A few weeks ago, my wife, Annie, and I were having lunch with our 13-year-old son, Joe. Because he’s often curious about what I do at work, I decided to ask a question: Do you understand the difference between stocks and bonds? He had an answer which was generally correct but not entirely complete.
So, I asked him to pretend he had started a company that manufactures video games. His company is off to a good start but could grow faster if he built a factory and automated the manufacturing process. Unfortunately, he doesn’t have the money for this. What should he do? Well, he could get the funds by borrowing money or selling part of his company.
Borrowing money means going to a bank for a loan or directly to investors by issuing bonds. In many respects, bonds are the equivalent of a bank loan. A company sells bonds in exchange for a promise to pay the money back at a future date, and in the meantime, pays a stated level of interest along the way.
For Joe, there are a couple benefits to issuing bonds:
- He remains the sole owner of his company and keeps 100% of the profits.
- The cost of borrowing is potentially much less than the reward to Joe if the investment leads to increased profitability.
The main drawback is that he now has a debt which will need to be repaid (with interest).
On the other side of the transaction is the lender, and there is a couple of primary benefits to them:
- The interest payments received are agreed upon at issuance, and the return is known.
- Security: In the event Joe’s company doesn’t do so well, the bond holders get paid back before he does.
Selling a portion of his company is commonly done by issuing stock. A company often issues stock to raise capital necessary to expand their operation – similar to taking a loan or issuing bonds.
For Joe, the benefit of selling stock vs. borrowing is:
- He doesn’t have a debt to repay.
- Assuming he puts the money raised to good use, it should have a multiplication effect on his own share value.
The downside is, he now has other owners to answer to and share in the profits his company generates.
On the other side of this transaction, the new owners hope that Joe’s factory doubles the profits of the company and that the value of the stock doubles right with it.
The risk to the owner is that Joe’s video games stop selling and he goes out of business. The potential loss to the owner is 100%.
I asked Joe this question because naturally I want the best for him. Understanding the differences between being an owner and a lender is a foundational concept which will someday help him make his own investment decisions. As is the case for many investors, he will likely be both owner and lender, but understanding why and what to expect from both of these roles will help him succeed and have confidence along the way.