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Equity vs. debt | Stocks and bonds | Finance & Capital Markets | Khan Academy - YouTube
Channel: Khan Academy
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Everything we've talked about
so far with this startup
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company selling socks and all
of that, has been raising
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money from an equity.
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We raised private money-- when
the company was private it
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went to VCs and it went to angel
investors, and maybe you
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could go to your friends and
family to raise money.
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And then the company could go
public and raise money from
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the public markets.
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But there's actually
two ways that a
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company can raise capital.
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So this is why this playlist is
called capital markets, or
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it's part of it, the name
of raise capital.
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Capital is just essentially--
I mean the easy way to think
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about it is you're raising cash
that you want to invest
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in some way to grow your
business or to sustain your
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business or start
your business.
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So everything we talked about so
far was equity, and that's
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essentially selling shares in
your company to raise money.
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And so that's all of
those VC examples.
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The equity investor-- so when
you sell equity, you're
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essentially selling-- you're
kind of making that person
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who's buying the stock-- you
know, an equity is the same
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thing as stock-- you're making
the person who's buying a
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stock kind of a partner
in the company.
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So if the company-- let's say
there's two situations-- if
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the company goes bankrupt-- and
I'll talk a lot more about
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what bankruptcy even means--
but if the company goes
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bankrupt, all the shareholders
end up with nothing.
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They end up with nil.
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But if the company has a lot
of upside, the stock gets a
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lot of upside.
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Because they're partners
in it.
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If this was a company, that
start-up that we talked about,
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if it turns into Amazon.com and
becomes a billion-dollar
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company, everyone is going
to do really well.
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Everyone's going to share
in that upside.
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But there's another way to raise
money, and actually this
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is probably something that's
more familiar at
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the household level.
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I mean at the household level
you never raise equity.
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You never say, you know what--
well you can, but you're not
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going to say hey, I need to buy
a house, why don't I go to
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my rich friend and offer to sell
10% of the stake in my
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house to him and he'll be kind
of a partner in my house.
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That could happen but for the
most part it doesn't.
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Usually when you do something on
a personal level you raise
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money through debt.
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And that's interesting.
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So what's good about debt is
it's-- so let's think about it
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from the point of view of
the person who's lending
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the money to you.
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Debt is just borrowing money.
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I think all of us know what
borrowing money is.
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I go to my rich friend and I say
hey, could I borrow $1 and
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I'll give you $1.25 in a year?
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And he says, OK, you're
good for it.
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But I'm essentially promising
I'm going to give the money
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back at some future date.
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If I sell equity, I'm not
promising anything.
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I'm like hey, I got a great
business, why don't you give
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$1 and then you get a 20%
cut of my business.
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If my business does awesome,
you get 20% of all of the
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profits of my business.
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If my business does horrible,
well you took a risk, you get
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nothing and I get nothing.
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Debt says regardless of how my
business does, if it does
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awesome all you're going
to get is the interest.
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That's kind of the upside.
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So the upside's limited,
right?
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If I borrow money at 9%
interest, all that person's
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going to get is 9%.
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Even if my company becomes the
next Google or Microsoft or
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whatever else, that person's
just going to
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get 9% on their money.
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While this person might have
gotten a hundred times their
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money because they made a bet.
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On the other hand, this downside
is much lower.
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So limited downside.
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Because they're going to get
their money back at a
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certain-- you know, there's a
certain payment schedule.
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And they're going to get their
money back before the
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stockholders-- so let's say
in a situation where the
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company's going into
difficulty-- and we'll do a
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whole playlist on bankruptcy--
the people who lend money to
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the company will see their money
before the stockholders
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see anything.
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So how does all of this come
out from the balance sheet?
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So let's say we have
a public company.
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If you wonder what a CFO at a
company does, this is really
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the main decision that they're
always making.
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Do we raise money-- well, how
do we raise money if we need
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it, and do we raise money from
the equity markets or from the
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debt markets?
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So let's come up with
a company again.
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Let's say that that's
its current assets.
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Not current-- I don't want to
say current assets, it's the
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assets that it currently has.
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Current assets means something
different, and we'll talk
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about that in the future.
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But let's say, so that's
its assets.
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You know it might have
some cash here.
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We'll go into more detail.
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We'll actually look at real
company balance sheets and
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decipher what all of the terms
on the balance sheet mean.
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But that's its assets for now.
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And let's say right now all of
its money it's raised so far
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has been equity.
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And let's say it's a publicly
listed company.
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It doesn't have to be.
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Let's say that's all of its
equity, and let's say it has,
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I don't know, 10
million shares.
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And the other interesting thing
about when a company's
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public-- remember, every time
when a company was private and
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it took an investor, when it
took equity investors, they
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had to sit and have a
negotiation saying what is
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this worth?
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What are these assets worth?
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But what's cool is, is when
you have a publicly traded
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company, these shares are traded
on an exchange, right?
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These shares are on, let's
say it's on the
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New York Stock Exchange.
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So every day you could
go to Yahoo!
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Finance or wherever and you
can look at a chart.
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Let me draw a chart.
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You can draw a chart.
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And we've all seen stock
charts, I think.
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So let's say that this is this
could have been its IPO date
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or it could just be the start
that we're looking at, and
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let's say the stock IPO went up,
and then the whole market
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went down a little bit.
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But the stock-- maybe
it's there, right?
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But on any given, really almost
any given second,
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there's a price that somebody
traded that stock at and it
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might not be the best price,
but it is a price.
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And we'll talk about why that
happens, because you might
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have 10 million shares, and if
only, I don't know, 100 shares
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get traded at any second, or
let's say only 100 shares get
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traded in the day, is that
an indicative price?
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Because that's not
a huge percentage
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of all of the shares.
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But anyway, we'll talk more
about what volume means
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relative to the total float
and all of that.
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But let's say at this split
second the company shares
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traded at $15 a share.
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This is $15, right, at
this second in time.
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This is like right now.
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Traded at $15 a share, and you
could look it up on your
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Bloomberg terminal
or whatever else.
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So essentially the market
is providing us a
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value for this company.
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The market is saying wow, the
market is willing to trade the
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share at $15.
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There was a willing buyer and
a willing seller at exactly
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$15 a share.
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So that means that the market at
that moment is valuing this
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company at $15 per share times
10 million shares.
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So $15 per share times 10
million shares-- not
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necessarily a dollar sign.
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So the market is assigning
a, 15 times 10 is 100.
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$150 million market cap.
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Market capitalization
for the company.
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And you could look on the kind
of, I think it's the key
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statistics tab on Yahoo!
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Finance, and you'll see market
capitalization for a company.
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And it's just the number
of shares times the
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price of the shares.
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This is essentially what
the market's value
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of the equity is.
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The market is saying that
this piece right here
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is worth $150 million.
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And since this piece is the same
size as the assets, we
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have nothing else on the
right-hand side, the market's
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essentially saying that the
assets right now are worth
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$150 million.
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And these aren't always
going to be equal.
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We'll see probably in a few
videos when you start raising
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debt you have to do an extra
calculation to figure out what
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the asset value or-- and I'll
throw out a new term here, the
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enterprise value
of the firm is.
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The enterprise value's
essentially the asset value
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minus excess cash.
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The cash the company really
doesn't need to operate.
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And we'll go into more
detail of that.
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But we'll just view it as
the assets for now.
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So if I'm the CFO of this
company, and let's say we need
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to raise another, I don't
know, $15 million.
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I have two options.
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I could say OK, the company is
trading at $15 per share, I
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need to raise $15 million,
so I could issue
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another million shares.
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It wouldn't be the initial
public offering because I'm
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already public.
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It would be a follow-on
offering, or sometimes it's
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called a secondary offering.
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Although the word secondary has
kind of two connotations.
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But it would be a follow-on
offering where I would issue,
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I'd go to the board, we would
essentially create another
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million shares, and then sell
them into the market, and
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hopefully people will buy it at
$15 a share or probably a
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little bit less because we're
kind of flooding the market
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with a ton of shares.
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Maybe they buy it at $14
per share, and we
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would raise $14 million.
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And that would be a follow-on
offering.
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So we can always use the public
markets as a way to
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raise more money.
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We didn't have to go to all
this-- I mean, for the most
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part we didn't have to do this
huge valuation exercise and
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negotiations and do all of this,
hire banks and all that.
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Although the banks will
still collect fees.
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We actually would have to
hire banks to do this.
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So that's one option.
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Or the other option is we're an
established company, we're
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generating cash, we could
make interest
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payments if we want to.
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We could go to a bank.
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And actually there's a lot of
different ways to do this.
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But we could essentially
borrow money.
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And let's just say we do that.
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Instead of doing this--
let's say we do both.
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So let's say we did a $1 million
follow-on offering,
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that gave us $14 million.
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And let's say we want another
$2 million, but this time
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instead of selling shares--
so right now how many
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shares do we have?
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We sold 1 million, we
had 10 million, we
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have 11 million shares.
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Let's say, you know what, let's
say as a CFO I feel like
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our shares are going to
move up a lot more.
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So we don't like selling
them at this low price.
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And let's say interest
rates are really low.
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Instead we're going
to borrow money.
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That's essentially
raising debt.
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So let's say we borrow another
$3 million because we need it.
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So actually this would be debt,
$3 million of debt, and
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we would get $3 million
of cash.
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So now our assets are
all of this stuff on
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the left-hand side.
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And what are our liabilities
now?
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Now, we didn't have liabilities
before because
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everything we had
were equities.
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But now we do.
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Now we owe somebody $3
million right here.
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And I'll talk more about all the
different ways to kind of
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borrow money.
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But it's essentially, it could
just literally be a bank loan.
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They might have just gone to
Bank of America and said hey,
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we're a big company and we're
good for the money, why don't
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you lend us $3 million.
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And maybe it would be $3 million
at a low interest
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rate, at maybe 6% per year.
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And Bank of America feels good
because you have a high--
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we'll talk more about credit
ratings and all of that-- but
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they say oh, you have
essentially a good company
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credit score.
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So we'll give it to you at
a low interest rate.
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So what happens in the future
is, these assets are going to
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generate, hopefully,
some cash.
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And before these guys see it--
let me do to it in the--
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before these equity holders--
this is the equity holders
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right now-- before the equity
holders see anything, these
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guys have to get paid their
interest. And I'll show you
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all of that on a line-by-line
basis in an income statement.
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Everything we've done so far
has been a balance sheet.
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But something interesting
is happening now.
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Now all of a sudden your assets,
which is that side-- I
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know I just keep writing over
the same drawing-- your assets
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are now larger than
your equity.
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I think now, and this is just
kind of a review of the
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balance sheet video, you see
that the assets are equal to
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your equity, which is this right
here, your equity plus
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your liabilities.
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Your liabilities now
are $3 million.
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Plus liabilities.
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So if you wanted to know what
your assets are worth, because
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your assets are equal
to your equity.
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So what's your market value
of your equity?
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Well, we figured that
out already.
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We have 11 million shares now.
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And let's say the stock plummets
to $10 a share for
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some strange reason or for
a not-strange reason.
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So what's the market cap? $10 a
share, 11 million shares, we
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have a $110 million
market cap.
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We're doing a market value.
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And we'll talk more about the
difference between market and
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book value.
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But this is the market
value of your equity.
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And then what is your
liabilities?
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Well we owe $3 million,
so plus 3 million.
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So we could say that for the
most part the market value of
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our assets, the market thinks
that this entire left-hand
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side is going to be worth the
value of our equity, the
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market cap of the company, plus
the amount of debt, which
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is equal to $113 million.
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So the value of these assets are
$113 million, and that for
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the most part is the enterprise
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value of the company.
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What is the company's
assets worth?
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And we'll talk-- there's a
little bit of a tweak we'll do
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in the future on enterprise
value.
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But that's essentially how you
kind of can value what the
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company's worth.
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A lot of people when they do
a market capitalization
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calculation they say
oh, that's what
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the company's worth.
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Well no, that's what the
equity is worth.
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Market cap is what the
equity's worth.
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If you want to know what the
company's worth, you have to
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take the market cap and
then add the debt.
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Another way-- well, I won't get
too complicated because I
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just realized I've run
out of time again.
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See you in the next video.
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