Before understanding about the ‘what’ and ‘how’ of the stock market, let us understand the ‘why’ of the stock market.
When a company wants to expand its business’ reach, develop new business, or diversify in any field it needs capital (money) which can sometimes be more than the net profit it earns. The company now faces a dilemma of figuring out how to raise enough capital.
There are 2 ways to raise capital:
- Debt Financing (Taking a loan)
- Equity Financing (Selling its part ownership)
In this method company can just take a loan from a bank and pay it back with the interest. However, this way company is put to a little risk. The company after taking the loan has to make sure to have steady cash flow so that it can make regular payments of the interest. Failing to do so makes the company vulnerable to bankruptcy. Still, companies do take to this method to raise capital, if it continuously has surplus net profit.
In this method there are no loans or interest, but a part of the ownership is sold (known as equity) for the capital raised for the growth of the company. There are two distinct ways in which these take place.
Angel Investors or Venture Capitalists:
Part ownership of the company is sold to a person (Angel Investors) or a firm (Venture Capitalist) for the seed money the company requires to grow. The Angel Investors and Venture Capitalists mostly invest in a company in its early stages based on the potential of the company’s growth.
Initial Public Offering:
Later when a company is big enough the company can go to the public (Retail Investors) for the investment. In this process the company reduces the current shareholders’ equity (diluting their equity) and issues it for the public to buy. The percentage of equity of the company is divided into ‘n’ number of shares.
For example: 20% of stock is divided into 1,00,000 shares. Therefore buying 1 share make the investor 20/1,00,000 = 0.0002% owner of the company.
This process of issuing stock to the public as shares is known as IPO (Initial Public Offering).
These shares then have to be bought and sold somewhere, right? Hence the stock market came into being.
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