EconomicRiddleTwo

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Company-building

Tom, Dick, and Harry decide to start a software company. They sell half the company for $1 million dollars to investors. The investors now have $1 million worth of stock; Tom, Dick, and Harry now have $1 million worth of stock; and the company has $1 million in the bank.

Where did the extra $2 million come from? --StanSilver

I don't think I understand:

 Before. Tom&co have $2M stock; investors have $1M in bank. => $3M 
 After. Tom&co have $1M stock and $1M in bank; investors have $1M stock => $3M

Seems to sum to me. -- SunirShah

This riddle is a bit more interesting, as stock is often easily convertable to money. As I see it, the "extra" amount is only $1 million, however. Here is the scenario:

 Before

Tom&co have 100% control of the corporation; investors have $1M in bank. => $1M

 After

Tom&co have 50% control of the corporation and $1M; investors have 50% control. Presumably, Tom&co could sell the other 50% for $1M and have $2M in the bank (and no control).

In some ways, this is similar to the house-building riddle, except that the valuable creation is control of the corporation.

One reason I find this interesting is that much of the value of some companies (famously "internet" companies) is this "extra" value. For instance, a company might make only 10% of its shares available for public trading. Suppose there are 10M shares, and only 1M are publically traded. The stock price is $30, so the company is valued at $300M. However, only $30M of stock has been bought by the public. If the company tried to quickly sell another 5M shares (out of its 9M holdings), they would probably drop the price significantly.

Yet another interesting quirk happens when a company decides to create more shares (not by splits, but by issuing more new shares). This practice (called "dilution") reduces the control of the existing shareholders, but it can often be approved by a majority of shareholders. --CliffordAdams

The point I was trying to make was:

 Before. Tom&co have nothing; investors have $1M in bank. => $1M 
 Then. Tom&co have $2M stock; investors have $1M in bank. => $3M 
 After. Tom&co have $1M stock and $1M in bank; investors have $1M stock => $3M

How do you get from before to then? We have decided effort can be turned into money (sold), but Tom&co sure don't exert $2M worth of effort between startup and IPO. --StanSilver

The short answer is: the investors believe that Tom&co have created $2M of value in that time. That value is probably not immediate, but the investors believe that Tom&co is their best investment. If the investors could reproduce Tom&co's value for much less than $2 million, they would do better to reproduce it ("steal the idea") and have 100% control. Forces like patents, specialized expertise, time-to-market, or even just catchy trademarks can easily cost more than $2M to reproduce. --CliffordAdams (who remembers Yahoo! when it was two guys with some bookmarks, not a $50 billion company)

Yes, I agree. I believe that Tom&co have created $2M of value in that time, but not by $2M of effort. My belief is that the $2M represents the net present value of the future earnings of the company they created.

This is interesting. Assume net present value of an income stream can be approximated by "how much money in the bank would generate the same cash flow". Thus, at 10% interest, 50,000 a year has a net present value of $500,000.

Also assume you have ten programmers, each making $50,000 a year. Total income is $500,000 a year. Total net present value is $5M. Then, the programmers shake hands, agreeing to form a company that will make $2M a year. The new net present value is $20M. Poof. $15M created by ten people shaking hands. --StanSilver (anybody want to shake hands?)

Starting with slightly different premises:

Tom, Dick, and Harry decide to start a software company. They have a great idea that would be worth $2 million + their salaries and expenses, but it will cost $1 million to get off the ground. Without the $1 million to back it up, the idea is worthless.

So the company sells half of itself for $1 million dollars to investors. The investors now have $1 million worth of stock; Tom, Dick, and Harry now have $1 million worth of stock; and the company has $1 million in the bank.

Where did the extra $2 million come from?

Yes, $2 million is created. The transaction made the $2 million idea possible, and that is reflected in the stock. The $1 million may be spent soon, but workers and suppliers will get the money, so it will not disappear. (In other words, we can expect this $1 million to be created via EconomicRiddleOne, if necessary. Of course, there are similar processes for destroying money.)

It should be noted that $2 million of stock is NOT quite the same as $2 million of cash money -- nobody (knowledgeable and sane) completely relies on being able to sell a stock for the same price a month from now as it is worth today, whereas most people rely on being able to withdraw the same amount from a bank a month from now as they have today.

-- JasperPaulsen

CategoryEconomy

EconomicRiddleTwo

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