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At the end of this module, you will play an interactive game to evaluate your understanding of different funding options businesses use at various stages of growth.

This module establishes the foundation of basic market concepts you'll need going forward in our stock market modules. We'll now address a fundamental question: Why do companies go public? Understanding this is crucial for future topics.

The Birth of a Business

Before we delve into why companies go public, let's understand a basic concept: how a typical business starts. We'll build a relatable story to understand IPOs better. Let's break this story into scenes to see how a business and its funding environment evolve, ultimately leading the company to list publicly.

The Angel Investors

Imagine a passionate entrepreneur with a business idea - fashionable, organic cotton t-shirts. The designs are unique, priced competitively, and made with high-quality materials. The entrepreneur is confident and eager to start.

A typical challenge arises - funding the idea. Assuming no business background, the entrepreneur might not attract serious investors initially. They'll likely approach family and close friends to pitch the idea and raise capital.

Let's say the entrepreneur pools some money and convinces two friends to invest. These friends invest based on trust. These friends are known as Angel Investors. Angel money is not a loan, but an investment in the business.

Imagine the founder (entrepreneur) and the angels raise $500,000 in capital. This initial funding to kickstart operations is called Seed Funding. It's sometimes called the "Friends & Family Round." Importantly, the seed fund goes into the company's bank account, not the entrepreneur's personal account.

Angel funding can come from professional investors who target promising companies.

In return for the initial seed investment, the original three (founder and two angels) will receive company shares, granting them partial ownership. The company's only asset at this stage is cash, so its value is limited to the cash on hand. In this case, let's say the valuation is $500,000. One could argue the company's idea adds value, but for simplicity's sake, we'll focus on the cash.

Issuing shares is straightforward. The company might assume each share is worth $1. Since they have $500,000 in capital, there would be 500,000 shares, with each share priced at $1. In this context, $1 is called the par value of the share. The par value can range from $1 to over $1 per share, following regulations set by the Securities and Exchange Commission (SEC) to protect investors.

With the seed funding, the entrepreneur starts the business cautiously. They hire the right people, establish processes, and begin manufacturing high-quality t-shirts. At this stage, the entrepreneur has a small manufacturing unit and one retail store.

The Venture Capitalist

The entrepreneur's hard work pays off, and the business generates a steady revenue stream. The company breaks even after two years. The entrepreneur is no longer a novice but more knowledgeable and confident. Backed by this confidence, they want to expand by adding another manufacturing unit and a few more stores.

The entrepreneur is in a better position now compared to two years ago. The key difference? Revenue generation. This validates the business and its offerings. The entrepreneur can now target experienced investors for funding. The investor who typically invests at this early stage is called a Venture Capitalist (VC), and the money the business receives is called Series A funding.

Let's assume the entrepreneur raises the $700,000 needed to expand. Typically, when new investment enters the business, a few things happen:

The founder's share ownership is diluted.

The business valuation increases.

All previous investors (in this case, the two angels) see a potential profit on their initial investment.

With the VC's money, the company's valuation increases, creating notional wealth for early investors.

As we move forward in our story, the founder now has the capital needed. As planned, the company opens an additional manufacturing unit and a few more retail stores. Business is booming; product popularity is growing, leading to higher revenue. The management team becomes more professional, increasing operational efficiency and profitability.

The Banker

Three more years pass, and the company is phenomenally successful. They decide to expand to at least three more cities. To support this retail presence, the company plans to increase production capacity and hire more staff. Whenever a company plans such expenditure to improve the overall business, it's called Capital Expenditure (Capex).

There are a few options for the company to raise the required funds for their CAPEX:

The company can reinvest a portion of the profits they've made over the last few years. This is called funding through internal accruals.

The company can approach another VC and raise another round of VC funding by issuing shares (Series B funding).

The company can secure a loan from a bank. The bank would be more likely to lend due to the company's success. This loan is also called debt.

Let's assume the company uses all three options to raise funds for Capex. They reinvest $1.5 million from internal accruals, secure $1 million from another VC through Series B funding, and get a $1.5 million loan from the bank.

It's important to note that the company's valuation increases again with the $1 million coming from Series B. With this increase, previous investors see even greater potential profits. This exemplifies wealth creation for entrepreneurs with strong ideas and competent management teams.

Real-world examples of such wealth creation stories in the United States include companies like Google, Apple, Amazon, and many more.

The Private Equity Firm

A few years go by, and the company's success continues. With this ongoing success, the now well-established company sets its sights on national expansion. They also plan to diversify by manufacturing and retailing fashion accessories, cosmetics, and perfumes.

The CAPEX requirement to fuel this new ambition is now around $6 million. The company decides against debt financing due to the interest rate burden (finance charges) that would eat into their profits. For example, if the company generates $100 in profit and pays $20 in finance charges, their profitability is reduced to $80. We'll explore this further in the Fundamental Analysis module.

The company decides on Series C funding. However, a typical VC wouldn't be suitable because VC funding is typically smaller, in the millions. This is where a Private Equity (PE) firm enters the picture. Think of a PE firm as a VC's bigger brother. Here are some key differences between a PE and VC:

VCs typically invest smaller amounts, while PE firms typically invest larger sums.

VCs invest in early-stage businesses and take on a higher risk. PE firms invest in more mature businesses with less risk.

When PE firms invest, they often take a seat on the company's board to oversee its operations.

PE investors are highly qualified and experienced professionals. They invest large amounts to provide capital and place their people on the company's board to ensure the company moves in the right direction.

Typically, PE firms invest funds for large CAPEX requirements. They also don't invest in startups; instead, they prefer companies with existing revenue streams and a few years of operation. Deploying the PE capital and utilizing it for CAPEX requirements takes a few years.

Let's assume the company raises funds through a Private Equity firm and expands its business.

The IPO

Fast forward five years after the PE investment. The company has thrived. They've successfully diversified their product portfolio and have a presence in major cities across the country. Revenue is strong, profitability is stable, and the investors are content. However, the founder has even bigger dreams.

The founder now aspires to take the brand international, with locations in major cities worldwide. The company needs to invest in market research to understand demographics in other countries, hire new staff, and increase manufacturing capacity. Additionally, they need to invest in real estate globally. The CAPEX requirement is substantial; the management estimates $20 million.

The company has a few options to fund the CAPEX requirement:

Fund Capex from internal accruals

Raise Series D funding from another PE firm

Secure debt financing from bankers

Issue a bond (another form of debt financing)

File for an Initial Public Offering (IPO)

A combination of the above

For simplicity, let's assume the company decides to fund the CAPEX partly through internal accruals and the rest via an IPO. When a company files for an IPO, they offer their shares to the general public. The general public can then choose to purchase these shares at a specific price. Because this is the first time the company is offering shares to the public, it's called an Initial Public Offering.

After the IPO

Following an IPO, there's a buying process where investors can submit orders to purchase shares within a specific price range set by the company and its underwriters. This initial buying period is called the primary market.

Once the IPO is complete and the company's stock starts trading on a stock exchange, it enters the secondary market. This is where investors (people like you) can freely buy and sell shares from each other at market-determined prices.

Stocks constantly trade in the secondary market, with investors buying and selling shares throughout the day. This constant trading activity helps determine the price of a company's stock based on factors like supply and demand, investor sentiment, and the company's performance.

Let's Play a Game!

Bootstrapping: You have a brilliant idea for a fitness app that personalizes workout routines. With limited resources, you invest your own savings and utilize coding skills to develop a basic version of the app.

How will you launch your app and gain initial users?

• Option A: App Store Launch:

  • You submit your app to the App Store for a small fee.

  • This provides broad exposure but requires a standout app to get noticed.

  • Advantage: Potential for millions of users.

  • Disadvantage: Competitive marketplace, difficult to stand out initially.

• Option B: Influencer Marketing:

  • You partner with fitness influencers to promote your app to their audience.

  • This creates targeted buzz but requires investment in influencer fees.

  • Advantage: Targeted user acquisition through trusted voices.

  • Disadvantage:  Costly upfront investment, influencer endorsements can be unreliable.

Your decision will impact how you attract your first wave of users.

Early Traction:  Based on your launch strategy, your app gains initial traction and a loyal user base. Positive reviews and user engagement are promising!

How will you fund further development and growth?

• Option A: Angel Investors:

  • You pitch your app to potential angel investors seeking promising startups.

  • This provides seed funding but requires giving up some ownership.

  • Advantage: Access to capital for development and marketing.

  • Disadvantage:  Equity dilution, pressure to meet investor expectations.

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• Option B: Crowdfunding:

  • You launch a crowdfunding campaign to raise capital from a large pool of backers.

  • This maintains ownership but requires a compelling campaign and reaching a funding goal.

  • Advantage: Retain full ownership, potential for passionate community support.

  • Disadvantage:  Campaign success hinges on effective marketing and reaching funding target.

This decision will affect your company's financial future.

Expanding Your App:  With additional funding, you enhance your app with new features and functionality. User base continues to grow, and your app is generating positive revenue.

Decision Time! How will you scale your app to accommodate more users and explore new markets?

• Option A: Venture Capital Funding:

  • Secure funding from a VC firm specializing in tech startups.

  • This provides significant capital but involves stricter oversight.

  • Advantage: Rapid growth through substantial investment.

  • Disadvantage: Increased pressure to perform, potential loss of creative control.

• Option B: Strategic Partnerships:

  • Partner with established companies in the fitness industry.

  • This leverages existing infrastructure but requires sharing revenue and brand recognition.

  • Advantage: Faster market expansion through established partnerships.

  • Disadvantage: Reduced profit margins, potential loss of brand autonomy.

This decision will determine your app's global reach and user base.

Going Global:  Your app is a global phenomenon, used by millions worldwide. The next step - developing a premium subscription model for advanced features.

How will you monetize your premium features effectively?

• Option A: Freemium Model:

  • Offer a free basic version with a premium tier for advanced features.

  • This attracts a large user base but requires converting free users to premium.

  • Advantage: Broad user base, potential for recurring revenue through conversions.

  • Disadvantage:  Reliance on conversion rates, may be difficult to convince users to pay.

• Option B: Subscription Model:

  • Offer the entire app as a paid subscription service.

  • This provides guaranteed revenue but may limit user base initially.

  • Advantage: Steady revenue stream from dedicated users, more control over app experience.

  • Disadvantage: Smaller user base initially, requires a compelling value proposition for subscriptions.

  
  

This decision will impact your app's revenue model and user engagement.

Congratulations!  You've navigated the exciting process involved in app development and global expansion. Analyze the trade-offs you made at each stage. Did you prioritize rapid user growth or maintain creative control over your app?

The key takeaway from this section is understanding why companies go public and the process involved for a company to be traded on the stock market. This knowledge will guide your understanding and help you pick the right stocks for investment as we progress