This article will introduce readers to the basic concepts of investment, the most basic foundations of investment activities. This article will help readers better understand investment activities in general, so that later if we watch Shark Tank, we will understand what they are talking about and calculating.
1. Equity
We will start the story with a group of 5 friends A, B, C, D, E. All 5 of these people have a business mind, after discussion, they decided to pool their money to establish a company, and here are the possible cases:
Case 1: Each person contributes an equal amount of 200 million to open a company. At this time, the company will have a total value of 1 billion and because each person contributes an equal amount of money, it is obvious that everyone owns the same shares in the company.
If the company makes a profit in the future, the profit will be divided into 5 parts, or if the company is sold, the proceeds will also be divided equally into 5 parts.
Figure 5: describes the concept of equity
In terms of percentage, each person will get 20%, and this number will lead us to the first concept, which is the ownership ratio (Equity). In this case, because each person contributes 200 million to a company worth 1 billion, each person will have equity of 20%.
Case 2: Suppose the financial capacity of the 5 people is different, so the capital contribution will also be different. At this time, Mr. A will contribute 100 million, Mr. B, C, D will each contribute 200 million as usual, Mr. E has a slightly better financial condition, so he contributes 300 million.
The total capital of the company is still 1 billion, and at this time it is obvious that we cannot divide the ownership ratio equally as in case 1. And this is the time when a problem that most investors, especially young people starting a business, will easily occur, which is the confusion between ownership and operation .
There will be a case where Mr. A will say, “Although I contribute less money, my skills and efforts to the company are more valuable, so I will contribute more, therefore my percentage should be calculated higher than the amount of money I contribute . “
This is a classic mistake that young people often make when starting a business (I myself have been there). The act of contributing capital to establish a company is an aspect of ownership .
Then you use that capital to hire people to work for the company, and instead of hiring others, you hire yourself, at this time you will receive a salary depending on your ability and effort that you put into the company, that is the operational aspect .
And in reality, if Mr. A is a really good person, and if we have to pay Mr. A a salary that is exactly what he can receive compared to his ability, the company will not have enough money, because the company’s initial budget is very limited.
But Mr. A cannot work for free and the company cannot calculate the percentage of ownership for Mr. A as Mr. A proposed. At this time, the company will consider paying Mr. A a basic salary, and the rest will be converted into special benefits reserved for Mr. A (such as preferred shares, bonus shares, etc.), and Mr. A will only enjoy these benefits when he completes his work well.
And suppose in case Mr. A is not able to do his job, the company can still fire Mr. A, meaning that Mr. A will no longer participate in the company’s operations, but Mr. A is still the owner (of a part) of the company and still receives full benefits of a co-owner of the company, and Mr. A is still invited to shareholder meetings.
That’s how companies separate ownership and operations.
Figure 6: Ownership ratio in case of unequal capital contribution
Back to the story, we only discuss the ownership issue and not the operation issue. At this time, Mr. A’s capital is 100 million, Mr. B, C, D are 200 million and Mr. E is 300 million, a total of 1 billion. To ensure fairness in ownership ratio, the company will be divided into many parts.
For example, if divided into 10 parts, Mr. A owns 1 part, Mr. B, C, D own 2 parts each, and Mr. E owns 3 parts. And if divided into 100 parts, Mr. A’s ownership ratio will be 10%, Mr. B, C, D own 20% each, and Mr. E owns 30%.
2. Dilution
After about 2 years of operation, the company has had stable development and started to enter a period of strong growth, so the company needs to mobilize a certain amount of capital to continue developing the company. At that time, I was a friend of the company director and knew that information, so I contacted the company to discuss capital mobilization.
Currently, I have 1 billion in hand and I have two options, one is to lend to the company (become a creditor of the company) and two is to contribute capital to the company, thereby becoming a shareholder of the company (co-owner of the company) . And because I am a friend of the director and trust the company, I decided to choose option two, which is to contribute capital and become a shareholder of the company, accompanying the company.
Because within 2 years of operation, the company has developed steadily, so the company’s valuation is no longer worth 1 billion as the initial total capital contribution. For example, the company’s current valuation is 4 billion, and with the capital of 1 billion that I contributed, the total value of the company has increased to 5 billion, and obviously I will receive a 20% ownership ratio corresponding to the 1 billion that I contributed.
Here, many of you will be confused that the initial capital contributed is 1 billion, now I contribute another 1 billion, making a total of 2 billion, so I should have an ownership ratio of 50% corresponding to the 1 billion I contributed, right? Similarly, with 100 million, Mr. A owns 5%, Mr. B, C, D each owns 10% corresponding to 200 million, and Mr. E owns 15% corresponding to 300 million, right?
This is a very serious mistake because as mentioned above, the company has developed more than when it was first established (more machines, more workers, higher revenue, …) so the company’s value is no longer 1 billion.
And because I contributed capital later, I cannot calculate my ownership ratio the same way as A, B, C, D, E when they came in first, that would be unfair to them.
Back to the problem, at this time my 1 billion will account for 20% of the total 5 billion value of the company, so what is the ownership ratio of A, B, C, D, E at this time? And what is the basis for calculating their ownership ratio? Because if they still keep the same ownership ratio as before, then currently, the total ownership ratio of shareholders will be 120%, this will be very unreasonable.
So, to ensure the total ownership ratio of shareholders is at 100%, A, B, C, D, E will have to divide their ownership ratio and each of them must divide so that the total ownership ratio that they cut to divide for themselves is exactly 20% of their own. So how to divide to ensure their rights? They will do it like this.
Figure 7: Illustration of the concept of stock dilution
To calculate the ownership ratio of old shareholders and new investors, the company must go through an important activity, which is company valuation . This is an extremely complex activity, old shareholders will want to value the company as high as possible and new investors will want to value the company as low as possible.
To make it simpler, I will not go into this activity too deeply, and after negotiating back and forth, both sides agreed on a company valuation of 4 billion, and with the 1 billion I just contributed, the company will have a total value of 5 billion.
At this time, the ownership ratio of A, B, C, D, E must change to create 20% ownership ratio to give to themselves. And each old shareholder will reduce 20% of their total ownership ratio. For example, in the case of A, A’s ownership ratio will be reduced by 10% × 20% = 2% , meaning A only has 10% – (10% × 20%) = 8% .
Similarly, B, C, D will each have 4% less and only have 16% left, E will have 6% less and only have 24% left. Because each person takes a piece like that, the company will have a surplus, at this time the total reduced ownership ratio of A, B, C, D, E (the surplus) will be 2% + 4% + 4% + 4% + 6% = 20% , exactly equal to their ownership ratio.
And the current ownership ratio of all shareholders will be Mr. A with 8%, Mr. B, C, D each with 16%, Mr. E with 24% and me with 20%, adding up to exactly 100%. This activity is called dilution .
If we talk about it mathematically, we can summarize it with the following formula:
(%A + %B + %C + %D + %E) × 20% = %F
⇔ (%A × 20%) + (%B × 20%) + (%C × 20%) + (%D × 20%) + (%E × 20%) = %F
When a shareholder’s ownership percentage is diluted, it means that their ownership percentage is reduced to make room for new investors. Although the ownership percentage is reduced, the ownership value is increased because the ownership percentage is now calculated based on the new value of the company, not the old value.
Specifically, Mr. A owns 8% of a company valued at 5 billion, not a company valued at 1 billion as at first, which means that Mr. A’s assets are equivalent to 8% of 5 billion, which is 400 million, much higher than 10% of 1 billion, which is only 200 million. Similarly, the assets of Mr. B, C, and D will now be 800 million each and Mr. E will be 1.2 billion.
Figure 8: Shareholder ownership ratio and value change when stock dilution is completed
Valuation and ownership ratio calculation activities are two-way relationships (not valuing the company first and then calculating the ownership ratio). The company’s valuation of 5 billion will only be specifically confirmed when the investment transaction in the company is completed.
In other words, this company is only officially worth 5 billion when I am willing to spend 1 billion in exchange for 20% ownership. If I decide not to invest anymore (cancel the deal) halfway through, and the deal falls through, even though I have calculated everything, the company is still not worth 5 billion.
In reality, these activities are extremely complicated, such as the concepts of pre-money, post-money, which are the valuation of the company before and after investment, and concepts such as anti-dilution, preemptive rights, etc. But within the scope of this series of articles, those concepts are not really necessary, so I will not mention them here to avoid confusing readers.
3. Stock split
The above is the basic way companies divide shares, and in reality, they will not only divide the ownership percentage into 100 parts like in the example, but will divide into millions, even billions of parts. Because when the company reaches a huge value (about 100 billion for example), but still divides only 100 parts, the value of each part is too large, leading to the fact that not many people will have enough money to buy these parts.
And especially when the company is listed on the stock exchange, there will be many investors participating in investing, and obviously with a price of 1 billion VND / share, at that time, not many people will have enough money to buy the company’s shares.
Figure 9: Stock split
If divided into a million shares, the price of each share will fluctuate around 100 thousand / share, at that time there will be more people able to buy and access the company’s shares. But no matter how much or how little, the nature remains unchanged, the owner of the company’s shares is still a co-owner of a part of that company.
Imagine that the company continues to grow and the company’s value increases 10 times again, and the price per share will now be 1 million VND/share.
This price is still too high for people with little money, and to solve that problem, the company continues to divide the stock, for example in this case it is divided into 5 times, so 1 old stock will be converted into 5 new stocks, the price of each new stock will now be 200,000 VND /share.
This is called a stock split . And these stock splits do not increase our ownership or the value of our holdings, they simply increase the number of shares we hold (and of course the value of each share will be reduced in proportion to the share split).
4. Difference between stock, share, shareholder, dividend and related concepts
Although the nature is not much different, if not explained, I’m afraid you will be confused and a bit confused. I made the comparison table below for easy visualization. And the comparisons below are mainly for you to understand and avoid confusion, but in fact there are still no general regulations and clear definitions of these concepts, please refer to:
| Share | Stock |
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People who hold shares are called shareholders and dividends are the portion of profits (cash or shares) distributed to shareholders.
In addition, we have another concept that needs to be paid attention to, which is market capitalization. This is the number that represents the total value of that company, and once we understand what a share is and what a stock split is, it will not be difficult for us to understand the formula for calculating the market capitalization of a company, which is:
MARKET CAP = SHARE PRICE × SHARE OUTSTANDING
(*) Share price = value of one share.
(*) Share outstanding = total number of shares issued (ie total number of shares that the company has chopped up).
Thank you for reading my sharing, hopefully it has brought more or less useful value to you.
- Sky -