It was just for simplicity. In the image I just show '$20 million' for each debt chunk, which is the principle that must be repaid to them, but they will also be entitled to interest payments. If I was an accountant for Blok Inc creating a balance sheet to show the liabilities of the company, I'd have to build that in. I might calculate that the actual amount owed over time to a particular debt investor is, for example, $25 million, but that valuation would depend on the interest rates they've secured and a bunch of accounting geekery that would just distract from the main thrust of the piece if I had to try explain it
For example, if they were doing 'mark-to-market' accounting, the valuation would be based on how much the bonds could be *resold* for in secondary markets - which is affected by changes in the prevailing interest rates more generally over time - whereas the 'book value' ignores that external environment and is based on the assumption that a bond is held to the very end of its life. In reality, there are different ways our scenario above could play out: a buyer could actually just buy the equity chunk, and leave the bondholders in place, or they could buy the entire building outright, in which case they would pay off all the bondholders, which would affect the book valuation because they are doing 'early redemption' - cutting the life of the bond short. Anyway, this is why I wanted to keep it simple! For the purposes of basic finance education that stuff in unnecessary
I'm with my fintech background as well but only on the basics, not CDS or CDO thing.
Thank you for writing this article, I'll share this in case someone asks me what bond is, leverage, etc, because you can explain better with the illustration.
Amazing post! Just to make sure I understand "finance your financing", if I borrow $4.5m from another bank for a 25% equity stake... does that mean I now have only 5% of Bloks Inc? Because the original plan was that with $5m I would have 25% of the shares (other people put up the remaining $15m)
1) In all cases you are buying 25% of the shares for $5 million, but the key question is 'where are you getting the 5 million from?' Is it coming from your savings, or are you borrowing it?
2) If you have it in your savings, you are handing over 5mil for the 25% stake. Let's imagine the building is now sold for 120 million, and 5mil in shares goes to 10 million. You've doubled you money with the leverage I described in the piece
3) If, however, you borrowed the 5 million, you're still going to hand it over for a 25% stake, but you obtained 4.5mil of it from a bank, and only 500k came from your savings. This means, if the building is sold for 120 million, your 5 million in shares goes to 10 million, and then you can pay the bank 4.5 million back, leaving you with 5.5 million. That's 11 times the amount of the 500k you put in. This is 'leveraging your leverage'
A slightly complex way to visualize this is to imagine *linked balance sheets*. The term 'share' is normally associated with finance, but it just refers to 'share of ownership'. For example, if you own a mug on your table, you have '100% of the shares in the mug'. If you had to build a balance sheet to show this, you'd be in the middle, and then you'd have an *asset* labelled 'mug' on the one side, and a *liability* on the other, which refers to who has a claim on the mug: in the liability section you might write 'I own 100% of the mug and can do whatever I want with it'. We ordinarily wouldn't do this, but every single player in the story above also has a personal balance sheet, with things they own and claims against that.
So, for example, there is a company called Blok Inc that owns an *asset* on one side - the building - but then has issued a whole series of *liabilities* on the other: promises given to different players who get to claim different slices of the asset. From the perspective of Blok, a shareholder is actually someone that is owed something, or who can make demands. From the perspective of that shareholder, though, the Blok share is an asset that they own, and - for all we know - the shareholder could be heavily indebted to some other player we can't see on the other side, who actually has a 'debt stake' against their share asset, much like the bondholders have a debt stake against Blok's building asset.
If you've used your own money to buy the 25% stake, and you imagine that as a single 'asset', then - on your liability side - you've 'equity financed' 100% of that stake, but if you borrow you might have debt financed 80% of it and equity financed 20% of it, just like Blok has done for its building asset. Once you get used to seeing the 'fractal' nature of financial claims, you can see how you can use debt financing to leverage an already leveraged thing, and there technically isn't any theoretical end to how much 'leveraging of leverage' you can do, albeit the more you do it, the more risk you're in if there is a slight downturn. Sorry if this is a bit of a complex description
Cloudmoney is much more focused on money itself than my first book, and my position on money is a lot more nuanced and developed within it. The Heretic's Guide to Global Finance is more of a (politicized) beginner's guide to finance at a more general level. People still enjoy it, but it's much more scrappy than Cloudmoney because it was written by a younger version of me (it came out 2013) for a small publisher with almost no budget :)
This is why I rely on Substack for ALL my education.
Thanks!…but why just ignore interest owed to debt investors?
It was just for simplicity. In the image I just show '$20 million' for each debt chunk, which is the principle that must be repaid to them, but they will also be entitled to interest payments. If I was an accountant for Blok Inc creating a balance sheet to show the liabilities of the company, I'd have to build that in. I might calculate that the actual amount owed over time to a particular debt investor is, for example, $25 million, but that valuation would depend on the interest rates they've secured and a bunch of accounting geekery that would just distract from the main thrust of the piece if I had to try explain it
For example, if they were doing 'mark-to-market' accounting, the valuation would be based on how much the bonds could be *resold* for in secondary markets - which is affected by changes in the prevailing interest rates more generally over time - whereas the 'book value' ignores that external environment and is based on the assumption that a bond is held to the very end of its life. In reality, there are different ways our scenario above could play out: a buyer could actually just buy the equity chunk, and leave the bondholders in place, or they could buy the entire building outright, in which case they would pay off all the bondholders, which would affect the book valuation because they are doing 'early redemption' - cutting the life of the bond short. Anyway, this is why I wanted to keep it simple! For the purposes of basic finance education that stuff in unnecessary
This is a clear explanation, Brett :)
I'm with my fintech background as well but only on the basics, not CDS or CDO thing.
Thank you for writing this article, I'll share this in case someone asks me what bond is, leverage, etc, because you can explain better with the illustration.
Thanks so much Sekar - really glad that you find it useful :)
You are very good at explaining these things clearly!
Glad to hear that Jay. Thanks for the support
Amazing post! Just to make sure I understand "finance your financing", if I borrow $4.5m from another bank for a 25% equity stake... does that mean I now have only 5% of Bloks Inc? Because the original plan was that with $5m I would have 25% of the shares (other people put up the remaining $15m)
Hi Terry, let me clarify for you
1) In all cases you are buying 25% of the shares for $5 million, but the key question is 'where are you getting the 5 million from?' Is it coming from your savings, or are you borrowing it?
2) If you have it in your savings, you are handing over 5mil for the 25% stake. Let's imagine the building is now sold for 120 million, and 5mil in shares goes to 10 million. You've doubled you money with the leverage I described in the piece
3) If, however, you borrowed the 5 million, you're still going to hand it over for a 25% stake, but you obtained 4.5mil of it from a bank, and only 500k came from your savings. This means, if the building is sold for 120 million, your 5 million in shares goes to 10 million, and then you can pay the bank 4.5 million back, leaving you with 5.5 million. That's 11 times the amount of the 500k you put in. This is 'leveraging your leverage'
A slightly complex way to visualize this is to imagine *linked balance sheets*. The term 'share' is normally associated with finance, but it just refers to 'share of ownership'. For example, if you own a mug on your table, you have '100% of the shares in the mug'. If you had to build a balance sheet to show this, you'd be in the middle, and then you'd have an *asset* labelled 'mug' on the one side, and a *liability* on the other, which refers to who has a claim on the mug: in the liability section you might write 'I own 100% of the mug and can do whatever I want with it'. We ordinarily wouldn't do this, but every single player in the story above also has a personal balance sheet, with things they own and claims against that.
So, for example, there is a company called Blok Inc that owns an *asset* on one side - the building - but then has issued a whole series of *liabilities* on the other: promises given to different players who get to claim different slices of the asset. From the perspective of Blok, a shareholder is actually someone that is owed something, or who can make demands. From the perspective of that shareholder, though, the Blok share is an asset that they own, and - for all we know - the shareholder could be heavily indebted to some other player we can't see on the other side, who actually has a 'debt stake' against their share asset, much like the bondholders have a debt stake against Blok's building asset.
If you've used your own money to buy the 25% stake, and you imagine that as a single 'asset', then - on your liability side - you've 'equity financed' 100% of that stake, but if you borrow you might have debt financed 80% of it and equity financed 20% of it, just like Blok has done for its building asset. Once you get used to seeing the 'fractal' nature of financial claims, you can see how you can use debt financing to leverage an already leveraged thing, and there technically isn't any theoretical end to how much 'leveraging of leverage' you can do, albeit the more you do it, the more risk you're in if there is a slight downturn. Sorry if this is a bit of a complex description
Thanks again! Which of your books would you recommend reading first…not as an investor/ gambler, but just mystified by the mechanism of money?
Cloudmoney is much more focused on money itself than my first book, and my position on money is a lot more nuanced and developed within it. The Heretic's Guide to Global Finance is more of a (politicized) beginner's guide to finance at a more general level. People still enjoy it, but it's much more scrappy than Cloudmoney because it was written by a younger version of me (it came out 2013) for a small publisher with almost no budget :)
Those arrows should be to scale, not just directional.
I'll bear that in mind for a future version :)
Just a quick sideline…I was going to mention I thought your written work didn’t even need the visual assist: it was very clearly explained.
Hi Dawid, this comment isn't adding anything positive to the discussion around this piece, so I'm going to remove it. I hope you understand