|Understanding Capital Markets
Essentially, capital is wealth, usually in the form of money or property. Capital markets exist when two groups interact: those who are seeking capital and those who have capital to provide. The capital seekers are the businesses and governments who want to finance their projects and enterprises by borrowing or selling equity stakes. The capital providers are the people and institutions who are willing to lend or buy, expecting to realize a profit.
A CAPITAL IDEA: Investment capital is wealth that you put to work. You might invest your capital in business enterprises of your own. But there’s another way to achieve the same goal: Let someone else do the investing for you.
By participating in the stock and bond markets, which are the pillars of the capital markets, you commit your capital by investing in the equity or debt of issuers that you believe have a viable plan for using that capital. Because so many investors participate in the capital markets, they make it possible for enterprises to raise substantial sums—enough to carry out much larger projects than might be possible otherwise.
The amounts they raise allow busi nesses to innovate and expand, create new products, reach new customers, improve processes, and explore new ideas. They allow governments to carry out projects that serve the public—building roads and firehouses, training armies, or feeding the poor, for example.
All of these things could be more diffi cult—perhaps even impossible—to achieve without the fi nancing provided by the capital marketplace.
A DIFFERENT PERSPECTIVE: There are times when individual investors play a different role in the capital markets and become seekers, rather than suppliers, of capital. The best example is a mortgage.
Those providing capital
GOING TO MARKET: Sometimes investors buy and sell stocks and bonds in literal marketplaces—such as traditional exchange trading floors where trading deals are struck. But many capital market transactions are handled through telephone orders or electronic trading systems that have no central location. As more and more of the business of the capital markets is conducted this way, the concept of a market as face-to-face meeting place has faded, replaced by the idea of the capital markets as a general economic system.
PRIMARY AND SECONDARY: There are actually two levels of the capital markets in which investors participate: the primary markets and the secondary markets.
Businesses and governments raise capital in primary markets, selling stocks and bonds to investors and collecting the cash. In secondary markets, investors buy and sell the stocks and bonds among themselves—or more precisely, through intermediaries. While the money raised in secondary sales doesn’t go to the stock or bond issuers, it does create an incentive for investors to commit capital to investments in the first place.
OTHER PRODUCTS, OTHER MARKETS
The capital markets aren’t the only markets around. To have a market, all you need are buyers and sellers —sometimes interacting in a physical space, such as a farmer’s market or a shopping mall, and sometimes in an electronic environment.
There are a variety of financial markets in the economy, trading a range of financial instruments. For example, currency markets set the values of world currencies relative to each other. In this case, market participants exchange one currency for another either to meet their financial obligations or to speculate on how the values will change Similarly, the commodity futures market and the money market, among others, bring together buyers and sellers who have specific financial interests.
Those seeking capital
Many investors put money into securities hoping that prices will rise, allowing them to sell at a profit. But they also want to know they’ll be able to liquidate their investments, or sell them for cash at any time, in case they need the money immediately. Without robust secondary markets, there would be less participation in the primary markets—and therefore less capital could be raised. (Of course, there are also other reasons why investors may stay away from primary markets.)
THE PRICE IS RIGHT
One of the most notable features of both the primary and secondary financial markets is that prices are set according to the forces of supply and demand through the trading decisions of buyers and sellers. When buyers dominate the markets, prices rise. When sellers dominate, prices drop. You’ve undoubtedly experienced the dynamics of market pricing if you’ve ever haggled with a vendor. If the two of you settle on a price at which you’re willing to buy and the vendor is willing to sell, you’ve set a market price for the item. But if someone comes along who is willing to pay more than you are, then the vendor may sell at the higher price.
If there are a limited number of items and many buyers are interested, the price goes up as the buyers outbid each other. But if more sellers arrive, offering the same item and increasing the supply, the price goes down. So the monetary value of a market item is what someone is willing to pay for it.
In fact, price often serves as an economic thermometer, measuring supply and demand. One of the problems in command economies, in which prices are set by a central government authority instead of the marketplace, is that, without changing prices to clue them in, producers don’t know when to adjust supplies to meet demands, resulting in chronic overstocks and shortages.
Capital is the lifeblood of businesses, large and small.
Companies typically need capital infusions at several stages in their lives: at birth, as they grow, and if they’re facing financial problems. Fortunately, they can seek capital from several sources, though availability may vary depending on the age and size of the company. And each source has some advantages as well as potential drawbacks.
CAPITALIZING A START-UP
Imagine for a moment that you want to start a company. You’ll need capital to buy equipment, set up an office, hire employees, and attract clients, among other things. Most of the start-up capital—also known as seed capital—may be your own money. You may liquidate your investments, tap your bank accounts, or maybe even mortgage your home to get the capital you need.
The good thing about using your own capital to finance your enterprise is that you don’t incur any obligations to others, and you maintain control because you’re the only one with a stake. The risk, of course, is that if your business fails, all the money you lose is your own. And unless you’re unusually wealthy, there’s probably a limited amount of money you can—or are willing to—invest. A second major source for raising seed capital is friends and family or other early stage investors who are willing and able to commit money, either buying an equity interest or providing favorable-rate loans. As a group, they’re known as angel investors, though they may not all be saints.
Private companies may seek funding from venture capital firms—often referred to as VCs—that specialize in investing large sums at a particular stage of a company’s development. While some venture firms may assume the risk of backing start-ups, the majority invest in companies that seem poised for significant growth or that operate in a particular industry in which the VC firm specializes.
Venture capitalists are willing to take bigger risks than most other suppliers of capital because they have enough resources to make substantial investments in several companies at the same time. While each business by itself may pose a significant risk, if even a few succeed, the venture capital firm may realize large profits.
Most equity investors enjoy limited liability status. That means the most they can lose is the capital they put up. The distinction of being the first limited liability company goes to the British East India Company, which was formed in 1662.
Venture capitalists may consider hundreds of businesses before they find the handful that show the right potential. They then provide an infusion of capital in exchange for part ownership, or equity, including the right to share in the company’s profits. Ownership rights also give venture capitalists a say in how the companies they invest in are run, and, in some cases, there may be provisions for additional controls or increased equity if certain financial targets are not met.
Venture capital involvement isn’t necessarily a bad deal for a company, however, since VCs generally have experience in a particular market and can provide valuable insights, business contacts, and financial management. But in accepting capital from outside investors, businesses do concede a degree of control to their new partners. Venture capitalists also play a major role in determining what happens to the companies they invest in. Typical resolutions include a merger with or acquisition by a larger firm or an initial public offering (IPO).