What is the Difference Between Investing in a Loan and Making an Equity Investment?

One of the most difficult questions to answer after analyzing a company is which type of investment you should make – but it is extremely important. As an investor, you want places to put your cash that will generate you better returns long-term, so understanding the difference between a loan and equity is extremely important. More important, though, is understanding what your investment dollars are doing for the people you invest in. You are helping them succeed and profiting alongside them as a partner. Of course, there are different ways for you to help. Below are just a couple of ways to be involved.

When it comes to funding a new business, there are several different options to consider. Nine times out of ten, companies that are growing fast will require finding outside sources for money at some point during the process. When thinking about investing in a business, it is imperative to know what your options are, as well as how and when those investments will pay off. Doing some research will be an important step in this process.

Whether investing in a loan or making an equity investment, there will be pros and cons. The importance of understanding these is vital to the success of your investment. In this article, we will explore investing in a loan and making an equity investment, as well as learn the differences between the two. We will use the example of Nancy’s Nail Salon for reference.  From there, you will be able to understand which is right for you. Plenty of businesses are thriving in this environment, and just need your investment dollars to take it to the next level. That means investment gains for you, and lifelong success for them. Let’s get started!

 

Investing in a loan

We are all familiar with loans. We know that this means to borrow money for something and then pay it back with interest over a period of time. A loan, also known as debt security, is the most common form of outside capital for new businesses and start-ups. For many companies, taking out a loan is the easiest form of finding capital for a company to understand because the parameters are laid out and straightforward. Before investing in a loan, you should understand more about it, and what type of returns you can expect. For the following example, let’s assume that Nancy’s Nail Salon needed some money to expand her business. You decided that, based on your relationship with Nancy, you would lend her a few thousand dollars in exchange for principal + 5% interest one year from now. You both agreed that if she could not pay you back, she would sell one of her salon chairs to cover your payment.

 

How it works

When you decide to invest in a loan, this means that you are simply lending money to a company with an agreement that they will pay you back within a certain amount of time, with a specific amount of interest incurred. Investing in a loan will make you money in the form of interest. This can be a high return investment if done right, but the research and work need to be put in first. Below is a list of pros and cons for investing in a loan.

 

Pros of investing in a loan

  • If the loan is secured with sufficient collateral, you are guaranteed some form of payment. If, for example, Nancy was not able to make your payment one year from now, she must now sell her salon chair for cash in order to pay you back. If she was to go bankrupt, you could receive her chair as payment and sell it yourself as per the agreed terms.. Of course, there are risks with this type of investment but at least you should have a comfortable floor (or, chair in this case…) if you analyze the business properly.
  • You should make back your money, plus some. When investing in a loan for a start-up business or entrepreneurship, your money should not only be returned to you by a specified date, but you can also gain more money with the interest payments.
  • You may receive steady monthly payments. Rather than having to wait for your money to be returned, you can receive payments each month.
  • This is a lower-risk investment, which comes with lower-return profiles than otherwise. It can also be guaranteed in some cases. 

 

Cons of investing in a loan

  • Investing in a loan does not give you any rights or ownership to the company you are investing in, limiting your upside. A loan is simply that, a loan. You are not buying any part of the company, but simply lending money and then collecting it back with interest.
  • If a company goes under, you may have to wait to collect your money. Although you (hopefully) have collateral, the payoff probably will not be immediate, so patience may be necessary. Let’s say you give a loan to Nancy’s Nail Salon, but business just doesn’t take off. Well, even if you have collateral, you will probably not be able to collect right away, and then you must sell it, which can take some time. In this case, are you really comfortable owning a salon chair? Do you have the knowledge needed to sell it at the proper price? Probably not. That’s a type of risk you have to be willing to take.

 

Making an equity investment

Here’s where the really exciting returns can come from, especially if you find the right partner. An equity investment is much different than a loan in that it exchanges outside capital for ownership rights in a business. Rather than repaying the loan, you are investing in the business and will receive a percentage of ownership in that company. Investing in an equity can be extremely rewarding, but it also has some risks involved.

Here, we will look at the pros and cons of making an equity investment and how it works. Understanding what you are getting is necessary to make an informed decision about your investment.

 

How it works

When making an equity investment, you are exchanging your capital for a small piece of ownership in the business you are investing in. There are no fixed repayments laid out in an equity investment, meaning that most of the time you will receive a certain percentage of the profits made. However, there are certain hybrid agreements that can be made entitling you to a certain percentage of royalties and other benefits. You are essentially becoming part owner of the business you are investing in. When they succeed, you will too – interests are aligned. 

 

Pros of making an equity investment

  • Your potential pay-out could be higher than if you invest in a loan. Because you are receiving a percentage of the profits, if the business does well, so will you. This has the potential to be a high return investment.
  • You may have a say in the company and the decisions to be made. While you may only invest a small percentage, you will still be able to table discussions with what happens with the company, and in which direction it heads. Not that you have to.
  • There are plenty of companies looking for equity investors, so you have a ton of options.

 

Cons of making an equity investment

  • You will not receive a steady payment. Investing in equity takes a lot more patience when waiting for the payout. Until they are making money and their valuation grows, you aren’t making money – and it may only be on paper for some time.
  • It is riskier than investing in a loan. If the company doesn’t do well, then you won’t either. It all depends on the profits and long-term sustainability. For example, if you were to loan money to Nancy’s Nail Salon, a contract is drawn up and signed by both parties and collateral is collected if the company does not do well. If Nancy’s does do well, then you will receive your money plus interest, and that is that. However, if you were to invest in equity with Nancy’s Nail Salon  and they did not do well, there is no collateral to fall back on. In this type of investment, you do not have a claim to one of the salon chairs. Yet, if they were to do well, you would get your money back and more, as you would continue to collect a percentage of the profit the nail salon makes as long as you hold equity with the company. 

 

Differences between investing in a loan and an equity

As you can see, there are plenty of differences between investing in a loan and investing in equity. To make it simple, here is a list of the main differences:

  • Investing in a loan is temporary and gives you no rights to the business whereas investing in equity gives you certain ownership rights over the company.
  • Investing in a loan is a lower-risk investment, whereas investing in equity has the potential to be a higher return investment.
  • Loan investments can have a steady monthly or yearly payout, but investing in equity can mean a slow start and you may not get paid every month, especially at first.

In conclusion, understanding the difference between the two investments, as well as the pros and cons from each should help you make a smart, informed decision as to where you should invest your money. EnrichHER looks for investors who are willing to help women-led businesses not only succeed, but thrive. If you are looking to invest in a loan or make an equity investment with new majority founders, then contact EnrichHER today to discuss your options. Let’s get our founders to the top, and you alongside them. 

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