Larry and Barry are fictional characters which I have used in my monthly Chairman’s column in Venture, The Magazine for Business Owners and Entrepreneurs, and also in several published books and articles in this instructional essay. Larry is the young person asking questions and Barry is his wise mentor.
Larry: I want and therefore need some new sports equipment.
Barry: How are you going to get what you want?
Larry: My parents will give me what I want.
Barry: How will they get what you want so they can give it to you?
Larry: They will go to a store and buy it.
Barry: Two questions. Where will the store get the equipment and why will the store give your parents the equipment?
Larry: I don’t know.
Barry: The store buys what you want from another business, which either makes or buys the equipment and your parents buy the equipment by paying the store the necessary amount of money.
Larry: So where do my parents get the money to buy the equipment and what is money?
Barry: Money, which is sometimes called cash or currency, is a unit of exchange, which means something for something, which allows people to reward other people for doing something they want them to do.
Larry: Couldn’t my parents trade something the store wants for the equipment?
Barry: Great question. Yes, your parents could offer the store something they own or could create in return for the equipment you want. That could be some objects from your house, some of your mother’s jewelry or contributing some hours of work in the store. This sort of transaction is called barter and is probably the world’s oldest means of people exchanging things with each other. Basically, it is a deal, which means a transaction, of “if you do something I want for me, I will do something you want for you.”
Larry: But what if they don’t have anything the store wants or can’t agree as to what the value is of what they have versus what the equipment costs? Also, would they have to bring with them to the store whatever it is they are willing to trade for the equipment?
Barry: Yes, you get it. Such a barter trade would require inspection of whatever is being offered and a mutually agreed valuation. Therefore, in order to enable people to exchange goods and services money was created. People get paid money for services and merchants get paid money for goods, like the equipment you want. Your parents would have had to work in their jobs an amount of time to earn the amount of money necessary to buy the equipment you want.
Larry: So, money is the paper and coins my parents carry around with them so they can buy things and they get that money for doing things someone else wants them to do.
Barry: Correct, and the more money they have, the more things they can buy; and the harder and smarter they work the more benefit they will create for others and the more money they will receive.
Larry: But what is the money really worth?
Barry: That is a brilliant question. In some cases, the paper money is backed by and also convertible into precious metals such as gold.
Some coins themselves are made of precious metals such as gold or silver. For your practical purposes the value of a $1.00 or multiples thereof is how much it will buy in goods at a store or in services you want someone to do for you.
Larry: I get it. Money is only worth what it can buy and is used so that people can do business with each other in a convenient manner.
Barry: Yes, but there are other things money can do. Money can also earn money. Money can be used for a bet or investment. Money can be borrowed or loaned. Money can be a tool, a reward or a penalty. Money is and can be a lot of things and we will explore all of them.
Larry: Ok, so how does money make money?
Barry: If you have been paid an amount for doing something and do not have anything you need or want to spend the money on, you can deposit the money in a bank and receive a small amount of money as interest. Interest is a fee paid by the bank or borrowers for the temporary use of your money until you want it back.
Larry: How do I know the bank will give me back my money when I want it?
Barry: Another good question. In the case of a large and well-known bank it will probably be given back because the bank is government regulated and is required by law to honor its contract with you to return your money based on the terms of your deposit. In most cases you will be able to get your money back whenever you want from the bank, during business hours. In other cases, you may have agreed to keep the money in the bank for a specified period, in return for which the bank agrees to pay you a bit more interest, but will not give you your money back until the end of the agreed period.
Larry: Why is it so complicated? Why can’t I get my money back whenever I want it?
Barry: Because the bank is in business to loan your money and that of other depositors. From these loans the bank earns interest, which is really a use fee for the money, from the borrowers and those interest payments are at a higher rate than the bank is paying you as a depositor. Banks are in business to obtain deposits at a lower cost of interest than the banks charge their customers who want to borrow and use the funds. Since the bank takes the risk of their customers not repaying the money they borrow the bank gets a higher interest rate than it pays depositors because the depositors do not have directly any risk of the loan not being repaid.
Larry: So, if I don’t want to take any risk with my money I should keep it in cash at home or in the bank but not let the bank lend it to someone else?
Barry: Not quite, because the bank will normally be able to lend or invest its depositors’ funds, if only by purchasing government bonds or placing those funds with other banks and financial institutions. The bank is taking the risk and in return it earns a profit from its depositors’ money.
Larry: So, if I want to take some risk then I can loan my money directly to people wanting to use it.
Barry: Yes, that is possible but then you will have to investigate those people so that you are confident they will pay you whatever interest rate is agreed and the money back at the end of the loan period, which is called maturity.
Larry: You said that money can be bet or invested and I now understand that can be both good and risky. What I don’t understand is how money can be a penalty.
Barry: Money is a measure of value and that value is the buying power of the money. Therefore, if you bet or invest and lose, you are losing money or your buying power. You can also find that money is the measure of a penalty if you cause an accident and are not fully insured you may be required by a court to pay the damaged party an amount of money in compensation. Just remember what you have learned thus far and that is that money is a measure of buying power and the more money you have the more you can purchase or invest.
Larry: I keep hearing the word “business” and am not sure what a business really is.
Barry: A business is an organization or activity, which is owned by: a single individual, a group of people, an institution, a government or by other businesses. The objective of a business is to achieve and usually to earn a profit. To earn a profit the revenue of the activity must be greater than its expenses.
Larry: Must the profit always be money?
Barry: No. There can be Not-For-Profit companies but these have objectives of doing some form of social good.
Larry: So, what do businesses do to earn profits?
Barry: Businesses make things or provide services. Businesses must have customers to buy and pay for the things or services used. Businesses compete with other businesses to attract customers. They compete by the competitive novelty or quality of their products or services or by offering similar products or services as their competitors at a lower price.
Larry: How do the businesses do whatever is necessary to get customer orders?
Barry: The people or organizations forming the businesses must have or develop products or services to sell to customers. To do this the business owners and/or managers must hire or otherwise obtain the services of people having the ability to create those products or services.
Larry: How do the businesses pay for the people they need when getting started?
Barry: The business owners must either have and invest their own money in the business, borrow the money of others, or attract people having extra money to buy a part of the business.
Larry: Why would someone loan money to a new business or want to buy some ownership in the company
Barry: We are getting a bit ahead of ourselves but here’s the answer. Lenders make loans to earn a money use fee called interest. Banks pay interest to depositors, and governments and companies pay interest to investors who lend them money. The documents describing these obligations are called bonds, if the borrowing is longer term and notes if the borrowing is for shorter term. The organization borrowing money by selling the obligation has to pay an agreed amount of interest during the period before the lender, now called an investor, gets his or her money back.
Larry: So, because it is safer for the investor to lend money to a bank or the government than to a company or person, the investor will receive a lower usage fee, which is called interest, for making the deposit , because he believes that he is surer of getting the money back at the end of the contractual period.
Barry: Exactly correct, but more about investing later.
Larry: Ok, so what more do businesses do and are they always successful?
Barry: Businesses hire and manage people. They also obtain the necessary funding for their operations by borrowing or somehow otherwise getting the money necessary to pay their expenses of the business. Businesses also must successfully create products or services and be able to market these to customers at a price sufficiently high to cover the expenses of the business and to result in a profit. If they cannot do this during the period when the company has the money originally gathered, their business will fail and will have to be liquidated or sold.
Larry: Do most businesses fail or succeed?
Barry: Over time most businesses cease to exist, but this does not mean they necessarily fail. Businesses can be acquired or may no longer be of interest to the business owners because they have either met or failed to meet the business owners’ needs. The businesses can have been very successful and be acquired or they can just be a means for the founders to earn a living. Business owners have both product or service creation decisions to make as well as most importantly, marketing and pricing decisions. These decisions are how do we sell whatever it is we are offering and for how much, where and when?
Larry: Sure, seems complicated with lots of things which can go wrong for the business owner and therefore others.
Barry: It is challenging but very much worth it if the business is or becomes successful. The alternative for most people is to become employees and therefore never have the opportunities or risks of business ownership.
Larry: We’ve already started talking a bit about investing in businesses in our discussion of both money and business, as they are all related to one another. What more do I need to know about investment?
Barry: The answers are in the why and how of investing. People and organizations invest in order to benefit from an income return or capital profit on the amount of money exposed to risk of loss.
Larry: I don’t understand what income return or capital risk really means.
Barry: Capital is what the money used to buy an ownership interest in a company is called. It is also how the owners of the money describe the money they have available for investment. Risk is the possibility that the amount of money received after an investment is made will be less than the amount invested. The investor can lose all of the amount invested, if they do not receive any of it back or only have lost the use of the money if they only are paid the amount invested. In this case the investor would have suffered an opportunity loss, but not a capital loss.
Larry: What about the income return
Barry: The income return is the amount of money received, as a percentage of the amount of money deposited, loaned or invested, from the company or other organization having had the use of the money, in the form of interest, dividends or capital appreciation.
Larry: What are dividends?
Barry: Dividends are payments representing the share of a company’s profits which are distributed to its owners or shareholders as determined by the company’s Board of Directors.
Larry: What is the Board of Directors and who are the Directors?
Barry: The Members of the Board of Directors are elected by the shareholders of companies. The greater the percentage of ownership an investor holds the more influence the investor can have on the selection and approval of Directors. The Directors select the managers of the business and must approve the terms of employment of the managers as well as all important actions of the company. It is the majority of the Board of Directors which is most responsible for the performance of the company. The Chief Executive Officer and other officers of the company may also serve as Directors, but in the case of publicly traded companies it is more usual that a majority of directors will not be officers of the company.
Larry: What is capital appreciation?
Barry: Investment in the stock or shares of a company is usually only made by investors intending to sell the shares they have bought, at some time in the future when the success of the company will result in other investors wanting to own part of the company, at a higher price than the original investor paid for their shares. The difference between the investor’s cost and selling price is called capital appreciation and the shorter the time span between purchase and sale the higher the time-weighted percentage of capital appreciation.
Larry: So, the investor either expects to get a share of the profits earned by the company or a big gain by selling the shares purchased. Can the investor get both?
Barry: Yes, it is possible that a company can both pay dividends and that original investors will be able to sell their shares for a large profit. However, it is more usual for companies, especially technology focused companies, to reinvest their profits in the further development of the company, rather than to pay dividends.
Larry: Can investors either buy stock in or lend money to publicly traded or privately-owned companies?
Barry: Yes, of course, investors are free to take whatever action they believe to be in their best interest.
Larry: So, investors can either buy publicly trading stocks or mutual funds or let professional investors invest on their behalf
Barry: That’s correct.
Larry: Are there ways investors can be smart and invest in privately-owned companies?
Barry: Well, in my opinion, the best way of investing in privately-owned companies would be to use royalties, rather than buying stock in the company or lending money to the company.
Larry: How does this royalty thing all work?
Barry: The investor finds a privately-owned company in which the owners want to expand their business and need money to do so. The investor should agree that it is reasonable to believe that the amount of money sought will be sufficient to result in the company increasing its revenues.
Larry: Ok, so the investor likes the prospects for the company. Then what?
Barry: Then, the investor suggests that he or she could be interested in providing all or a part of the money needed if the company would pay a percentage of its revenues to the investor. A percentage of revenues used to acquire an asset, money in this case, is called a royalty and royalties have been used by investors and others for centuries.
Larry: So, if the revenues increase, the amount paid in royalties increases also? What happens if the investor is wrong and the revenues do not increase or cannot even be created?
Barry: It all depends on the terms of the royalty, but it is possible the investor will lose money.
Larry: How couldn’t the investor lose money if the revenues were significantly disappointing?
Barry: A royalty protecting the investor could have included terms whereby minimum royalty payments were assured by the company and/or others. The company could have paid someone to offer an assurance that at least the amount paid for the royalty would be paid by the end of the royalty payment period, thereby eliminating the capital risk, if the assurer was to honor their commitment.
Larry: That’s pretty neat. If the revenues increse the royalty owner gets paid ever increasing amounts and if they don’t it is still possible that some or all of the invested money gets returned.
Barry: It could work that way but even so the investor would risk an opportunity loss and the royalty payment period is likely to be 10 or 20 years. Of course, the terms of the assurance could be more beneficial for the investor, it all depends on the negotiation.
Larry: So, it all comes down to selecting the right companies from which to purchase a royalty. In any case, it is not just a bet on capital appreciation, which is probably a bet on the company being acquired at a good valuation.
Barry: Yes, and if the investor bought royalties from a number of royalty issuers the risks go down as the good ones will hopefully more than offset the bad ones. This is called diversification of risk.
Larry: Thanks Barry this has been time well spent and I know a lot more about Money, Business and Investment than I did before. Can I come back to you with more questions that I or some of my friends may have in the future.
Barry: Sure. Please do so through our friend and creator as below:
Arthur Lipper, Chairman
British Far East Holdings Ltd
858 793 7100
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