how a company grows from almost nothing to being traded in the stock market

In this post, I will explain how a company grows from almost nothing to being traded in the stock market. I will use this to explain basic finance terms.

Stage 0: Bootstrap Startup Tom and Ian start a lemonade business. The business involves buying lemon, sugar, cups and ice cubes. They buy these raw items at the start of the day and then sell the end product (lemonade) throughout the day. 

They need money for three things:

1.    The lemonade stand, juicer, ice box. This is called the fixed assets or Capital.You can use the same stand & juicer for making a long time. Thus, make this investment one time and can enjoy the benefits for a long time. The term "capital" is the central part of entrpreneurship and is the root for "Capitalism".

2.   The raw materials they buy at the start of the day. The raw material gets used up as you make the final product. The raw material and juice you have made it in a pitcher before selling is together called an inventory.

3.   Keep some change in the register for people who are paying with bigger denomination currency. This is called just cash.

Together the fixed assets + inventory + cash is called the company assets.

To get these assets they need to use some money - called an investment. It all costs about $100. Tom and Ian put $50 each. They shared the investment and the profits 50:50. In other words, each owned 50% shares in the company.

They use 10 lemons, 5 sugar packets, 10 ice cubes, 50 cups to produce  50 glasses of lemonade per hour. The raw materials cost $10 and they sell lemonade at $0.25/cup. This provides them 50 * $0.25 = $12.50 in total money got from the customers. This is called revenues. 

They spent $10 on raw material. This is called Cost of Goods Sold. 

The profit is now $12.50 - $10 = $2.50. This is called earnings. 

How significant is this $2.50? We need to see it as a percentage of the revenues. Profit divided by the revenues is called the margin. In this case the margin is:

Stage 1: External InvestmentBusiness is going ok and they want to grow it even bigger. They realized the following:

1.    Instead of buying lemons every day from a local vendor, they could buy it at wholesale from a distant wholesaler every week. If they buy lemons in bulk, they need to buy a big box to hold them. Bigger Inventory.

2.   Instead of squeezing them in their old juicer, they want to buy an industrial grade juicer. This enables them to produce juice faster and serve more customers. Increased Capital investments.

3.   By producing more lemonade & selling them more they could reduce the overall costs per glass. The same stand and labor could be used for the increased production. The idea that you can reduce your average costs by producing more is termed the economies of scale.

All this requires $100 more in investment. The founders - Tom and Ian don't have that much money. The bank won't lend them anything as they are very new in the business. They go to a local wealthy guy - Rich. 

Rich says he can give $100, but asks for a share of the profits in the business. In short, he wants to a co-owner of the company.

Now, how many shares should Rich get?

Tom and Ian get together to start valuing their company.

Assets:Fixed assets (juicer, stand): $50
Inventory: $50
Past profits (that they have it in the bank): $50

Total assets: $150

There is one thing that is missing here. What about the reputation and brandthey have built? 

1.    TomIan Lemonade Stand is popular among the local public, who frequent it. A lot of people made the drink their part of their daily routine.Brand.

2.   Local shopkeepers give discounts to these guys as they have proven to be trustworthy. Relationships.

3.   They have already set up paperwork with the local corporation and all this required manual work. Relationships.

4.   Through their daily routine, they found faster ways to squeeze the lemons.Intellectual Property & Processes.

What is the value of all this?

It is hard to put a value to all this. However, these items have a big impact on the future revenues.

Together these things are called the Intangible Assets. They are hard to touch and see. But, have a lot of hidden value.

Ian and Tom guess that the value these at $200. Rich scoffs at this and says he sees these are worth only $50. With no other option, they grudgingly take the offer.

Total value of TomIan Stand: $200 ($150 in tangible assets and $50 in intangible assets).

Rich is bringing $100 in new cash. Together the total assets after investment is $300.

Since Rich put $100 in that, he gets 33% in the company:



Tom and Ian share the remaining 66.66% equally among them. These 3 are now called the shareholders - as they all own the share in the company. Rich is not working the lemonade stand and is non-executive owner of the company. Rich is sometimes called the Angel Investor. He is the rich guy who acted like an "angel" to these small entrepreneurs.

Stage 2: GrowthThe business is now going quite well. Using the money from Rich and later a few more wealth people, TomIanRich Lemonade Corporation has increased production and have setup multiple stands in different parts of the city.

Now, they dream really, really big. They want to bottle the lemonade and sell it worldwide. They reason that their unique flavor has already proven to be a hit in their city.

This expansion requires a substantial amount of new money - 100 million dollars. Tom & Ian project that this 100 million investment could provide them a profit of over $500 million in the next 10 years. Sounds attractive.

It would be impossible for them to find that many rich people from their contacts directly. However, they guess that if each person in their state invests $10 in their company, they can easily get that investment. Each of the investor could be given a small percentage of the company & its profits. Since a $100 million in investment could produce $500 million in profits (according to "Estimates) it is likely that an ordinary investor who put $10 could get $50 in the next 10 years if everything goes well.

However, how do they get $10 from 10 million people? Where do they go to?

Stock Markets. 

Stock markets are like an eBay for investors. There are a bunch of people who are selling you shares in their company in return for your money. Just like you buy tomatoes in your regular market, you can buy shares. To make it even more simple, you can both buy and sell at any time. This is called a trade or an exchange. 

What are the functions of the stock markets (also called exchanges):

1.    They bring a large number of investors and good companies in a single place. Thus, investors have a lot of companies to choose from and companies have a lot of investors to provide money. This works the same for any marketplace. A Stock market is a company just like eBay or Amazon that brings different parties together. Just like Craigslist competes with eBay, New York Stock Exchangecompany competes withNasdaq.

2.   They verify the credentials of the company to make sure only really quality companies are listed in the board. The best exchanges allow only the best companies. Thus, it is a mark of honor to be listed on the New York Stock Exchange. 

3.   They provide each ways for transfer of payments & share certificates between the buyers and sellers.

The first time a company enters the stock market is called the IPO or Initial Public Offer. The "public" here refers to the fact that you are raising money from common public (instead of just rich people who are Angel investors). This requires a lot of transparency in your accounting and companies prepare this process for months. Twitter is now rumored to be in this process of preparing for its IPO.

Google executives at its IPO in Nasdaq.

Share price.TomIanRich Corporation has now successfully entered the New York Stock Exchange. They divided the company into 10 million pieces (called the shares) and sold 5 million of them at $20 a piece. This called the share price.

Do you see the value of an item in eBay change? Yes it does. It depends on how hot an item is. If more people are interested in holding the share of a company X, the share prices would go up.

On Dec1, Tom finds a new way to use the lemonade formula for making a lemonade candy. New investors see that and believe that the profits will be moving up. As new investors flock in, the share prices move up.

On Dec 5, Ian finds a major damage in one of their warehouses and announces that this will cause a drop in their profits. Many existing investors sell shares and share prices move down.

On Dec 10, a major healthcare institute announces that lemonade is good for the body. Smart investors understand that this will cause more lemonade consumption, meaning more future profits. This again causes the stock to move up.

In short, the share price moves up and down as investors adjust their profit projections based on the arrival of new news.