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Current time:0:00Total duration:11:20

Video transcript

in the last set of videos we've hopefully familiarize ourselves with the different ways that a company can raise capital it can do it through debt or equity and we learned that debt securities are often called bonds and equity securities you're probably familiar with those are stocks and then I left you with a cliffhanger and let me let me draw it so I don't get ahead of myself so these are the assets of a company and it was able to generate these assets so there's a couple of ways you can generate assets you can get investors through equity and we've done several videos on that you start with the angel investors or maybe your rich uncle and then you've entered good venture capitalists and you do an initial public offering and you can do follow-on offerings and so on and so forth now we see government's will buy equity in you if you are a bank that's too big to fail but we'll do a whole playlist on that so equity that's one way that you can get cash or get capital so that you can buy assets to run your business the other way is you can borrow money from people so the equity holders they become this these are actually the owners of the company so you might have been part of the equity holder you have to sell some of the equity or sell some shares in your company for someone else to give money and then they become kind of like your partner and the other way is you can borrow money let me draw that that will just put generally as liability debt isn't the only kind of liability but that's a pretty reasonable simplification for now there's other things and general liability means you owe something to somebody in the future liabilities not liability well yeah these are liabilities so these are liabilities and we'll assume right now that your debt is your main liability you might have other liabilities you might have some type of legal liability where someone is suing you or you know you had sprayed asbestos on a bunch of playgrounds thinking that it was actually good for the playground equipment and now you know there's all of this liability because well you get the idea but for now on we'll have the simplification that debt is your liability and we said well you know there's quite different kinds of debt if you securitize and it's often a bond right that'd be a certificate that says it's an IOU from a company it'll pay you coupons or interest and so forth or you could also just get regular bank debt where you owe the bank money and I left you with the question the last time around I said let's say this company goes into bankruptcy and let's say that these assets aren't worth what we think they are right in this world if we just have to sell off these assets fine the equity you know the debt guys would get paid off and then the equity guys would get left over with whatever else so let's say if this was if on our books so whenever you hear things like Book value and I've done a couple of videos on Book value vs. market value but the book value is essentially what you have it on your on your accounting books you say that this is worth 10 million dollars right let's say we've bought land and factories and whatever else worth 10 million dollars let's say your debt is six million dollars six million dollars and your equity would be worth four million dollars and let's say for whatever reason the economy turns south or you know maybe this was some type of you know business that's now not viable so it's going to go to bankruptcy and I'll get a little bit more specific on the different types of bankruptcy but we're assuming liquidation right actually I'll just get specific right now and sorry for the diet so when we say bankruptcy and bankruptcy is is probably it's a very common word and I think most people have a general sense what it means they know it's bad and it means to some degree that a company can't operate as it was before but there's a lot of confusion over what it means there's actually two types of bankruptcy there's liquidation liquidation and that's meant essentially saying that you know what this business doesn't it make any sense it doesn't make sense to have the employees and run the factories you're never going to make any money so you might as well just sell everything you have you liquidate it all that's one type and that falls in the category of chapter 7 and we're just talking about corporate bank bankruptcy right now there's also personal bankruptcy and we'll maybe we'll do a couple of videos on that it might be especially relevant in in this economy well the other type is reorganization or restructuring reorganization or restructuring and restructuring says you know what this Factory here it's actually making something useful it's Jax regenerating money and actually we can get more value for what we have here if we keep it running and we'll just keep it run and we'll restructure the company and usually that means changing this hand this side of it so maybe we'll cancel some debt and all of that and well show you how that's done in in a reasonably fair way but just to get just to understand kind of a simplified scenario let's take liquidation into consideration so let's say that this was my let's say that this was my website selling shoes online and then all of a sudden people have stopped wearing shoes it's it's just it's just gone out of fashion so it makes no sense anymore to sell shoes online so I'm just going to liquidate my assets my real estate that I might have my warehouses etc etc and my question that I left you with in the last video is who gets it so let's say when we liquidate it so we go into bankruptcy and it's essentially all of the assets are taken into possession by the Bankruptcy Court they're going to sell these assets and let's say when they sell them they don't get 10 million dollars for these assets they only get they only get I don't mean they only get 5 million dollars for them right I paid for I'm thinking that they were useful in some way but they end up not to be so my assets let me see if I erase them let me erase some things you know I just realized when I talked earlier about you know there's two ways to raise capital there's a third way to raise capital right you can sell shares you can issue debt you can borrow money obviously the third way is actually just make money right once you start a company hopefully you generate earnings and that'll also generate cash or capital that you can reinvest in the business and we'll talk about that but I just want to make it clear that that's obviously the best way to generate capital for your business is when the business itself generates capital so let's say that these assets when you actually sell them off aren't worth 10 million dollars anymore but they're worth we make the pointer smaller they're worth $5,000,000 $5,000,000 so my question in the last video is who gets this five million dollars do you somehow split it evenly between all of these people or does one of them get more of it or one of them gets less of it and I think you'll get a sense but based on how I where I took the five million out of who gets the money it's the debt holders and the way I drew it right here you can kind of view it as as you go up in this direction you're getting more senior more senior or if you're going down and this way you're getting more junior and seniority when you talk about a company's capital structure is just you know what if there's anything left who gets their money first and even within the debt you'll have different layers of debt though there might be different debt holders who have different levels of seniority so this one might be called senior secured debt senior secured debt senior means they're high up on the stack they're the one of the first people to get their their money and secured means that there's actually some collateral on the assets side that they get if the company can't pay so maybe this is like a piece of land right so just in kind of our everyday personal finance world your mortgage is actually secured debt it's secured by the collateral of your home if you can't pay the debt the bank comes and takes your home it forecloses on the property so that's what secured means it means that there's some collateral and in the event of a bankruptcy this guy can immediately go and get the collateral that his debt is secured by so this is considered a very very senior form of debt senior secured then you might have here you might have senior senior unsecured unsecured senior and there's a lot of words around you know senior junior subordinated and all of that but this is a good a sense that there's just a hierarchy here some people are the first people to get the money and then whatever is money left goes to this person then if there's any money left it goes to this person and then if there's anything left it goes to this person and once you're in bankruptcy court it does tend to be a negotiation between the different you can almost view a buckets of debt and we'll do a more complicated example in the future on that we'll actually delve into the details of bankruptcy but this is a general notion that the senior guys get made whole first then the more junior guys gets whatever's left and so on and so forth and if there's no money for the equity there's no money for the equity and that makes sense right because the debt holders you know all day we're getting their upside was just interest right so they're also should get limited downside and event things turn bad equity holders they kind of took a gamble things were great they would get all of the upside and now that things turned bad they take a lot of the downside and they're actually lucky that they don't owe money that's actually the I guess you could call it the beauty of a corporate structure that you have little liability and sometimes in history these people would actually owe the difference they would actually owe this extra million dollars that they can they'd all go to debtors prison and all that but we'll talk more about it in the future so anyway just going back on the different tranches of debt or buckets of debt so we could call this senior unsecured and that means that they're still senior they're still fairly high up the seniority ladder but they're unsecured there's no particular assets that they can go run but as long as there's enough for them don't get it so let's let me put some numbers here so let's say there was I don't know one million of senior secured let's say there's two million of senior unsecured and let's say that this is two million of subordinated subordinated subordinated just means they're not senior unsecured unsecured so in this reality what will happen is the Bankruptcy Court to liquidate all of this stuff and then they'll handled out an order of seniority these guys get their million dollars back so they're made whole and they probably charge a lower interest rate because they didn't perceive their risk that high to begin with these guys right here the senior unsecured they'll get the next two million and then there's 1 million dollars left right and that 1 million dollars will go to these dis support native debts so they'll get 50% of their money back so they took a little bit of a hit but that's okay because when things were good they probably got higher interest to to compensate them for the risk usually as you go as you get more and more junior and you take on more risk you get more upside or more interest and in this case the equity holders get nothing they get wiped out so it just goes to zero so that's that's the answer to the question I I said who gets the money well it's it's the debt holders get first dibs and if if there was actually let's see if there was I don't know if there was 7 million dollars here instead of 5 million then you would have paid so if this was 7 you would have paid the 6 off completely and then the equity holders would have gotten 1 million dollars and so they would have gotten something if there was enough money to hand it to them anyway in the next video I'll cover this was liquidation where we just say this isn't worth running let's just give it all away or let's sell it and give it back to our are our creditors the next video I'll talk about reorganization where we say hey you know what this business is a good business it just has too many liabilities and see you in the next video