Table of Contents

Overview
Debt Financing
Equity Financing
Key Takeaways
Frequently Asked Questions

Have you come across a business you want to invest in? Or do you own a business looking to grow and want to know the advantages and disadvantages of different investment options? This article will provide an overview of the two main ways you can invest money in a business: debt and equity investments. It will also explain the key legal implications for the different kinds of financing.

Overview

It is helpful to understand who is who in a debt or equity transaction. Your particular objectives will differ depending on if you are:

the one making the investment in the business; or
the owner of a business hoping to raise money.

Regardless of your position, you should understand the interests and objectives of both parties.

The Business Owner

As a business owner, you are likely hoping to raise money to grow your business. For instance, perhaps you want to scale up the size of your operations to cut costs and grow sales. Or you may want to:

buy a piece of equipment;
move into a new market; or
distribute a new product.

Alternatively, you may have a large payment coming up that you need help meeting. Unless you have a substantial sum of cash lying in reserve, you will likely need to raise money from outside investors. Your two main options are:

to borrow money (raise debt finance); or
to sell shares in your company (raise equity finance).

The Investor

If you have excess cash lying around, it is always sensible to put the money to work by investing. There are many ways to invest your money. One of them is by investing in private businesses (rather than public companies). However, for the vast majority of non-professional investors, investing in private companies is risky because it is largely unregulated. That said, those who invest in private businesses do so by either:

lending money to a company (debt); or
buying shares in a company (equity).

Unfortunately, it is difficult to walk up to established companies that are not trading on the public markets and solicit them as an investment opportunity. As above, most private companies willing to be approached tend to be early-stage businesses hoping to raise seed-financing (i.e. equity).

Debt Financing

Legal Overview

Legally, debt refers to a certain kind of contract between two parties.

A contract is an agreement that has the force of law. If either party fails to uphold their end of the agreement, the other party can enforce the terms of the contract by going to court and asking a judge to order performance on their behalf.

In the context of debt financing, at its simplest, a debt agreement is where the investor promises to give the company a certain sum of money in exchange for the company promising to pay the money back, usually with an additional amount (interest). If the company does not pay the debt back, in theory, the investor (also known as a lender, noteholder, or creditor) can ask the court to make an order requiring the company to make a payment (a debt order). But, if the company has no money, not even a court order can recover the money. Therefore, most debt financing seeks to improve the position of the debt investor so that they will only lend if certain conditions are met.

Terms of a Debt Agreement

Therefore, most debt agreements contain additional terms, usually in favour of the lender. The two most common terms are:

security agreements, where you agree to transfer the legal right to a piece of property to the lender if you default (breach the debt agreement) on your business loan; and
covenants, which are promises to do or refrain from doing something, such as taking out additional loans or failing to generate a sufficient amount of cash over a specific period.

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Equity Financing

Equity is a measure of ownership in a company, which you can measure by shares. Your company’s share capital refers to how much money your company has raised by issuing shares. If you raise money through equity financing, you are effectively selling ownership to another person in your company.

If you are the only shareholder of your company before equity financing, you will lose a percentage of ownership. This is called dilution.

In exchange for owning shares in a company, the equity investor will either want the value of their shares to grow so they can sell them later, or for the company to increase its profitability and pay them dividends.

Practical Considerations

Shareholders hold certain legal rights. For instance, if you usually pay yourself through a dividend issuance, you will have to pay the same amount per share to your new shareholders. However, if you prejudice them in any way, they can take actions against you and your company. For many companies issuing their first equity raise, their equity investors will usually want additional protection. This can be by:

being appointed as a director so that they can control the day-to-day operations,
being issued different share classes; or
drawing up a shareholder agreement setting out additional rights.

Therefore, this is one of the key disadvantages to equity financing: by selling ownership, you also lose some control over your company.

Key Takeaways

Debt and equity are the two fundamental ways people invest in companies. A debt investment is a contract between a company and the investor setting the terms of a debt issuance (usually a loan). This contract obligates the investor to provide the company with a sum of money in exchange for the company promising to pay the money back plus interest and abide by the other terms of the loan. An equity investment is the purchase of shares of ownership in a company. Shareholders are entitled to share in the profits of the company, either directly through dividend payments or indirectly by later selling the shares at a higher price than they bought them for. If you need help understanding how trust corporations operate, our experienced corporate 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 at 0808 196 8584 or visit our membership page.

Frequently Asked Questions

What is a debt investment?

Most of us are familiar with a debt investment where a bank lends a company money. This is a contract that sets out the amount of money lent, at what rate it will be repaid, and any other additional terms like promises not to borrow more money.

What is an equity investment?

Buying and selling shares on the stock market is the most common form of equity investment. For smaller businesses, in exchange for providing a company with money, the investor receives shares that correspond to ownership rights in the company.

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