An Overview of Financial Markets - II

(Recap: In part I, the motivation for the series had been laid out. In part II, we had discussed a bit about stock markets, what are their objectives, why liquidity is important etc. The previous article had been concluded with the point that to understand stock markets (which is the secondary market) better, it is important to understand the primary market. In this part we look at the primary markets.

Acknowledgments are also due here to Shyam Sundar (Peter to IITM guys :)) as some of the ideas came in our conversation.)

III

Primary Markets

As a definition, we can use the wikipedia definition that primary markets is that part of the capital markets that deals with the issuance of new securities. Hence, the term primary. It is like this is where there instruments originate, then they are traded on the secondary markets.

But what are these instruments? The common term for them is securities. Again, the term is self-explanatory. A security has a commercial value and you can use it in a commercial transaction as a security of some kind.

But why do these securities originate? Who originates them? Why do they come into existence?

For that consider the following scenario. You have a business idea, say, something related to setting up a website for something. You do some estimation and find that 40 lakhs is needed to get the project off the ground. You may have savings of 10 lakhs and can maybe borrow 10 lakhs from family and friends. So what has to be done for the 20 lakhs?

You can approach a bank. But a bank may not like the risk they are seeing. Like most dotcom financial projections, your projections promise the moon and sky, if you reach a certain critical traffic. And honestly, that is a big "if". Even if a bank were to fund it, it would require something as collateral and you may not have that.

Another alternative would be to approach an investor who has the stomach to take the kind of risk you are looking at. But before that, you need to write a business plan. Too much hype is made of business plans mainly due to the proliferation of business plan competitions. A B-plan (I hate that term!) is simply a checklist of items to make sure you have thought things through. Therefore, any business owner needs to think about:

• What is it exactly he/she is selling
• How to get the information across to the public that they exist - there is an art in this. The look and feel of the communication exercise matters as much to the public's perception as is the actual look and feel. Ok, not as much, because even the best marketer can't sell a bad product, but between two almost equal products, marketing can make a huge difference.
  
• How much money would be needed to finance the funding – how long would funding be required, when can the venture be expected to break even
• Operational issues – what sort of office do you want, where should your office be, how many people to hire, where to get them etc.
  

It is just an organized way of thinking about a business. At the starting time, only a few things would be clear, the rest of the picture emerges as you go along. But atleast, when you have a plan, you know what you know and what you don’t know!

Therefore, before going and meeting the investor you draw up financial projections. According to your projections, subject to certain assumptions, you don’t make money for the first two years but after that you really start raking it in. After the initial two years, you expect to make upwards of 2 crores a year say.

The investor looks at the plan and he likes it. He likes your business model and the idea but he is not sure if you have the maturity to execute it. Imagine the following conversation:

Investor (I): I like the business model. In fact, I think you are being conservative. This business can really grow exponentially once we take the hit for the first two years.

Entrepreneur (E): (Smiling) That’s encouraging…

I: But, I have my doubts on how you would implement it. I think you need to come back to me with some more details on the team. Fine, how much money are you looking at?

E: I have 20 lakhs, I estimate I need 30 more to get the process started.

I: Hmm… I really like your business. Subject to a better team, I am interested in taking equity stake. I could give you 30 lakhs for majority stake in your company.

E: How much?

I: I would own around 60% since I am giving that much money. But don’t worry I will be a dormant partner. Think about this. The other option is that I give you money in return for an interest payment. The interest payment can really screw you, this way I swim and sink with you.

E:(To himself) I am not comfortable with that at all. What if he is not dormant? What if he gets edgy after one year?

(To the investor) What happens if I borrow for an interest payment?

I: Hmmm… In that case, I am ready to invest 30 for 5 years at an annual rate of 20%.

E:(To himself) Wait… that means I need to pay you 6 lakhs a year as interest! And in the final year I have to return the principal and interest at 36! That is nonsense! This guy is sitting on his ass, doing nothing and I have to pay 6 a year in interest!

(To the investor) This is too high. In the first two years, I am anyway making a loss, this just adds to it.

I: (Persuasively) Look, I think you can reduce the operating costs. The interest payment would not pinch so much and…

E: If it is 20%, then you must give me a two year interest holiday? I can pay the corresponding interest at a later date…

I: You are not getting my side of the deal. If I charge 20% and say the company goes bankrupt in 2 years, I atleast get back 12 lakhs…

E: if the company goes bankrupt, you will get a claim on whatever I get by selling the assets of my company like the servers and stuff…

I: Haha… how much will that be! If I give you a 2 year holiday, I could earn much more by just putting my money in a fixed deposit. That is why I offered equity stake as an option. Think about these things and get back to me.

E: My problem with equity stake is this. You are a nice guy, I like you. Suppose, for some reason, you sell the stake to someone and exit and that person does not work with me, what happens.

I: If you have a problem with majority stake, we can work on a combination of debt and equity. Think about it.

E: Ok, I will do that. Thanks for your time.

I: Thanks for yours!
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This is a stylized example. An example is an isolation of reality, isolated by the author with an intention in mind. Please do not think this to be how actual negotiations get conducted. I don’t know how they happen, maybe it is like this, maybe it is not.

But the example brings out points I would like to illustrate.

• The entrepreneur needs money and the investor, unhappy with returns from other sources, is looking to increase his/her returns. It is basically an opportunistic union and while it would be great to have a human touch in the process, the priorities of each party are clear. The entrepreneur does what is best for his baby, the investor does what is best for himself or his shareholders. Having said that, if either one gets over smart, both tend to lose.

• There were two structures discussed here. One was an equity investment and the other was a debt investment. If the business goes according to plan and it really works out, the equity investment makes more money. How? Say, the investor took a 50% stake and the company grew to having profits of 2 crores. This 2 crores is the earnings for the shareholders in the company. Therefore, the investor gets 1 crore, the entrepreneur and his family gets the rest. However, there are two options. The shareholders can take back the money i.e the 2 crores, but in that case, the company will not have any cash reserves to begin the year. Or they could reinvest it back into the company to make more money (hopefully) the next year.

In the debt structure, the investor gets 20% in good times. But in the bad times he gets the first claim on the proceeds from the liquidation. At the time of bankruptcy, the equity holder gets whatever is remaining after the creditors have been paid off. That makes sense, if the equity holder could have the first claim in good times and bad, then even when the going gets slightly tough, he may be tempted to run the company into the ground! Therefore, the debt structure is a less risky structure; both the loss and gains are capped. The equity structure is riskier. The moral from this is that in a good deal, the reward must be commensurate with the risk taken.

In the above example, the entrepreneur was a small guy and the investor was also a relatively small guy. It need not be. A big company like Reliance can approach investors for money for a new plant they are putting up. A bigger company could approach investors for funding for a takeover. These investors could be a bank, could be a private equity fund, could be a hedge fund etc. The actual structure of the deal would depend on the risk appetite of the investor and their commitments to their shareholders.

This "structure" that we spoke about is essentially a contract. That piece of paper now has some value, hence it becomes a security. Depending on the nature of the contract, this can either be made into a mass product and sold to everyone. Or you can make specialized, newer contracts from this and sell it to specific institutions. Either way, these agreements, if they have a value, can be traded. Where would they be traded? In the secondary markets.In the next part, we would take a closer look and begin to look at how to apply these ideas to real world situations.