Suppose there is a new startup company Meme inc. in Mumbai that manufactures merchandise such as toys, clothes and mobile covers based on latest meme from social media. The company is doing this business since last 3 years and it is making good profit. This company was established by 4 friends, who also equally invested in the company. Thus, in percentage terms, each one of the friends owns 25% in this company.
Now, in 2017 they realize that their merchandise are quite popular among kids and teenagers and there is good demand to it. So they think about expanding their market and sell across the Indian market. They predicted that there are more young children across India and this number is going to increase and so also the number of meme. They also realize that, even if toys don’t get sold in India, they can export them. Which means there is a good future market for the toys. But the current plant of Mumbai has limitations, it can only manufacture say 2 lakh toys whereas considering expansion of market for company and the future market of 2027, the company need to produce additional 20 Lakh toys. To expand this plan the company need capital i.e. money. for this plant they need Rs. 25 crore. How to get this money?
There are at least 2 options available in front of Meme inc. either they can approach a bank and ask for loan i.e. debt or they can issue corporate bonds. Even for corporate bonds they will have to pay interest. Apart from this debt – interest way, they have another option, they can go for equity i.e. sharing their ownership. In case of Debt, the lending bank charges interest on the given loan and meme inc don’t want to pay this extra sum or carry debt on them. While in case of equity the shareholders become partners in the growth story of company, it can be a win-win.
Now, remember the 4 friends i.e owners, Lets assume that they each have 25% ownership in the company. Now, these 4 owners decides that they will each give-up 5% of their share and this 5*4=20% shares i.e. ownership will be offered to trade in trading market. That means any one in share market can buy from this 20% outstanding shares and claim ownership of Meme inc. (Yes even with 1 share you have ownership)
So, the management of meme assigns this task of selling initial shares to a bank. This bank then decides how manes shares and at what cost to sell so that the IPO will get required sum of 25 crore. They also ask for past years data to know how Meme inc has been running and making profits. depending on that profits and health of Meme inc The investment bank (a.k.a underwritters) issues an IPO (initial public offering) and make advertisement of this. And then people, mutual fund companies and foreign investors apply for this IPO of Meme inc.
1-2 weeks later this stock gets listed on the stock exchange such as BSE and NSE and now its open for trading! and in this way our Meme inc gets the 25 crore cash from market. Now they are free to expand their plants. But now on they need to inform their decisions of business to all of the share holders they do this communication via SEBI (securities and exchange board of India) and SEBI intern informs the share holders.
This is the simplest version of what the share market is about. The market is a way of raising capital to finance the needs of a business. of course the above case of Meme is too simple, in reality there are numerous other factors that changes the equation but most of the Information is available to average investors to make an informed choice.
Now there can be some basic questions in your mind such as,
- Minimum how many shares I need to buy?
You can start with even one share once the IPO is listed. Just in case of IPO there is a lot size i.e. you need to buy them in bunch of say 10, 15, 24 anything as decided by the underwriter company. This information is provided in a paper called as red-herring prospectus. It also tells investor about the company, why it need that capital and how it is going to use it etc.
- how the underwriters i.e. the people who create this IPO know what should be initial price of per share of Meme inc?
For that the underwriters conduct elaborate study. They study balance sheet of the business, consider performance of the other already listed competitors. In case of Meme, they will look for already listed toy company, they compare such data eg. how market values toy as a sector.
- So Meme inc. got its 25 Crore, I applied for IPO and received its 200 shares of say 50 each. then what? why this Rs. 50 grows to 60, 80 and so on. Who gets this money?
The share market is always about future, it expect that the company will grow in future – and accordingly sets new price targets. If company achieves those targets that means the company is growing and your each share is part of that growth! A growing company earns profits and then they share this profit in the form of divided to its share holders.
- What if Meme Inc fails in its business and swindle off the 25 crore?
There is always such risk and there for its important to know about quality of the management of a company before investing. It is said that you must invest in a company whose business you can understand – what they do to make money. If market fails to see earning growth then the stock price/ share price will fall, and it can even fall bellow the listing price, in case of meme 50 Rps. Its always better to buy stocks of a well established company.
You can post your questions, I will try to answer them.
In nutshell, Equity market is not some gambling, its the way in which economy actually works, Countries run. So don’t shy away from equity because there is risk. such risk is a part of life and in economy such risks are rewarded handsomely. The crucial factor to consider is INFORMATION and KNOWLEDGE. You must know some concepts and terms to trade and grow your money. Do not venture into the market without knowing these basics. I will cover that in next part of this series.
Next -> Basics of Share market.