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So let’s begin.  Were going to go into business together.  Were going

  • to start a company and were going to start a lemonade stand

  • and now I don’t have any money today, so I'm going to have to raise money from investors

  • to launch the business.  So how am I going to do that?  Well I'm going to form a corporation.

  •  That is a little filing that you make with the State and you come up with a name for

  • a business.  Well call it Bill’s Lemonade Stand and were going to raise money from

  • outside investors.  We need a little money to get started, so were going to start

  • our business with 1,000 shares of stock.  We just made up that number and were going

  • to sell 500 shares more for a $1 each to an investor.  The investor is going to put up

  • $500.  Were going to put up the name and the idea.  Were going to have 1,000 shares.

  •  He is going to have 500 shares.  He is going to own a third of the business for his

  • $500.

So what is our business worth at the start?  Well it’s worth $1,500.  We

  • have $500 in the bank plus $1,000 because I came up with the idea for the company.  Now

  • I'm going to need a little more than $500, so what am I going to do?  I'm going to borrow

  • some money.  I'm going to borrow from a friend and he’s going to lend me $250 and were

  • going to pay him 10% interest a year for that loan.

Now why do we borrow money instead

  • of just selling more stock?  Well by borrowing money we keep more of the stock for ourselves,

  • so if the business is successful were going to end up with a bigger percentage of the

  • profits.

So now were going to take a look at what the business looks like on

  • a piece of paper.  Were going to look at something called a balance sheet and a

  • balance sheet tells you where the company stands, what your assets are, what your liabilities

  • are and what your net worth or shareholder equity is.  If you take your assets, in this

  • case weve raised $500.  We also have what is called goodwill because weve said the

  • businessin exchange for the $500 the person who put up the money only got a third of the

  • business.  The other two-thirds is owned by us for starting the company.  That is

  • $1,000 of goodwill for the business.  We borrowed $250.  Were going to owe $250.

  •  That is a liability.  So we have $500 in cash from selling stock, $250 from raising

  • debt and we owe a $250 loan and we have a corporation that has, and youll see on

  • the chart, shareholdersequity of $1,500, so that’s our starting point.

Now let’s

  • keep moving.  What do we need to do to start our company?  We need a lemonade stand.  That’s

  • going to cost us about $300.  That is called a fixed asset.  Unlike lemon or sugar or

  • water this is something like a building that you buy and you build it.  It wears out over

  • time, but it’s a fixed asset.  And then you need some inventory.  What do you need

  • to make lemonade?  You need sugar.  You need water.  You need lemons.  You need

  • cups.  You need little containers and perhaps some napkins and you need enough supplies

  • to let’s say have 50 gallons of lemonade in our start of our business.  Now 50 gallons

  • gets us about 800 cups of lemonade and were ready to begin.

Let’s take a new look

  • at the balance sheet.  So now weve spent $500 on supplies.  We only have $250 left

  • in the bank, but our fixed assets are now $300.  That is our lemonade stand.  Our

  • inventory is $200.  Those are the supplies and things, the lemons that we need to make

  • the lemonade.  Goodwill hasn’t changed at 1,000, so our total assets are $1,750 and

  • we still owe $250 to the person who lent us the money.  Shareholder equity hasn’t changed,

  • so we haven’t made any money.  All weve done is weve taken cash and weve turned

  • it into other assets that were going to need to succeed in our lemon stand business.

  •  

So let’s make some assumptions about how our business is going to do over time.

  •  Were going to assume were going to sell 800 cups of lemonade a year.  That’s

  • not a particularly ambitious assumption, but we should assume the lemonade business is

  • fairly seasonal.  Most of the lemonade sells will happen over the summer.  Were going

  • to assume that each cup we can sell for $1 and it’s going to cost us about $530 per

  • year to staff our lemonade stand.  

So now let’s take a look at the income statement,

  • so the income statement talks about the profitability, about the revenues that the business generated,

  • what the expenses are and what is left over for the owner of the company.  So weve

  • got one lemonade stand.  Were selling 800 cups of lemonade at our stand.  Were

  • charging $1, so were generating about $800 a year in revenue and were spending $200

  • on inventory.  There is a line item here called COGS.  That stands for cost of goods

  • sold.  We have depreciation because our lemonade stand gets a bit beat up over time and it

  • wear out over five years, so it depreciates over 5 years.  Weve got our labor expense

  • for people to actually pour the lemonade and collect cash from customers and we have a

  • profit.  We have EBIT and that is earnings before interest and taxes, of $10.  That

  • is kind of our pretax profit for the business.  We didn’t make very much money because

  • you take that pretax profit of $10 and you compare it to our revenues.  It’s about

  • a 1.3% margin.  That is not a particularly high profit.  Now weve got to pay interest

  • on our debts and we have a loss of $15 and then we don’t have any taxes, but at the

  • end of the day we still lose money.  

So the question is, is this a particularly good

  • business?  Well were losing money and our cash is basically going down over time.

  •  Is this a business we want to stay in?  Now the cash flow statement takes the income statement

  • and figures out what happens to the cash in the company’s till, so when you put up $750,

  • some money goes to pay for a lemonade stand.  Some money is lost selling the product and

  • at the end of the day we started with $750 and now we only have $500.  Let’s look

  • at the balance sheet.  What has happened?  Our cash has gone down from 750 to 500.

  •  Our fixed assets have gone from 300 to 240.  That means our lemonade stand is starting

  • to wear out.  Goodwill hasn’t changed.  We still owe $250 and our shareholder’s

  • equity is now down to $1,490, so it was the 1,500 we started with minus the $10 we lost

  • over the course of the year.  

So should we continue to invest in the business?  Weve

  • lost money in the first year.  Is it time to give up?  Well let’s think about it.

  •  Let’s make some projections about what the company is going to look like over the

  • next several years.  Let’s assume that we take all the cash the business generates

  • and were going to use it to buy more lemonade stands so we can grow.  Let’s assume were

  • not going to take any money out of the company and were not going to pay a dividend.  Were

  • going to keep all the money in the company and reinvest it.  Let’s assume that were

  • going toas we build our brand we can charge a little more each year, so were going

  • to raise our prices about a nickel, five cents more for each cup of lemonade each year and

  • then were going to assume we can sell 5% more cups per stand per year.  So weve

  • got built in growth assumptions. 

Now let’s take a look at the company.  So if

  • you take a look at this chart youll see in year one we started out with one lemonade

  • stand.  We add one a year and then by year five were up to seven because weve got

  • a big expansion plan.  Our price per cup goes up a nickel a year and our revenue goes

  • from $800 and starts to grow fairly quickly and the growth comes from increased prices

  • for cups of lemonade and it also comes from opening more stands.  So by year five we

  • have almost $8,000 in revenue.  Our costs are relatively constant, which is the lemonade

  • and the sugar.  That’s about $1,702.  We have depreciation as more and more stands

  • start to wear out over time.  Weve got labor expense, but by year five the business

  • is actually doing pretty well.  We went from a 1.3% margin to over a 28% margin.  The

  • business is now up to scale.  Were starting to cover some of our costs.  Were growing.

  •  Were still paying $25 a year in interest for our loan and we have earnings before taxes,

  • after interest of $2,300 by the end of year 5.  So we put $500 into the business.  We

  • borrowed 250 and by year five were making a profit of $2,300.  That sounds pretty good.

  •  Now we have to pay taxes to the government.  That is about 35% and we generate net income

  • or another word for profits of $1,500 by the fifth year and about a dollar a share.  

So

  • if you think about this our friend put up $500 to buy 500 shares of stock.  He paid

  • a dollar and after five years if our business goes as we expect he is actually making a

  • dollar a share in profit.  That sounds like a pretty good deal.  So what has been the

  • growth?  The growth has been fairly dramatic over the period and that is what has enabled

  • us to become a successful business.  Now these are just projections, but if theyre

  • reasonable projections this might be a business that we want to start or invest in.

Now

  • let’s look at the cash flow statement.  So as the business becomes more and more profitable

  • we generate more and more cash and the cash builds up in the company.  We go from $500

  • of cash in the company to over $2,000 of cash over the period.  The balance sheet, again,

  • the starting balance sheet had shareholder’s equity of $1,490, but as the business becomes

  • more profitable the profits add to the cash.  They add to the assets of the company.  Our

  • liabilities have not changed and the business continues to build value over time.  So again

  • by the end of year five weve got $4,000 of shareholder equity and that’s almost

  • three times what it was when we started. 
Now is this a good business or a bad business?

  •  How do we think about whether it’s good or bad?  One thing to think about is what

  • kind of earnings are we achieving compared to how much money went into the company.  Now

  • this is a business that we valued at $1,500 when we started.  Someone put up $500 for

  • a third of the company.  We gave it a $1,500 value.  By the end of year five it’s earning

  • over $1,500 in earnings, so that’s over a 100% return on the money that we put into

  • the company.  That’s actually quite a high number.  We spentlet’s talk about return

  • on capital.  Weve spent $2,100 in capital building lemonade stands and we earned $2,336

  • in year five on the capital we invested.  That’s over 100% return on capital.  That is a very

  • attractive return.  Earnings have grown at a very rapid rate, 155% per annum.  This

  • is really a growth company and our profitability has gone from 1.3% to 28.6% by year five and

  • that sounds pretty attractive and it is.  

So let’s look at the person who put up the

  • loan.  Well that person put up $250 and the business has been profitable.  Weve been

  • able to pay them their interest of 10% a year, $25 a year and theyre happy because they

  • put up $250.  Theyre getting a 10% return on their loan and the business is worth well

  • more than $250.  Weve got more than that in cash.  As a result, theyre in a safe

  • position, but theyve only made 10% on their money.  

Now let’s compare that with

  • the equity investor, the person who bought the stock in the company.  That person earned

  • a dollar a share in year five versus an investment of a dollar a share, so he is earning over

  • 100% or about 100% return on his investment versus only 10% for the lender.  So who got

  • the better deal?  Well obviously the equity investor.  Now why did the equity investor,

  • why do they have the right to earn so much more than the lender?  The answer is they

  • took more risk.  If the business failed the lender is entitled to the first $250 of value

  • that comes from liquidating the company, so if you sell off the lemonade stands and you

  • only get $250 the lender gets back all their money.  Theyre safe.  They got their

  • 10% return while the business was going.  They got back their $250, but the equity investor,

  • the person who bought the stock is wiped out because they come after the lender.

So

  • what is the difference between debt and equity?  Debt tends to be a safer investment because

  • you have a senior claim on the assets of a company and it comes in lots of different

  • forms.  Youve heard of mortgage debt on a home.  That’s a secured loan secured

  • by a house, but you could have mortgage debt on a building for a company.  There is senior

  • debt.  There is junior debt.  There is mezzanine debt.  There is convertible debt, but the

  • bottom line, it’s all debt.  It comes in different orders of priority in a company

  • and the rate your charge is inversely related to your security, so the better the security

  • and the less risk the lower the interest rate youre entitled to receive.  The more junior

  • the loan the higher the interest rate youre entitled to receive, but you can avoid the

  • complexity.  All you need to think about is debt comes first.  It’s a safer loan,

  • but youre profit opportunity is limited.

Now the equity also has their varying forms.  There

  • is something called preferred equity or preferred stock.  There is common equity or common

  • stock and again stock and equity are basically synonyms.  Theyre options, but really

  • not worth talking about today.  The important point is that equity gets everything that

  • is left over after the debt is paid off, so it’s called a residual claim.  Now the

  • good thing about the residual claim is that business grows in value if you don’t owe

  • your lender anymore, but all that value goes to the stock holder.  So the question is

  • why was the lender willing to take only a 10% return when the equity earned a much higher

  • rate of return and the answer is when the business started there was no way of knowing

  • whether it would be successful or not and the lender made a bet that if the business

  • failed they could sell off the lemonade stand.  It cost $300 to make it.  They would have

  • some lemons, some lemonade.  Even if they sold it at a much lower price than the dollar

  • they originally projected the lender felt pretty comfortable that they would get their

  • money back, whereas the stockholder is really taking a risk.  They were betting on the

  • profitability of the company and they were taking a risk that if it failed they would

  • lose their entire investment, so they were entitled to get a higher return or have the

  • potential to have a higher return in the event the business we successful.

So let’s

  • talk about risk.  Lots of different ways people think about risk, but the one that

  • we think is the most importantyou know a lot of people talk about risk in the stock

  • market as the risk of stock prices moving up and down every day.  We don’t think

  • that’s the risk that you should be focused on.  The risk you should be focused on is

  • if you invest in a business what are the chances that youre going to lose your money, that

  • there is going to be a permanent loss.  When youre thinking about investing your own

  • money, when youre thinking about one investment versus another don’t worry so much about

  • whether the price moves up and down a lot in the short term.  What matters is ultimately

  • when you get your money back will you earn a return on your investment.  

How do

  • you think about risk?  Well one way to think about risk is to compare your risk to other

  • alternatives, so you could buy government bonds and government bonds are considered

  • today the lowest risk form of investment and the US Treasury issues 10 year, 3 year, 5

  • year debt.  There is a stated interest rate and today a 10 year Treasury you earn about

  • a 3% return.  So you give your government $1,000 and you get $30 a year in interest.

  •  At the end of 10 years you get your $1,000 back, so that’s very, very safe and that

  • sort of provides a floor.  Now obviously if youre going to make a loan you can lend

  • money to the government and earn 3%.  Well if you can lend money to a lemonade stand

  • you want to earn meaningfully more, so in this case the lender is charging a 10% rate

  • of interest.  Why 10%?  Because they want to earn a nice fat spread over what they can

  • make lending to the government because a startup lemonade stand business is a higher risk business.

Equity

  • investors sort of think about things similarly, so the higher the valuationthe more risky

  • the business the higher the rate of return the equity investor is going to expect and

  • the lower the risk business the lower the return the equity investor is going to expect

  • and equity investors don’t get interest the same way a lender does.  What equity

  • investors get is they get the potential to received dividends over the life of a company.

  •  

Let’s talk about raising capital.  You started this lemonade business.  Now

  • the point of this was to make money in the first place.  The business is doing very

  • well yet I, having started the business coming up with a name and the concept, hired all

  • the people, I've made nothing, right.  So the business has grown in value, but where

  • is my money?  I need money to buy a car for example, so I want to buy a car for $4,000.

  •  What are my choices?  What can I do?  Well weve taken all the cash the business has

  • generated.  Weve reinvested it in the business.  Now the good news is weve taken

  • all that money.  Weve been able to use it to buy more lemonade stands and these lemonade

  • stands are more and more productive and it’s grown the value of the business faster and

  • faster.  Now my alternatives could included instead of growing the business so quickly,

  • instead of investing in more lemonade stands I could simply have paid dividends to myself.

  •  Now the good news about that is I get money along the way, but the bad news about that

  • is the business wouldn’t grow as quickly and if you have a business as profitable as

  • this lemonade stand company and you just open a new lemonade stand and people earnwe

  • can earn hundreds of dollars in each new stand it makes sense to keep investing.  

Well

  • how do I keep my business going and growing, taking advantage of the opportunities, but

  • take some money off the table?  How do I do that?  Well I could sell the company,

  • so I could sell my lemonade stand business.  I started this one in New York.  Maybe

  • there is someone in New Jersey who wants to buy me, consolidate with my lemonade stand