There are many different ways for an investor to inject funding into a private company. Generally, it is a matter of deciding between a debt and equity investment.
Investors need to understand the difference between loaning a company money in return for interest and potential future repayment (debt), and giving the company money in return for shares (equity). This distinction is particularly important when a company reaches its end, either via a successful sale or due to circumstances not as fortunate, such as an insolvent liquidation. This article will explain both debt and equity investment, and explain when each is most appropriate.
Debt is generally a safer way to invest in a company, but there is less opportunity for a large return. A debt investment involves the investor loaning the company money 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 secured loan will be accompanied by a security agreement. This will secure the investor’s loan against all the company’s assets (a general security agreement) or a particular asset (a specific security agreement). If the company cannot repay the loan, the investor can force the company to sell the asset so they receive their money back. They can alternatively sell their relevant proportion of the asset, depending on whether there are higher ranking secured creditors.
An unsecured loan does not give the investor such rights. In this situation, investors must trust the company’s contractual promise of repayment under the loan agreement. If the company cannot repay the loan, they will become an unsecured creditor.
Many investors choose to invest through equity because of the potential for a high return. The investor will purchase shares in the company at an agreed valuation in the hope that the business will grow in value and they will see a return on their investment when they sell their shares. As an ordinary shareholder, the investor 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 which give the investor additional/preferred rights to ordinary shareholders. The company and investor negotiates these preferred rights. A common preferred equity right is a liquidation preference. In effect, this means that if the company is sold or becomes insolvent, the preferred equity shareholder will be paid out before the ordinary shareholders.
Sale of the Company
Upon sale, the company will pay back debt investors before equity investors. However, that is not to say that debt is the better investment mechanism.
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 and the debt investor receives their $100,000 back, plus $10,494 in interest.
Debt Investor’s Payout: $110,494
If that investor had invested via equity and purchased 10% of shares in the company with the $100,000, upon sale they would receive $1,000,000: a 900% return. Therefore, if the company has a successful sale event, the equity investor will be better off.
Equity Investor’s Payout: $1,000,000
If, however, the company sold for $500,000, the debt investor would be in a better position. As a creditor, the company will pay them prior to 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%).
Debt Investor’s Payout: $110,494
Equity Investor’s Payout: $38,950
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.
Preferred Equity Investor’s Payout: $100,000
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 and, depending on the nature of the company’s debts, very 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 the creditor hierarchy. 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 as a result of their liquidation preferences.
Debt and equity investment are different. Neither method is superior overall. Rather, 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.
If you require assistance with your investment into a private company, contact LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.
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