell the Tulip bulbs while I take care of other tasks related to running a business, fourth I may need to buy equipment to hold the bulbs, cash register etc, and fifth the company may have other operating expenses such as advertising, legal costs etc.

If I wanted to start this business I better have some money saved up to cover a few months’ worth of rent and expenses, at least until my business starts generating enough money to cover all my expenses.

If I have enough money saved up, and I put that in the business as initial capital that is considered equity. If I estimate the company needs $10 000 a month to cover all its expenses, and I estimate it can make about $5 000 a month for the first three months in income from selling the bulbs, I already know I would need to put $5 000 a month just to cover the expenses in the first 3 months for a total investment of $15 000. A company also need equipment and other materials to start operating, this is known as starting fixed capital cost. We may need to purchase equipment which is a onetime cost, the equipment can be used for many years. Let’s assume the company needs about $10 000 worth of equipment and other materials to start operating. Now in order to start this company, I would need about $25 000.

If I had $25 000 saved up, and If I put in all of my savings that would be an equity investment. I would be the 100% equity owner of the company. In the 4^th month of operation, if the company makes a profit of $10 000, I am entitled to all of that money if I choose to take it out of the company. If I only had $15 000 saved up and my mom invested the other $10 000 as an equity partner, now the company has two owners. I own 60% ($15000/$25000) and my mom owns the other 40%. In the 4^th month if the company makes a profit of $10 000, I am entitled to $6000 (60%), and my mom is entitled to $4000.

Let’s assume I was the sole owner of this company. It is a few years down the road, and I now own multiple stores and the company is valued at $10 million dollars [Valuation of a company: http://tinyurl.com/p7kckvz ]. I want to expand, and expansion involves expenses. In order to cover these expenses I am going to sell portion of my ownership to raise the funds. If I need money in the millions, it is hard to go to one’s mom to raise the funds unless she is a millionaire. In this case you take your company public, what that means is you sell ownership of your company on an exchange for money. The stock prices of companies are pretty much how much a unit of ownership of a company is valued at by the market. The company could have also sold unit of ownership on a private exchange which means the unit of ownership is not publicly trades and the company is only responsible to answer to its private owners. When it is publicly trades it is regulated by the government regulatory bodies.

If I do not want to share the ownership of my company I can go to a Bank or another Lender and borrow the money I need for expansion. Lenders will lend you money if you can demonstrate that your company routinely makes a profit that will cover interest payments on the loan and periodic principal repayments. Similar to a person getting approved for a mortgage. The company can also pledge its buildings/equipment as collateral for the loan to get a better interest rate on the loan or to even be approved for the loan. If the company does not want to have private loan with a Bank/Lender, it can sell debt to the public on an exchange similar to stocks. These are standard units of debt of a certain face value with a known coupon rate with terms. The company will pay the public lenders certain interest (coupon rate) over a period of time, and it will repay the loan at a known future date.

This folks is what stocks (equity) and bonds (debt) are. Financial Engineers have found many other financial products based on these two types of funding, but that is a topic for another day!