In Short
- Debt Investment: Involves lending money to a company with the expectation of repayment, often with interest. This method is generally safer for investors but offers limited returns.
- Equity Investment: Entails purchasing shares in a company, providing potential for higher returns if the company grows. However, it carries greater risk, as returns depend on the company’s performance.
- Considerations for Investors: The choice between debt and equity investment should align with the investor’s risk tolerance and return expectations. Secured debt offers lower risk but capped returns, while equity can yield higher returns with increased risk.
Tips for Businesses
When seeking investment, assess your company’s financial health and growth prospects to determine the most suitable funding option. Debt financing requires regular repayments and may necessitate collateral, whereas equity financing involves sharing ownership and profits. Align your choice with your long-term business goals and consult with legal and financial advisors to navigate the complexities of each option.
There are many different ways an investor can inject funding into a private company in New Zealand. Generally, you can give funding in the form of debt (like a loan) or equity investment (like buying shares). As an investor, you need to understand the difference between loaning company money in return for interest and potential future repayment (debt), and giving the company money in return for shares (equity). This distinction is critical when a company reaches its end, either via a successful sale or due to unfortunate circumstances, like an insolvent liquidation. This article will explain the differences between debt and equity investment and why you might consider one form of investment over another.
Debt
As an investor, debt is generally a safer way to invest in a company. However, there is less opportunity for a large return. If you make a debt investment, you will loan the company money. Consequently, the company will promise to pay this money back at a future date. You can document this arrangement with a loan agreement. This agreement will set out:
- when and at what rate interest on the loan is payable; and
- when the investor can get their money back.
A loan can be secured or unsecured. A security agreement will accompany a secured loan. This will secure repayment of loan against either:
- all the company’s assets (a general security agreement); or
- a particular asset (a specific security agreement).
If the company cannot repay the loan, you can force the company to sell the assets you have taken security over. You can then take the sale proceeds and use the money to repay yourself. If there are other creditors which have security over the same asset, you may have to share the proceeds with the other creditors. This is dependant on whether they have priority over the assets ahead of you.
An unsecured loan does not give you the same rights. Instead, you are an unsecured creditor. In this situation, if the company does not repay you, you must file a letter of demand and proceed through the court system before you can access the company’s assets.
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Equity
Many investors choose to invest through equity because of the potential for a high return. You can purchase shares in the company at an agreed valuation, hoping that the business will grow in value, and you can receive a significant return when you sell their shares. As an ordinary shareholder, you will also receive a right to vote in shareholder meetings and a right to dividends if the company decides to pay these.
Some investors further negotiate to receive preference shares in return for their investment (preferred equity). These are shares that give the investor additional or preferred rights to ordinary shareholders. You can negotiate these preferred rights with the company. A common preferred equity right is a liquidation preference. In effect, this means that if the company is sold or becomes insolvent, the company will pay preferred equity shareholders before the ordinary shareholders.
Continue reading this article below the formSale of the Company
If the company sells to a third party, the company will pay back debt investors before equity investors. However, that is not to say that debt is the better investment mechanism.
Example
A company is valued at $1 million at the time of the investment. A debt investor lends the company $100,000 at a 5% per annum interest rate (compounding monthly). The company grows significantly over the next two years and is looking to sell for $10 million. The sale triggers repayment of the loan. Consequently, the debt investor receives their $100,000 back, plus $10,494 in interest.
If that investor had invested via equity and purchased 10% of company shares with the $100,000, upon sale, they would receive $1,000,000. This is a 900% return. Therefore, if the company has a successful sale event, the equity investor will be better off.
If, however, the company sells for $500,000, the debt investor would be in a better position. As a creditor, the company will pay them before paying the equity investor. Only once the company repays all creditors, can it distribute the remaining funds. If our debt investor was the only creditor, the company would pay them $100,000, plus $10,494 in interest. This leaves $389,506 for distribution between the shareholders.
Our equity investor will receive 10% of the surplus, being $38,950 (a loss of 61%).
However, if our equity investor had negotiated preferred equity, they would be only slightly worse off than our debt investor. Out of the surplus funds, the preferred equity investor would receive their entire $100,000 investment back (assuming a 1 x non-participating liquidation preference) and the remaining $289,506 will be left to distribute between the ordinary shareholders.
Liquidation of the Company
When a company goes into liquidation, a liquidator comes on board. The liquidator’s primary duty is to all of the company’s creditors. The shareholders rank behind the creditors. Also, depending on the nature of the company’s debts, shareholders often receive nothing in an insolvent liquidation.
Therefore, if a company cannot pay its debts and goes into liquidation, the debt investor will be better off. The company will pay them before the equity investor and the preferred equity investor.
The debt investor’s payout will depend on where they sit in comparison to other creditors. For example, if there are secured creditors, they will be paid before the unsecured creditors. If there are any surplus funds left once the company has paid all the creditors, the liquidator will consider equity investors. As with a sale, the company will pay preferred equity investors before ordinary shareholders due to their liquidation preferences.
Key Takeaways
Debt and equity investment are different. Neither method is superior overall. Instead, an investor should consider the level of risk they are willing to take. A lower risk investment is a secured debt investment. However, the rate of return in this situation is capped at the accrued interest. An equity investment has the potential for a much higher return, but there is also a higher chance of the investor not getting their money back at all. Some investors attempt to mitigate this risk by negotiating preferred equity terms on their investment.
For more information about debt or equity investment and capital raising, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0800 005 570 or visit our membership page.
Frequently Asked Questions
Debt investment is where you loan the company money, where the company will promise to pay this money back at a future date. You can document this arrangement with a loan agreement.
Equity investment is where you purchase shares in the company at an agreed valuation, hoping that the business will grow in value. The aim is to receive a significant return when you sell the company’s shares.
Upon liquidation, a liquidator will first seek to pay back all of the company’s creditors. Company shareholders rank behind the creditors. If you are a debt investor, the company will pay you back before the equity investor and the preferred equity investor. If there are any surplus funds left once the company has paid all the creditors, the liquidator will consider equity investors.
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