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The Finance of Startups: For Dummies (Part 6)


So last month’s installment of Finance of Startups, I covered “par value” after encountering the term in Etsy’s S-1. In it, recall that par value is the price at which a security is issued and redeemed at. Well, par value really leads into a much longer conversation around a particular security called Bonds.

In gist, Bonds are similar to loans or “IOUs” (read: debt) whereby you, as an investor, lends money to a company, government, other institution with the promise of paying you back with interest. So in this case, par value is the amount the bond is issued at, and multiplied against the number of bonds issued, equivalent to the money lent.
To understand bonds, we’ve got to explore a few concepts of bonds including:
  • Maturity date
  • Coupon rate
  • Premium vs. Discount

I’m happy for you, and Imma let you finish, but first… let’s recap par value

So “par value” actually arose from recently looking at Etsy’s Form S-1 as they’re seeking an IPO.
So I’m going to dive into par value, especially in relation to bonds. Yes, the S-1 is for stock issuance (equity financing), but to give you a better picture (and for myself), I’ll paint this in the light of bonds (debt financing). Then, I’ll circle back around to par value for stocks. Also, yes, I’m about to get a little technical!

Par value (also known as par, nominal value, and face value) refers to the original price a security is issued at (and redeemed). Par value is more typically referred to in bonds where bonds are issued at and redeemed after its maturity period at par – typically $1,000 or $100.

Now, let’s talk about your Maturity

The maturity date (period), in the case of bonds, is the date at which the bond expires (bond is redeemed at the par value at this point). Oftentimes, bonds have a maturity period of 30 years.
There. That was simple. Next!

Coupon rate and payments

Going hand-in-hand with par value is the concept of the coupon rate which is similar to a fixed dividend and is a percentage of the par value – payments referred to as coupon payments. As a bond is bought and sold, traded, its coupon payment is exactly the same for the life of the bond till it hits maturity no matter the actual price of the bond at the time of the transaction – because the coupon payment is based on the par value (original issue!). Okay, here are a couple examples:

Example 1. 
Bond AA is issued with a 30-year maturity, coupon rate of 8% and par value = $1,000
Year 0
Bond is bought at $1,000
Year 1
Coupon payment is issued at $80
Year 2
Coupon payment is issued at $80
Year 3
Bond is sold and bought at $1,100
Year 4
(New buyer) Coupon payment is issued at $80
Year 5
Coupon payment is issued at $80
Year 30
Bond is redeemed for $1,000

Example 2.
Bond BB is issued with a 30-year maturity, coupon rate of 4% and par value = $100
Year 0
Bond is bought at $100
Year 1
Coupon payment is issued at $4
Year 2
Coupon payment is issued at $4
Year 3
Bond is sold and bought at $98
Year 4
(New buyer) Coupon payment is issued at $4
Year 5
Coupon payment is issued at $4
Year 30
Bond is redeemed for $100

Make sense so far? Okay, so if you’re looking at the above, you might be savvy and ask why bonds would trade above or below par – depends on the economy’s interest rates! Depending the interest rate of the company, due to the fixed returns of bonds, financiers may opt to invest in bonds or choose an alternative security that pays higher.

Are you trading at a Premium or a Discount?

If the coupon rate is 8% and interest rate is 5%, bonds may trade above par value (called a “premium”) because the bond yields a greater return. This is what happened in Year 3 for Bond AA example above.

If the coupon rate is 4% and the interest rate is 5%, bonds may trade below par value (called a “discount”) – Bond BB in the examples above. Make sense?

Recall again…

“So all this talk about bonds, but Etsy and other companies are issuing stock with some par value. What gives?”

Well, companies will typically attach a very, very small par value (like Etsy’s S-1 shows above) to a stock or no par value at all. This enables Etsy to limit or avoid altogether liability should a stock drop. For example, if Company Not Great issued stock with a par value of $10, and its stock started trading at $5, then it would technically be liable to the shareholder at $5 per stock!

Conclusion

Okay, that was technical. Does that make sense?
  • Par value for stocks à very little, or none to limit liability. For bonds, par value is the “face value” (or nominal value) of the bond that it is issued or redeemed at maturity.
  • The par value works with a coupon rate to determine fixed annual payments.
  • And depending on the economic interest rates, the bond may be traded at a premium or a discount (because you could get better returns either through the coupon payments or via other investments).
As always, feel free to email or tweet at me @TheDLu if you’ve got more questions, or if you want me to do some financial research for you for next month’s Finance for Startups.



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