Module 9: Intro to Finance

Lesson 1: What is Money?

Introduction

This lesson will introduce you to the concepts of value, money, and financial statements.

Money and Value

To discuss the definition of money, we first need to define the concept of value, which is the perceived benefit derived from a good or service. For example, one may value apples for their intrinsic capacity as food. Money is a way in which we can measure value, and serves three main functions:

  • Unit of account: Money can serve as a direct numerical measurement of value for a good or service, acting as a standard description of value.

  • Medium of exchange: A useful form of money is accepted by a large number of participants in a market.

  • Store of value: Money should "generally" be stable relative to most of the goods and services it is exchanged for.

Money has had many forms throughout history, and we refer to physical money as currency. Some earlier forms include precious metals, gems, and seashells, which we refer to as commodity money. Later, we began to create money that represented discrete portions of those commodities which we call representative money.

In more recent years, most countries have moved away from representative money in favor of fiat money, which derives its value only from a government promise to back its value. While fiat money has no intrinsic value, it is beneficial as a medium of exchange within a country. For more on this topic, investigate the Breton-Woods System and Nixon Shock.

Even more recently is the development of cryptocurrencies, which have exploded as a medium of exchange. Cryptocurrencies derive their usefulness as money from highly secure networks of computers solving difficult math problems. They are primarily a response to the 2008 Great Recession in which several governments printed a glut of new money (thus causing a fall in value from the excess supply). This was to an effort necessary to jumpstart the economy again, but it had the side effect of creating doubt in the role of government in managing the value of its own currency.

Most currencies also have three other properties, which are not necessary, but useful:

  • Fungibility: Each unit of currency is interchangeable

  • Scarcity: The currency is not easy for everyone to create more of, as generating more currency can debase its value

  • Portability: Currency should be easy to transport and exchange between parties.

Activity: Phone a Friend

Phone-a-Friend

In the first section of this module, we began exploring the definitions of value, money, and currency. These three concepts are often used interchangeably in colloquial use - how well do those around you know the differences?

Instructions

As a conversation starter amongst friends or family, ask What is money? Do their answers differ from what you've learned in this unit? How do their life experiences alter their definition?

Financial Statements Used in Accounting

A company is a group of people endeavoring the advancement of a commercial or industrial purpose - that is, they are working together to create something of value. Companies can be public or private, with public companies being ones in which ownership can be purchased on an exchange. Both public and private companies are regulated by their industry, type, and scale by different departments of government. They raise financial capital through various means in order to provide goods or services. The two main fundraising vehicles are the issuance of bonds (selling debt, equivalent to taking out a loan) or selling shares (selling equity/ownership in the company). Smaller companies such as startups generally raise money through seed, angel, or venture capital (VC) investment.

Regardless of size, all companies require accounting, which is the practice by which governments, companies, and organizations measure their financial state. As a company grows, it is subject to ever more strict accounting standards, and public companies are required to report their accounting every year through official 10K (annual), and 10Q (quarterly) reports.

Accounting reports generally require three documents which we will cover here. However, there is far more to learn in a full accounting course! Those documents are the balance sheet, the income statement, and the cash flow statement.

The balance sheet is a statement of who owns what capital in the form of assets and liabilities. It tracks the fundamental accounting equation: Assets = Liabilities + Equity. Assets are the physical and nonphysical resources owned by the company that adds a positive value to the balance sheet. They include things such as cash, real estate, and copyrights. Liabilities are similar to assets but are resources that add negative value to the balance sheets. These are items such as loans, wages owed, or the purchase of another company. Finally, equity is the leftover if all of the company's assets were sold, and debts were paid off (i.e., Equity = Assets - Liabilities). An example would be that if you were to purchase a home worth $200,000, and took out a loan for $160,000. Your equity in the home would be the $40,000 down payment. If the value of the house were to increase over the loan period, your loan is already contracted to a specific value, and thus your equity would increase. For those interested, there is also an expanded accounting equation that takes into account other features of a company's balance sheet.

The income statement is a statement of the total revenues and expenses for the company. It will also often be referred to as the P&L (pronounced P-N-L) statement. Where the balance sheet tracks all of what the company owns, as well as who owns it (i.e., assets and liabilities), the income statement tracks the company's performance in terms of money made (or lost!).

In the income statement, it all boils down to Net Income, which equals revenues (money made from selling things) minus expenses. Expenses for a company include typical things like the costs of purchasing from their suppliers (categorized as “cost of goods sold”), salaries and employee compensation (categorized as “general and administrative”), or real estate lease costs. For firms that borrow and thus have debt on the balance sheet, they also have to subtract the expense of paying interest on those loans. There is another expense known as depreciation, but this is an accounting concept that we don’t need to visit in detail (basically, it’s an expense whereby you subtract out the costs of buying large equipment or real estate over time, rather than all upfront. This has to do with tax rules).

The income statement gives investors a “bottom-line” answer as to whether the company earned (or lost) money, and if so, how much. For that reason, the income statement is often used in what is known as Fundamental Analysis, which we will discuss in a later section. We will often calculate the earnings-per-share (EPS) by dividing the total earnings of the company by the number of shares available.

The third and final statement, the cash flow statement, is used to understand the short-term viability of a company through demonstrating how changes in the balance sheet and income statement affect cash coming into and out of a company. In general, one can derive a cash flow statement from the combination of the balance sheet and income statement. The three major parts of the statement are the cash from operating activities, investing activities, and financing activities. For more on cash flow statements and what is contained in those activities, check out the Investopedia page.

Activity: Find a set of Financial Statements

Find a Statement

Now that we've discussed what is in a set of the most rudimentary financial statements let's explore what a real 10K or 10Q looks like.

Instructions

Using EDGAR or a Google search, try to find a copy of a company's 10K or 10Q. Identify the three major statements within it. Are there any line-items that you haven't heard of? What are additional items contained in an official document that we haven't covered here?

Lesson 2: What is Risk?

Introduction

In this lesson, we will explore the concepts of risk and its relationship with returns for investments.

Defining Financial Risk

In investing, there is always some unpredictability in the outcome, such as whether our financial return becomes much higher or lower than expected. We refer to this unpredictability as uncertainty. For several different types of financial instruments, we will calculate the volatility of the instrument over a period of time as the measure of uncertainty.

This uncertainty can lead to large gains or losses in capital, which we refer to as risk. In many cases, we will use the calculated volatility as a stand-in for risk. However, depending on the specific type of risk we would like to model, we may approximate it in different ways. This module will cover several of the most commonly discussed types of risk.

Activity: Self-Research

Risk Self-Research

Now that we have discussed what risk is in general, are there any particular types of risk that you find interesting?

Instructions

Make a google search for types of risk. What kinds of risks did you find? Which of those pertain to financial risk? Of all of the types that you found, are there any that are fascinating to you, and why?

Types of Risk

Volatility Risk

In securities trading (e.g., in the stock market), there are two principal types of risk we are concerned with: systematic and non-systematic risk. Systematic risk (not "systemic") is the risk associated with the market as a whole, and cannot be diversified away in any particular market. Consider an index such as the S&P500, which tracks the top 500 companies by market cap. If the index plummets, it suggests that the overall market is losing value simultaneously. Non-systematic risk, sometimes referred to as idiosyncratic risk, is associated with an individual instrument. For example, if you own shares of Tesla, the value might fluctuate wildly relative to the CEO publishing tweets, regardless of what the market did that day. This risk can be diversified away (mitigated) by including the instrument in a portfolio with other investments.

Default Risk

One of the ways banks make a profit is by making loans to individuals or families. However, how can they know that they will be paid back? Any company that makes loans is likely to assess the credit risk of those they make loans to. In the U.S., we often utilize a calculation created by the Fair Isaac Company (FICO Score) to assess "creditworthiness". Any method of assessing a person's likelihood of paying back a loan is fair, as long as the features used in the assessment do not violate legal statutes for specific types of discriminatory practices.

Liquidity Risk

Imagine you own a real-estate company. After you have received your seed capital, you rush out and buy up as many properties as possible in order to establish yourself in a region, and in the process, you completely exhaust your cash on hand. Later, a large bill comes in the mail, which you are incapable of paying because you have no cash on hand. You now have to sell one or more of your properties to raise enough cash to pay for this bill; however, it will take some time to be able to receive the cash from the sale due to how slow real estate transactions operate - which refer to as the “illiquidity” of the market. In order to accelerate finding a buyer, you may need to sell one of your properties at a loss. The risk of finding yourself in the situation without enough cash on hand to cover debts is referred to as the liquidity risk. Liquidity risk is important for all companies to assess (especially banks) as they may need to take out high-interest short-term loans in order to cover debts in the near term, which can affect profits.

Activity: Risk Reflection

Risk Reflection

In the previous section, we had you research types of risk, and in this one, we defined a few that are useful for this course. Of all of those, which are relevant to your day-to-day experiences?

Instructions

Consider your current company (or a friend's company if you're not currently working), what kind of risks is that company exposed to? How do they mitigate risk? What kinds of risks that weren't discussed here are relevant to your role?

Risk vs Return

If we're given a choice of three different portfolios that all had the same estimated return, how would you decide which was best to invest in? Generally, the investment that gives the most return per its amount of risk is considered the smart choice. To make this assessment, we will often calculate the Sharpe ratio of the investment, which is simply dividing the total return by the volatility of the investment. We can also calculate a similar metric known as the Sortino ratio, which only incorporates the downside risk. A third ratio we may utilize is the Information ratio (IR), which will compare performance relative to some benchmark like the S&P 500.

In addition to these ratios, we can also utilize the Capital Asset Pricing Model (CAPM) to model the expected return of an investment relative to its risk. The model can be expressed at a high-level as:

Expected Return = (Risk-Free Rate) + (Beta * Market Risk Premium)

Where the risk-free rate is often the interest rate (yield) on a short term government bond, Beta is equity beta (how much—e.g., one-for-one or twice as much—a particular stock moves in proportion to the broader equity market), and the market risk premium is the difference between the risk-free rate and the expected return of the market. The market risk premium can be considered to be a descriptor of the long-run return expected by the equity market, over and above short term government bonds (the riskless rate).

Essentially, the CAPM states that an investor expects an equity return to be at least what she can get from a risk-less investment, plus an extra amount for taking on the risk of the stock. However, not all equities are equal: higher beta stocks are proportionally riskier since a higher beta means that they fall more deeply whenever there's a market downturn. Greater reward (higher long-term returns) are therefore expected in order to compensate an investor for holding that type of higher beta, higher risk stock.

Activity: Ratio Deep Dive

Ratio Deep Dive

Now that we have begun discussing different ways to compare investments, are there any methods that we haven't listed here?

Instructions

In this unit, we described the Sharpe, Sortino, and Information Ratios. Are there any other ratios you can find that are useful for comparing across portfolios? What information do they allow us to compare different potential investments? When would you use them?

Lesson 3: Investing

Introduction

In this lesson, we will begin introducing some of the core concepts related to investing, why we want to invest, and some of the ways we can compare potential investments.

Inflation and Investing

For a variety of reasons the cost of goods and services in a market will increase over time, meaning that one dollar will buy less of a given good or service over time. We refer to this process of the devaluing of money over time as inflation. We often measure inflation using the consumer price index, which essentially is an index that tracks the prices of a basket of goods and services over time. The central bank (a part of the government) attempts to keep inflation from getting too high in part through manipulation of the supply of money.

Due to a fear of inflation and a desire to generate profits, individuals and companies seek to make investments - purchase of an asset that will (hopefully) be worth a higher value at a later date and/or produce a stream of profits. All investments involve some amount of risk and thus are expected to make returns that are higher than the rate of inflation. In some investments, like loans, the interest rate is directly related to the amount of risk associated with the investment. In others, the reward to risk profile is less present, but still there. For example, equity investments in a company will often pay period cash flows (a dividend) and also increase in price over time. The riskier the equity, the higher the dividend yield, and anticipated future stock price. Equities are riskier than loans, and thus tend to have higher investment returns. Generally speaking, this means that while equity investments may not outperform bonds from one particular month to the next, they can be expected to outperform over the long run (e.g., 2 to 10+ years).

Activity: Inflation Reflection

Inflation Reflection

Now that we have discussed the implications of inflation on the value of money, let's consider how that affects us on a personal level.

Instructions

Consider your own personal investments, and your annual salary increases. Are you keeping up with, or beating inflation? How much larger would your annual increases need to be in order to avoid devaluation? If you're not currently employed, do research on the average entry salaries for the roles that you would like to take on. How much would those salaries need to increase each year to stay ahead of inflation?

Time Value of Money

Which would you rather have: 10,000 today or 10,000 next year? If you had to choose one, you'd probably select today, because if you did, you can take that money and invest it. By the end of a year (if you invested wisely), you'd end up with more than $10,000. This is the time value of money: there's a benefit to having money now, rather than later.

We quantify that benefit from interest rates or the expected percentage return on capital. Put it this way: Would you rather have $10,000 now, or $10,010 a year from now? The latter option doesn't sound very appealing, does it? Indeed, that's only one-tenth of a percent of return. That doesn't even beat inflation--you'd effectively be losing money! But how about this: $10,000 now, or $15,000 in a year? A 50% annual return sounds pretty appealing.

These rates, 0.10%, and 50%--are interest rates or rates of return. In a competitive market, what goes into determining a particular interest rate ultimately depends on the alternative options the borrower and lender both have. If there's a lot of money looking to be parked somewhere, and no one really interested in borrowing, interest rates will drop. If people expect inflation to be really high, they'll only lend their money out if the interest rate is high enough to compensate them for that.

There's a way to compare money today versus money tomorrow. Money today, or in the present, is called Present Value, or PV. Money tomorrow, or in the future, is called Future Value, or FV. The two are linked by the expected return each time period. For example, to find out what $10,000 is worth 5 years from now, assuming a 10% annual return and assuming that profits are reinvested annually, we use this formula:

FV = PV * [1+(i/n)]^(n*t)

Where FV is the future value, PV is the past value, i is the interest rate, n is the number of compounding periods within a year, and t is the number of years:

FV = $10,000 * [1+(.10/1)]^(1*5)
FV = $10,000 * (1+.10)^5
FV = $16,105

Here, we assumed that our returns were re-invested each year. If we put these re-invested returns to work more quickly (perhaps if we received dividend payments every quarter, reinvesting as soon as they were received), our compounding period would be shorter. Since this means we'd be investing capital earlier, a more frequent compounding period means that we'll end up with slightly more investment return in the future. Taking the same example above, returns were the same, but the returns were re-invested quarterly, instead of annually (so that the annual 10% return were received and re-invested in four equal installments each year):

FV = $10,000 * [1+(.10/4)]^(4*5)
FV = $10,000 * (1+.025)^20
FV = $16,386

The annual return was the same, but we ended up with $281 more after five years because we consistently had a bit of a head start when re-investing those returns. This is why compound returns are important.

It's important to note that if you rearrange the above formula, you can solve for present value:

FV = PV * [1+(i/n)]^(n*t)
-->
PV = FV / [1+(i/n)]^(n*t)

A lot of financial models for valuing stocks, companies, and even real estate use this formula. Consider why with a simple example: If there was a building for sale that you knew would be worth $100,000 next year, but you were only considering investments yielding at least a 10% return, what's the maximum price you'd offer to buy it for?

 Future Value: You expect it's worth $100,000
 Your Required Return: 10%
 Time Horizon: 1 year
 Compounding Period: 1 (only at the end of the year do you finally sell the building and earn any cash)

 Using the Formula:
 PV = FV / [1+(i/n)]^(n*t)
 PV = $100,000 / (1+.10)^1
 PV = $90,909

You'd pay no more than $90,909 to acquire the building. Anything less, and your expected return would fall below 10%.

Real estate is not the only area that uses the present value to evaluate investments. Investment bankers use present value when trying to figure out how much a company might sell for. Venture capitalists estimate present value on more established start-ups to estimate how much a given equity funding round is worth. Stock traders will use their forecasts for what a stock will be worth in the future to estimate a fair price to pay for it today. In practice, the approach is a bit more involved for each of these scenarios (for example, a stock trader would need to find not just the present value of the expected future price of the stock, but also the present value of each expected dividend received while holding it), but the basic formula and principle is exactly the same. Present value is an important and frequently used concept in finance.

Activity: Calculate TVM

Calculating TVM

In order to build some familiarity with the TVM equation, let's run through a quick practice problem

Instructions

You are presented three opportunities for investment:

  • An investment that will be worth $20,000 after 2 years, compounding semi-annually at 5% interest

  • An investment that will be worth $15,000 after 1 year, compounding only once at 4% interest

  • An investment that will be worth $18,000 after 1 year, compounding semi-annually at 8% interest

Which investment values your present cash the highest? Which one seems riskiest? Which would you want to invest in? (Hint: This question does not have a straightforward answer)

Modern Portfolio Theory

Now that we’ve talked about both risk and investments, we should discuss how to manage them together as part of a larger portfolio.

Imagine a portfolio containing three stocks that each achieve an annual return of five percent. However, all three of those stocks have a tendency to not move together on a daily basis: on a given day, one stock may have a positive return, whereas another will have a negative one. In other words, on a day-to-day basis, some of the ups and downs get "washed out", even if, over the long run each stock individually reaches 5%.

Therefore, if you absolutely knew that each stock's annual return was going to be 5%, would you be better off by buying only one stock, or a combination (portfolio) of all three? Does it matter?

As it turns out, it's wiser to have a portfolio of all three. That's because even if you knew both investment options would return 5% at the end of the year, the portfolio option is a lower risk bet: on any given day during that year, the value of that option will fluctuate less. You'll be more secure on a day-to-day basis the value of your investment.

Let's put it this way: Suppose you could choose two stocks, A or B. Both cost 5,000 initially, and both will be worth 10,000 in a year. You can wait a year, or you could sell and cash out anytime before that at whatever each is worth at that time. However, on any given day, Option A might range in worth from 2,000 to 8,000, whereas Option B will only range in value from 4,000 to 6,000. If you had to choose which one would you buy?

Unless you just like thrills, you'll probably select Option B. That's because it ultimately offers the same financial return ($10,000) for the same cost, but offers much less volatility (or uncertainty about what you could sell it for if you had to) in the meantime.

This is the essential idea behind Modern Portfolio Theory (MPT). A portfolio or asset is not only evaluated based on the returns that it makes, but also on how risky, or volatile, it is. Moreover, because some assets are less correlated with each other (when one goes up, the other goes down, and vice-versa), different investments can be strategically combined into a portfolio to reduce overall portfolio volatility.

Modern portfolio theory (MPT) helps us to optimize our return for given risk tolerance. The less tolerance we have about interim financial performance, the more we'll seek out assets that have lower volatility or that move less in tandem with the other investments that we have (less "correlation"). Wherever possible, we'll always try to find investments that have strong expected returns, yet each exhibits short-term performance that does not align with each other.

In sum, within MPT, we often analyze the volatility (large short-term movements in value) of individual stocks in order to understand their risk. We also evaluate the correlation stocks or how they move in comparison to each other. By balancing the assets in a portfolio, the risk associated with any given asset is partially mitigated by other assets. An ideal portfolio should attempt to not only produce strong returns but also minimize risk both as a whole.

Last, one of the most central ideas of MPT is the concept of an Efficient Frontier. When you have a lot of different individual investment choices, you can basically build any number of different portfolios, each a different combination of these individual assets. When plotting each potential portfolio's projected returns on one axis, and its projected risk (volatility) on the other, we can show a set of different portfolio options. From here, we can draw a curve, that for each level of risk, tells us the best portfolio (highest return) to select. This curve is the Efficient Frontier: the portfolio that provides the best return for a given tolerance of risk. The Efficient Frontier is used frequently in quantitative equity portfolio management: stock managers will select how much money to invest in each individual stock ("portfolio weightings") so that the expected return of the resulting portfolio is as high as possible for a given level of risk.

For those interested in taking a deeper dive into the updated Post-Modern Portfolio theory, definitely take a look into the Wikipedia article as delves into many of the fundamental statistical issues with MPT.

Activity:

Portfolio Comparisons

Now that we have discussed some of the core concepts in investing let's take a moment to look back at some of the themes we've covered so far with regards to making comparisons across potential investments.

Instructions

In this unit, we have covered Modern Portfolio Theory along with the Time Value of Money. In prior sections, we also discussed Sharpe Ratios, Sortino Ratios, Information Ratios, Volatility, and the CAPM model.

What does each of these pieces of information tell you about a portfolio that you may want to invest in? How can you use them to compare across multiple portfolios? Are there any metrics that you would give more or less weight to? How might you use these pieces of information to develop investment strategies?

Lesson 4: Markets

Introduction

In this lesson, we will discuss some markets for investment securities. In particular, we'll go into some detail about equity markets, insurance markets, derivatives, currencies, and real estate.

What is a Market?

Quite simply, A market is a place - physical or digital - that people gather in order to exchange goods or services. While there are many different types of markets, we will explore only a few of the most prominent ones here.

Investing in Companies

Securities are tradable financial assets that derive their value from one of three main sources: the equity of a company, the debt of a company, or a derivative of one of the previous two.

In one of our previous modules, we learned that companies raise capital by selling either equity or debt. In the case of selling equity, the financial instrument used to make a sale is referred to as stock. Generally, the owners of stocks have some say in how the company is run because the stock represents partial ownership of the company. Stocks are often traded on the market, known as a stock exchange. In the U.S., this includes exchanges such as the NASDAQ or the NYSE, but there are many exchanges in the U.S. as well as around the world. The values of stock prices tend to fluctuate throughout the day as those who are participating in exchanging stocks (traders) alter their beliefs about the future value of the company or stock in response to new information.

To avoid selling ownership stakes in the firm, some companies may instead issue corporate bonds, which are a financial instrument that sells the debt of the company. In effect, corporate bonds are loans, just as you might get a loan for a house or a car. Corporate bonds are rated by the three major rating agencies: Standard and Poor's, Moody's, and Fitch (other rating agencies exist, but almost all bonds will have a rating from one of the big three). Bond ratings help investors understand the credit risk associated with the investment, the risk that the firm defaults, or fails to keep making payments on its bonds.

Finally, there is a class of securities that derive their value more on the perception of a company's stocks or bonds, rather than the company's stocks or bonds outright. These are referred to as derivatives. Despite their esoteric sounding nature, derivatives are heavily traded. Two common derivatives are options and futures. Options are a contract for which the holder has the right, but is not required, to buy a security at a pre-arranged price at a later date; it is truly an "option" to buy something. A future is similar but loses the element of choice: the contract holder is instead obliged to make the purchase, at some point in the future.

Consider a scenario involving the purchase of either a stock or an option on a company: I have a belief that Corning Incorporated (GLW) will be worth a higher value in three months than it is right now. I could simply buy the stock, wait for it to increase in value, then sell at a higher price. Yet I could alternatively purchase an option, giving me the right to buy the stock within the next three months, but not the obligation. If I had bought the stock, and instead Corning fell, I could potentially lose a lot of money. If I had instead bought the option, the most I would lose is the price I paid to buy the option, which is comparatively less. Conversely, if Corning rose and I bought the stock, I would gain--but I could gain just as much (less the option fee) had I instead bought the option. In short, if used carefully, an option can be used for managing risk. It can also be used to speculate. There is an endless variety of ways in which you can choose to invest in securities and many strategies you can employ to manage risk and returns.

Last, derivative instruments represent a fascinating market in which prices are driven more by the potential for events, rather than real events themselves. Because of the complexity and enormous quantity of data involved in derivatives (you can only buy one type of stock for Google, yet on any given day there are more than 50,000 different varieties of Google stock options to buy), machine learning and statistics play a role in determining and forecasting prices in derivatives markets.

Investing in... Money?

Have you ever flown to a foreign country and needed to exchange your U.S. Dollars for some other currency? How are those prices set? Overshadowing the securities market in terms of trading volume is the foreign exchange market, also called Forex, or FX. In this market, the money of one type is exchanged for another, which is usually fiat currencies or cryptocurrencies. The prices on these markets also dictate the exchange rates offered around the world. In some countries, governments attempt to keep the price of their currency in relation to another "fixed", so that it does not fluctuate in relation to that currency (often the U.S. Dollar). However, from the 1980s onward, an ever-increasing number of countries have allowed their exchange rate to instead "float", whereby the value of that currency is largely determined by participants in the exchange rate market. As a result, forex markets have even more liquid, with transaction volume increasing dramatically.

Forex (FX) markets have three main instruments for exchanges. Spot markets are where two currencies are directly exchanged for one another. The second and third types of markets are considered derivatives. Namely, Forwards are contracts that swap two currencies at a future date, are typically a custom-tailored for a specific client or purpose, and are negotiated individually in an "over-the-counter" (OTC) transaction with an investment bank. Futures differ in that they are traded on a central exchange, can be re-sold, and have standardized features such as order size and pricing.

Investing in Risk Management

When you make a large personal investment in something such as a car, how can you protect that investment against risks? If you get into a major accident, how will you pay back the loan? These are all questions of risk management that fall directly into the realm of insurance. Insurance is a contract that allows the holder to collect a financial sum when a particular event (usually a bad one) occurs. In exchange, the contract holder also agrees to pay the contract issuer a fee on a regular basis, known as a premium. Groups of individuals may come together in order to seek a larger policy, which simultaneously lowers the risk for the insurer and thus lowers the cost of premiums for the insured.

How do insurers determine the price of premiums and the dollar amount that they will cover? Insurance is a realm largely of statistics - determining the likelihood of certain types of events occurring and how much that event may cost. These statistical analyses come from a wide variety of sources, and in the course, we will discuss how they have changed dramatically with the broader application of machine learning. Insurance has continued to evolve and is sometimes referred to as InsurTech when in the context of modern technologies.

Investing in Real Estate

Finally, we have the real-estate markets - where tracts of land or buildings are purchased, sold, and rented out amongst market participants. States and countries have vastly differing rules and regulations regarding the ownership and transferal of real-estate. Additionally, investments in real-estate have a tendency to be illiquid (if you had to sell your house tomorrow, do you think you'd get a good price?) and long-term. These are some of the reasons why real-estate markets have historically been more resistant to technological change. However, change most certainly has arrived in the form of PropTech - technologies used to aid in the valuation, sale, management, and other informational purposes in the market.

If you were looking to make a real estate investment, how would you go about deciding which plot of land would be the best value for your money? How would you know what the property is actually worth? As discussed in the previous lesson, this is another great opportunity to utilize a time value of money equation! If we have a belief about what the future value of the property is worth, we can discount the value back to today's dollars, in order to understand what a good price for the property could be.

Lesson 5: Startup Survival Guide

Introduction

In previous lessons, we explored what markets work and the basic definitions of equity and stock. In this module we will we will explore some of the financing stages of startups as well as different ways in which they compensate their employees.

Startups

Do you like to create new things? To push the boundaries of what people thought was possible? To create value for others with just your ideas? You may want to consider working for a startup!

Startups are nascent entrepreneurial companies that look to bring a new product or service to a market before rapidly scaling. They differ from “lifestyle businesses” in that they intend to rapidly scale and generally are designed to disrupt an existing market. If things go well, they are often purchased by a larger company or undergo an Initial Public Offering (IPO) in order to become a public company themselves.

Startups also raise capital differently than most other types of companies. In this module we will explore what some of the most common methods, and discuss the types of stock and remuneration offered by these early companies.

Funding Series

Startups are inherently a risky investment that few have the capital to take on. For this reason, there are relatively strict definitions on who can be an accredited investor in the U.S. However, in 2016 some of these rules were relaxed, enabling even more people to invest in early-phase companies.

There are five major funding rounds that startups go through on their path to becoming a public company. Each of these rounds is progressively larger in terms of funding received, and considered to be less risky for the investors.

  • Pre-Seed/Seed Funding: Also sometimes referred to as the “Founder’s” or “Friends, Family, and Fools” (3F) round. These are the earliest and riskiest investments to make and often come with short (1-2 year) timeboxes on delivering the next phase of product. Seed-stage companies should have a developed Minimum Viable Product (MVP) or prototype before seeking funds for this round. It is common for software or Software-as-a-Service (SaaS) products to have minuscule funding at this stage.

  • Angel/Early-Stage Funding: This stage begins the process of the rapid development of both the business operations and product iteration. Companies in this stage are building out their core teams, setting up manufacturing systems, and perfecting their flagship products.

  • Series A, B, C Rounds: each of these stages are (ideally) progressively larger amounts of funding from groups of investors. As startups continue to grow through these rounds, they begin to further optimize their business operations and expand to the size of a mid to large size corporation.

While we have only discussed up until series C, some businesses continue into series D or more rounds depending upon the types of projects they are undertaking. After a company has reached a longer-term stability and continued to grow, they may decide to transition to a pubic company in the process known as an Initial Public Offering (IPO). Still other companies may opt to remain private in order maintain equity in their company or avoid the regulatory requirements of being a public company.

Earlier investors are typically rewarded with a larger number of shares in the company, as they take on more risk relative to those investors that joined later when the company is more stable. In some regions, earlier investors aggressively lockout later investors that may potentially dilute shares, which motivates investors to invest earlier rather than later.

Activity: Crunch Numbers on Crunchbase

Crunching Crunchbase

In the previous section we covered the different funding stages of startups. In this activity we'll explore the different funding rounds for a few companies we may recognize.

Instructions

Take a visit to Crunchbase, a site that tracks the the amount of funding companies receive and what stage in their rounds that they are. Look into any company you're interested in working for, or one that is local to your city. Does the size of their funding surprise you? Who all provided funding for that company?

More than just stock

Recall that stocks represent a share in the equity, and thus ownership, of a company. This partial ownership often comes with voting rights for an event such as corporate policies, approval of new board members, and other events that impact the company at scale. The amount of voting power associated with each stock varies depending upon on the companies and its policies. For example, some companies scale the number of votes a stock is worth by the position of the person casting the vote. Stocks come in two major forms with regards to this voting power that we will explore here: Common and Preferred stock.

The vast majority of the time anyone is discussing the price or action on a stock, they are referring to Common stock. This form of stock confers ownership of the company as well as rights to dividends if the company distributes them. However, while Preferred stock still represents ownership of the company, it differs in two key ways. First, preferred stock doesn’t come with voting rights! Preferred stock-holders are generally beholden to the decisions of the company as a whole. Second, preferred stock-holders are given priority in the payment of dividends, a merger, or a liquidation. The dividends are also often pre-specified, so that there is a consistent return associated with holding the security. Essentially, holding a preferred stock trades voting powers in favor of financial priority. Preferred stock can be converted into Common stock under certain conditions as well.

In private companies, the descriptions of voting rights and compensation are largely dictated by the company policies. Preferred stock within the same company may have different subtypes with different voting, liquidation, and dividend rights among other factors. However, when a company transitions to public, there tends to be a flattening of the different types such that there are only the Preferred and Common stock types.

Relevant Remuneration

The end of many interview processes involves some negotiation of payment. When working at a startup, you may be offered the opportunity to exchange some of your potential income for equity in the company you are helping to build. This section will explore some of the possible ways in which you may be compensated for your work.

  • Regular Income: income which we would typically associate with working at a job. In some startups, there may not be enough cash on hand to pay competitive salaries, and thus other methods of compensation may be used.

  • Up-front equity: This is typically restricted to founders or extremely early employees in the company. Often in the pre-seed and seed stages of a company, there may not be enough cash to pay a salary, and thus a major share/ownership of the company must be portioned among those working on a project

  • Options: For companies that are beginning to grow may also offer options in the company in addition to a regular income. These options are often not able to be exercised until the company is acquired or reaches an IPO. Ultimately, however, the employee has the opportunity to possibly purchase shares at a significantly lower price than what the equity is currently worth, meaning that the stock could be sold immediately for a profit, or kept as it continues to grow.

  • Restricted Stock Units (RSU’s): an RSU is another stock-like compensation method that essentially assigns a certain number of shares to be given to the employee after a given amount of time known as the vesting period.

Owning equity in a company that is in the process of growing is intrinsically a long-term and illiquid risk. You will likely work for 3-5 years as your equity in the company fluctuates in value, you may wait even longer before you can actually liquidate the asset for cash. However, this risk also comes with the opportunity for outsized returns - if the company becomes highly valued (a "unicorn"!) then your equity could be worth millions overnight.