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William Ackman: Everything You Need to Know About Finance and Investing in Under an Hour

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Transcript:

0:00
??So let’s begin.  We’re going to go into business together.  We’re going
0:48
to start a company and we’re going to start a lemonade stand
1:10
and now I don’t have any money today, so I'm going to have to raise money from investors
1:13
to launch the business.  So how am I going to do that?  Well I'm going to form a corporation.
1:16
 That is a little filing that you make with the State and you come up with a name for
1:21
a business.  We’ll call it Bill’s Lemonade Stand and we’re going to raise money from
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outside investors.  We need a little money to get started, so we’re going to start
1:28
our business with 1,000 shares of stock.  We just made up that number and we’re going
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to sell 500 shares more for a $1 each to an investor.  The investor is going to put up
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$500.  We’re going to put up the name and the idea.  We’re going to have 1,000 shares.
1:41
 He is going to have 500 shares.  He is going to own a third of the business for his
1:45
$500.??So what is our business worth at the start?  Well it’s worth $1,500.  We
1:50
have $500 in the bank plus $1,000 because I came up with the idea for the company.  Now
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I'm going to need a little more than $500, so what am I going to do?  I'm going to borrow
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some money.  I'm going to borrow from a friend and he’s going to lend me $250 and we’re
2:04
going to pay him 10% interest a year for that loan.??Now why do we borrow money instead
2:09
of just selling more stock?  Well by borrowing money we keep more of the stock for ourselves,
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so if the business is successful we’re going to end up with a bigger percentage of the
2:17
profits.??So now we’re going to take a look at what the business looks like on
2:22
a piece of paper.  We’re going to look at something called a balance sheet and a
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balance sheet tells you where the company stands, what your assets are, what your liabilities
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are and what your net worth or shareholder equity is.  If you take your assets, in this
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case we’ve raised $500.  We also have what is called goodwill because we’ve said the
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business—in exchange for the $500 the person who put up the money only got a third of the
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business.  The other two-thirds is owned by us for starting the company.  That is
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$1,000 of goodwill for the business.  We borrowed $250.  We’re going to owe $250.
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 That is a liability.  So we have $500 in cash from selling stock, $250 from raising
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debt and we owe a $250 loan and we have a corporation that has, and you’ll see on
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the chart, shareholders’ equity of $1,500, so that’s our starting point.??Now let’s
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keep moving.  What do we need to do to start our company?  We need a lemonade stand.  That’s
3:15
going to cost us about $300.  That is called a fixed asset.  Unlike lemon or sugar or
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water this is something like a building that you buy and you build it.  It wears out over
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time, but it’s a fixed asset.  And then you need some inventory.  What do you need
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to make lemonade?  You need sugar.  You need water.  You need lemons.  You need
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cups.  You need little containers and perhaps some napkins and you need enough supplies
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to let’s say have 50 gallons of lemonade in our start of our business.  Now 50 gallons
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gets us about 800 cups of lemonade and we’re ready to begin.??Let’s take a new look
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at the balance sheet.  So now we’ve spent $500 on supplies.  We only have $250 left
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in the bank, but our fixed assets are now $300.  That is our lemonade stand.  Our
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inventory is $200.  Those are the supplies and things, the lemons that we need to make
4:00
the lemonade.  Goodwill hasn’t changed at 1,000, so our total assets are $1,750 and
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we still owe $250 to the person who lent us the money.  Shareholder equity hasn’t changed,
4:11
so we haven’t made any money.  All we’ve done is we’ve taken cash and we’ve turned
4:14
it into other assets that we’re going to need to succeed in our lemon stand business.
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 ??So let’s make some assumptions about how our business is going to do over time.
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 We’re going to assume we’re going to sell 800 cups of lemonade a year.  That’s
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not a particularly ambitious assumption, but we should assume the lemonade business is
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fairly seasonal.  Most of the lemonade sells will happen over the summer.  We’re going
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to assume that each cup we can sell for $1 and it’s going to cost us about $530 per
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year to staff our lemonade stand.  ??So now let’s take a look at the income statement,
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so the income statement talks about the profitability, about the revenues that the business generated,
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what the expenses are and what is left over for the owner of the company.  So we’ve
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got one lemonade stand.  We’re selling 800 cups of lemonade at our stand.  We’re
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charging $1, so we’re generating about $800 a year in revenue and we’re spending $200
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on inventory.  There is a line item here called COGS.  That stands for cost of goods
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sold.  We have depreciation because our lemonade stand gets a bit beat up over time and it
5:07
wear out over five years, so it depreciates over 5 years.  We’ve got our labor expense
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for people to actually pour the lemonade and collect cash from customers and we have a
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profit.  We have EBIT and that is earnings before interest and taxes, of $10.  That
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is kind of our pretax profit for the business.  We didn’t make very much money because
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you take that pretax profit of $10 and you compare it to our revenues.  It’s about
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a 1.3% margin.  That is not a particularly high profit.  Now we’ve got to pay interest
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on our debts and we have a loss of $15 and then we don’t have any taxes, but at the
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end of the day we still lose money.  ??So the question is, is this a particularly good
5:44
business?  Well we’re losing money and our cash is basically going down over time.
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 Is this a business we want to stay in?  Now the cash flow statement takes the income statement
5:46
and figures out what happens to the cash in the company’s till, so when you put up $750,
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some money goes to pay for a lemonade stand.  Some money is lost selling the product and
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at the end of the day we started with $750 and now we only have $500.  Let’s look
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at the balance sheet.  What has happened?  Our cash has gone down from 750 to 500.
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 Our fixed assets have gone from 300 to 240.  That means our lemonade stand is starting
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to wear out.  Goodwill hasn’t changed.  We still owe $250 and our shareholder’s
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equity is now down to $1,490, so it was the 1,500 we started with minus the $10 we lost
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over the course of the year.  ??So should we continue to invest in the business?  We’ve
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lost money in the first year.  Is it time to give up?  Well let’s think about it.
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 Let’s make some projections about what the company is going to look like over the
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next several years.  Let’s assume that we take all the cash the business generates
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and we’re going to use it to buy more lemonade stands so we can grow.  Let’s assume we’re
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not going to take any money out of the company and we’re not going to pay a dividend.  We’re
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going to keep all the money in the company and reinvest it.  Let’s assume that we’re
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going to—as we build our brand we can charge a little more each year, so we’re going
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to raise our prices about a nickel, five cents more for each cup of lemonade each year and
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then we’re going to assume we can sell 5% more cups per stand per year.  So we’ve
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got built in growth assumptions. ??Now let’s take a look at the company.  So if
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you take a look at this chart you’ll see in year one we started out with one lemonade
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stand.  We add one a year and then by year five we’re up to seven because we’ve got
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a big expansion plan.  Our price per cup goes up a nickel a year and our revenue goes
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from $800 and starts to grow fairly quickly and the growth comes from increased prices
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for cups of lemonade and it also comes from opening more stands.  So by year five we
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have almost $8,000 in revenue.  Our costs are relatively constant, which is the lemonade
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and the sugar.  That’s about $1,702.  We have depreciation as more and more stands
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start to wear out over time.  We’ve got labor expense, but by year five the business
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is actually doing pretty well.  We went from a 1.3% margin to over a 28% margin.  The
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business is now up to scale.  We’re starting to cover some of our costs.  We’re growing.
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 We’re still paying $25 a year in interest for our loan and we have earnings before taxes,
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after interest of $2,300 by the end of year 5.  So we put $500 into the business.  We
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borrowed 250 and by year five we’re making a profit of $2,300.  That sounds pretty good.
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 Now we have to pay taxes to the government.  That is about 35% and we generate net income
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or another word for profits of $1,500 by the fifth year and about a dollar a share.  ??So
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if you think about this our friend put up $500 to buy 500 shares of stock.  He paid
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a dollar and after five years if our business goes as we expect he is actually making a
8:01
dollar a share in profit.  That sounds like a pretty good deal.  So what has been the
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growth?  The growth has been fairly dramatic over the period and that is what has enabled
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us to become a successful business.  Now these are just projections, but if they’re
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reasonable projections this might be a business that we want to start or invest in.??Now
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let’s look at the cash flow statement.  So as the business becomes more and more profitable
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we generate more and more cash and the cash builds up in the company.  We go from $500
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of cash in the company to over $2,000 of cash over the period.  The balance sheet, again,
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the starting balance sheet had shareholder’s equity of $1,490, but as the business becomes
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more profitable the profits add to the cash.  They add to the assets of the company.  Our
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liabilities have not changed and the business continues to build value over time.  So again
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by the end of year five we’ve got $4,000 of shareholder equity and that’s almost
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three times what it was when we started. ?Now is this a good business or a bad business?
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 How do we think about whether it’s good or bad?  One thing to think about is what
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kind of earnings are we achieving compared to how much money went into the company.  Now
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this is a business that we valued at $1,500 when we started.  Someone put up $500 for
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a third of the company.  We gave it a $1,500 value.  By the end of year five it’s earning
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over $1,500 in earnings, so that’s over a 100% return on the money that we put into
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the company.  That’s actually quite a high number.  We spent—let’s talk about return
9:31
on capital.  We’ve spent $2,100 in capital building lemonade stands and we earned $2,336
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in year five on the capital we invested.  That’s over 100% return on capital.  That is a very
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attractive return.  Earnings have grown at a very rapid rate, 155% per annum.  This
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is really a growth company and our profitability has gone from 1.3% to 28.6% by year five and
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that sounds pretty attractive and it is.  ??So let’s look at the person who put up the
10:00
loan.  Well that person put up $250 and the business has been profitable.  We’ve been
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able to pay them their interest of 10% a year, $25 a year and they’re happy because they
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put up $250.  They’re getting a 10% return on their loan and the business is worth well
10:13
more than $250.  We’ve got more than that in cash.  As a result, they’re in a safe
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position, but they’ve only made 10% on their money.  ??Now let’s compare that with
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the equity investor, the person who bought the stock in the company.  That person earned
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a dollar a share in year five versus an investment of a dollar a share, so he is earning over
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100% or about 100% return on his investment versus only 10% for the lender.  So who got
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the better deal?  Well obviously the equity investor.  Now why did the equity investor,
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why do they have the right to earn so much more than the lender?  The answer is they
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took more risk.  If the business failed the lender is entitled to the first $250 of value
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that comes from liquidating the company, so if you sell off the lemonade stands and you
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only get $250 the lender gets back all their money.  They’re safe.  They got their
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10% return while the business was going.  They got back their $250, but the equity investor,
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the person who bought the stock is wiped out because they come after the lender.??So
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what is the difference between debt and equity?  Debt tends to be a safer investment because
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you have a senior claim on the assets of a company and it comes in lots of different
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forms.  You’ve heard of mortgage debt on a home.  That’s a secured loan secured
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by a house, but you could have mortgage debt on a building for a company.  There is senior
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debt.  There is junior debt.  There is mezzanine debt.  There is convertible debt, but the
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bottom line, it’s all debt.  It comes in different orders of priority in a company
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and the rate your charge is inversely related to your security, so the better the security
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and the less risk the lower the interest rate you’re entitled to receive.  The more junior
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the loan the higher the interest rate you’re entitled to receive, but you can avoid the
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complexity.  All you need to think about is debt comes first.  It’s a safer loan,
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but you’re profit opportunity is limited.??Now the equity also has their varying forms.  There
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is something called preferred equity or preferred stock.  There is common equity or common
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stock and again stock and equity are basically synonyms.  They’re options, but really
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not worth talking about today.  The important point is that equity gets everything that
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is left over after the debt is paid off, so it’s called a residual claim.  Now the
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good thing about the residual claim is that business grows in value if you don’t owe
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your lender anymore, but all that value goes to the stock holder.  So the question is
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why was the lender willing to take only a 10% return when the equity earned a much higher
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rate of return and the answer is when the business started there was no way of knowing
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whether it would be successful or not and the lender made a bet that if the business
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failed they could sell off the lemonade stand.  It cost $300 to make it.  They would have
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some lemons, some lemonade.  Even if they sold it at a much lower price than the dollar
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they originally projected the lender felt pretty comfortable that they would get their
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money back, whereas the stockholder is really taking a risk.  They were betting on the
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profitability of the company and they were taking a risk that if it failed they would
12:56
lose their entire investment, so they were entitled to get a higher return or have the
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potential to have a higher return in the event the business we successful.??So let’s
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talk about risk.  Lots of different ways people think about risk, but the one that
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we think is the most important—you know a lot of people talk about risk in the stock
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market as the risk of stock prices moving up and down every day.  We don’t think
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that’s the risk that you should be focused on.  The risk you should be focused on is
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if you invest in a business what are the chances that you’re going to lose your money, that
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there is going to be a permanent loss.  When you’re thinking about investing your own
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money, when you’re thinking about one investment versus another don’t worry so much about
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whether the price moves up and down a lot in the short term.  What matters is ultimately
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when you get your money back will you earn a return on your investment.  ??How do
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you think about risk?  Well one way to think about risk is to compare your risk to other
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alternatives, so you could buy government bonds and government bonds are considered
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today the lowest risk form of investment and the US Treasury issues 10 year, 3 year, 5
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year debt.  There is a stated interest rate and today a 10 year Treasury you earn about
13:53
a 3% return.  So you give your government $1,000 and you get $30 a year in interest.
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 At the end of 10 years you get your $1,000 back, so that’s very, very safe and that
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sort of provides a floor.  Now obviously if you’re going to make a loan you can lend
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money to the government and earn 3%.  Well if you can lend money to a lemonade stand
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you want to earn meaningfully more, so in this case the lender is charging a 10% rate
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of interest.  Why 10%?  Because they want to earn a nice fat spread over what they can
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make lending to the government because a startup lemonade stand business is a higher risk business.??Equity
14:23
investors sort of think about things similarly, so the higher the valuation—the more risky
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the business the higher the rate of return the equity investor is going to expect and
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the lower the risk business the lower the return the equity investor is going to expect
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and equity investors don’t get interest the same way a lender does.  What equity
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investors get is they get the potential to received dividends over the life of a company.
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 ??Let’s talk about raising capital.  You started this lemonade business.  Now
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the point of this was to make money in the first place.  The business is doing very
14:59
well yet I, having started the business coming up with a name and the concept, hired all
15:06
the people, I've made nothing, right.  So the business has grown in value, but where
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is my money?  I need money to buy a car for example, so I want to buy a car for $4,000.
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 What are my choices?  What can I do?  Well we’ve taken all the cash the business has
15:19
generated.  We’ve reinvested it in the business.  Now the good news is we’ve taken
15:22
all that money.  We’ve been able to use it to buy more lemonade stands and these lemonade
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stands are more and more productive and it’s grown the value of the business faster and
15:30
faster.  Now my alternatives could included instead of growing the business so quickly,
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instead of investing in more lemonade stands I could simply have paid dividends to myself.
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 Now the good news about that is I get money along the way, but the bad news about that
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is the business wouldn’t grow as quickly and if you have a business as profitable as
15:45
this lemonade stand company and you just open a new lemonade stand and people earn—we
15:46
can earn hundreds of dollars in each new stand it makes sense to keep investing.  ??Well
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how do I keep my business going and growing, taking advantage of the opportunities, but
15:54
take some money off the table?  How do I do that?  Well I could sell the company,
15:57
so I could sell my lemonade stand business.  I started this one in New York.  Maybe
16:00
there is someone in New Jersey who wants to buy me, consolidate with my lemonade stand
16:05
company.  Well the problem with that is once I sell it I can no longer participate in the
16:08
opportunity going forward and I believe in this business.  I think it’s going to be
16:11
very successful over time.  So that’s one alternative.??The other alternative is
16:16
I could pay a dividend.  We have by year five, over $2,000 sitting in the bank, so
16:18
I could pay that money out to the shareholders of the company, but that would really slow
16:19
my rate of growth going forward because I couldn’t afford to build and buy more lemonade
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stands and it’s not the $4,000 that I need in order to raise money.  So I'm going to
16:25
look at taking a business public.  What does that mean?  Well first of all, before we
16:30
take our business public we want to think about what it’s worth.??It’s year
16:34
five.  We’ve been doing a good job.  We’ve got a business that is profitable.  Everything
16:37
seems to be going well.  Well the problem is I've got some personal needs.  I've started
16:42
this company.  I've taken all the cash the business generates.  I've reinvested the
16:46
cash in the business.  I bought more and more lemonade stands.  The growth is accelerating.
16:51
 I feel great about it, but I need money.  How do I get money?  What do I do?  Well
16:57
I've got a company that generates a lot of cash each year, but I've been reinvesting
17:01
the cash, so one alternative is perhaps I don’t grow as quickly.  I don’t buy as
17:06
many lemonade stands and I start sending that money back to me in the form of a dividend.
17:11
 So each year I pay out some amount of cash in the company.  My need is really greater
17:17
than that.  There is only about $2,000 in the company today.  If I sent that out that
17:21
is half of what I need to by a car.  So how do I get the rest of the money or how do I
17:29
get more money?  Well I could sell the company, so that’s one alternative, but the problem
17:32
there is I've got this really good business.  It’s growing really quickly.  Why would
17:41
I want to get rid of it at this point?  So what should I do?  ??The other alternatives,
17:52
other than selling 100% of the business is to sell a piece of the business and I can
17:58
do that privately.  I can find an investor who wants to buy a private interest in the
18:01
company and if the business is worth enough I can sell them a piece of the business and
18:05
we can be successful.  The other alternative is I can take the business public.  Everyone
18:09
has probably heard of an IPO, an internet company is going public, people getting rich
18:14
on an IPO.  What is interesting is an IPO doesn’t make someone rich.  All it really
18:19
does is it takes a business that they already own and it sells a piece of it to the public
18:24
and it gets listed on an exchange like the New York Stock Exchange. ??An IPO, the
18:30
abbreviation stands for initial public offering and it’s initial because it’s the first
18:34
time a company is going public.  Going public means you’re selling stock to the broad
18:39
general public as opposed to finding one investor buying interest in the company and its offering
18:44
because you’re offering people the opportunity to participate and the way to do that actually
18:53
is you get a good lawyer.  You get a good bank, investment bank.  It’s going to be
18:59
your underwriter and you’re going to put together a document called a prospectus, which
19:04
is going to talk about all the risks and the opportunities associated with investing in
19:08
your company.  It’s going to have history of how the business is done over time.  It’s
19:13
going to have the balance sheet that we talked about.  It’s going to have income statements
19:17
from the previous several years.  It’s going to have cash flow statements and investors
19:21
are going to read that document and they’re going to learn about whether this is a business
19:26
they want to invest in and how to think about what price they want to pay for it. ??When
19:30
you decide you want to take your business public you’re going to have to reveal a
19:36
lot of information to the public in order to attract investors to participate and the
19:40
Securities and Exchange Commission they’re going to study this prospectus very carefully.
19:44
 They’re going to make sure that you disclose all the various risks associated with investing
19:47
in the company and you’re also going to have an opportunity to talk about the business.
19:50
 It’s some combination of a marketing document as well as a list of the appropriate risks
19:54
that people should consider before buying stock in the company.  That takes time to
19:59
prepare.  It costs money to prepare.  You’re going to need good lawyers.  You’re going
20:04
to need a good investment bank and you’re going to go through a process where you’re
20:07
going to make a filing with the FCC with a copy of the initial what’s called registration
20:12
statement for the offering or the prospectus.  The FCC is going to comment on it and eventually
20:17
you’re going to have a document that you can then sell shares to the public.??That
20:21
is kind of an exciting time for you because when you sell shares to the public that’s
20:22
really, in most cases, the way to get the optimally high price for the company, but
20:27
you don’t have to sell 100% of the business to the public.  In fact, typically you on
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