Let’s start with several questions this post aims to answer:
How do business ventures get funded? Who’s paying for the overhead when the company is first starting out and has no revenue? And what do they get out of this?
Then, let’s jump into a scenario, say you have a fantastic new business idea, but to get the business started will require $50K right now, which you don’t have. How do you fund your new venture?
Traditionally, there are 2 main avenues:
- Take a loan from a bank
- Take on some partners who have deeper pockets (i.e.: sell a portion of your new company)
The former is also known as debt financing, and the latter is equity financing.
When you take on debt, you agree to pay the lender some amounts of money on some fixed timeline. For example, 1% of the loan amount every month (aka. interest payment), and then 100% of the loan amount at the end of 10 years (principal payment).
When you take on partners, however, they share in the profits (or losses) of the entire enterprise. So, if after paying off all your bills (which may include debt payments), you are left with $1,000 to distribute between the partners, then you and your partners can get up to $1,000 in total. Who gets how much depends on your partnership agreement, as well as how much of the company each of you own.
First come, but maybe not first served
Who gets how much money, and when, is one of the 2 major differences between debt vs equity financing.
Debts must always be paid back, on the timeline agreed upon when the loan is taken out. If you fail to make even a single payment on the debt, it is technically in default, and may officially be in default after some grace period. At that point, the lender generally has some set of rights they can exercise, up to and including forcing you to give up ownership of your company to them.
Equity partners, on the other hand, generally have no fixed payments due. A company can very well never return a single cent to the equity partners! The main considerations are the partnership agreement, which will detail how any apartments, if made, will be distributed amongst the partners, and fairness – in general, in the absence of any details about how profits are shared, then all dividends will be made pro rata, i.e.: if each of the partners own 50% of the company, then every dollar distributed will see 50cents go to each partner.
One way of thinking about this, is that debt investors have the first dibs on revenue generated by the business. Once all debt payments are made, and all other costs are paid, whatever is left over (which may be nothing, or even negative – a loss) can be distributed to the equity partners. In exchange for this “seniority” in terms of payment, debt investors typically settle for a smaller and shorter-term profit – interest rates are generally much lower than what the business can be expected to return over the long term.
Control your enthusiasm
The other major difference between debt and equity financing is that of control, or rather rights – who has rights to do what with the company?
Debt investors generally have no rights on the company other than their regular payments (sometimes known as coupons). If, however, a payment was missed for long enough that the company is in default of the loan agreement, then debt investors generally have additional rights to recover their investment, such as forcing the equity partners to give up ownership of the company, or forcing a sale of the business to 3rd parties to repay the loan.
Equity investors are generally split into 2 groups – the general partners who oversee the actual running of the company, and may even be personally responsible if the company goes bankrupt, and the limited partners, who generally provide the funding for the business, but otherwise have no say in the day to day running of the company.
Mix and match
When you think carefully about it, debt investors and equity investors are very similar at a very high level, for each of them:
- Provide capital for a company
- In return, receives some promise of cash flow at a future time
- Also with some rights with regards to the company
And at this abstract level, it shouldn’t be surprising, then, to learn that the traditional little boxes that debt and equity investors fit in, are not nearly that clean cut in practice.
In practice, an investor in a company is labeled debt or equity based mostly on their rights to call an event of default on the company. If an investor can call an event of default on the company when their promised distribution is not received, then they are typically labeled debt investors.
Some examples, in order of decreasing priority when profits are being distributed (i.e.: an investor at a lower row is not paid, until all investors in higher rows are paid according to the agreement):
- Senior debt: typically the highest priority of debt investors. All coupons of senior debt must generally be paid, before anyone else sees a single cent.
- Mezzanine debt: not often seen, except in very large projects with huge capital requirements. These investors are paid after senior debt, but before all else in most cases, mezzanine debt either are exactly the same as senior or junior debt, except that they are paid in between the two. The additional carveout is almost always entirely just to provide the payment priority protection, and thus a higher interest rate than senior debt, but a lower interest rate than junior debt.
- Junior debt: when there are 2 or more classes of debt investors, the lower is called junior debt. They are typically more risky, as they are paid only after senior / mezzanine debts. Also junior debt typically doesn’t have collateral. But in exchange for the increased risk, junior debt tends to command the highest interest rates of all debt tiers.
- Preferred equity: preferred equity can really be anything at all – anything that you can describe in a legal contract (ther partnership agreement) is probably fair game. In some cases, preferred equity shares the same uncertain returns as equity, but are paid first in cases of bankruptcies (i.e..: their entire investment is returned to them, and whatever is left is distributed to the equity tier). Most commonly, however, preferred equity is very similar to debt – they get a fixed coupon that is generally at a higher rate than junior debt, and they may get a little bit extra if the business does exceptionally well. But in exchange for this higher rate of interest, preferred equity gives up the right to call an event of default on the company if their coupons are not made on time.
- Equity: the equity tier is typically the lowest priority in terms of distribution of profits. This means that if there isn’t enough money to satisfy the claims of all higher priority tiers, the equity tier may not get any profits at all. However, if the business does exceptionally well, then the equity tier may get a return much higher than all other tiers combined. The equity tier is also commonly known as “shareholders” (or “stock holders”). When you buy and sell a stock on the public markets, you are essentially trading ownership interests of the equity tier of that company.
A table where a company lists all its debt and equity investors, according to their priority in terms of payment and their contributions to the venture, is called a “capitalization table” or “cap table”. A table or description detailing how the profits are actually distributed is called “waterfall”.
How to make it to the table?
Which tier you want to invest in, is entirely up to you and your personal situation.
If you are a retiree, and you need stability of income, you may opt to give up some upside, but get more protection by going up the capital table.
But if you are investing for the long term, and you are diversified such that your investment in a single company is relatively small part of your entire portfolio, then it may make sense to take on the additional risks involved in the lower tiers, for a chance at a higher return – even if this particular company goes bankrupt and you lose all your money in it, hopefully, enough other companies that you’ve also invested in will succeed, such that you still make a greater return than investing at a higher tier.