Before investing in a small business, you must understand the difference between equity and debt financing.
Equity investments involve buying an ownership stake in a company. If you purchase a company's stock, you now own a portion of the business and are eligible to receive a share of the dividends and revenues the company earns.
When you make a debt investment, you loan money to the business in investing in a company in exchange for the promise of principal and interest repayments. Instead of taking out a traditional bank loan, the company you planyou're to invest in would rather secure funding from individual investors.
Equity Investments
In investing in a company as an equity investment, you're buying a "piece of the pie.”" Equity investors provide capital to business owners, usually to invest in small companies in cash, at the expense of a percentage of the business' profits and losses. The business can use the capital for almost any expense, including reducing debt, hiring new employees, and paying for daily expenses.
The profits or losses the investor receives are usually proportional to the capital they have invested. For instance, if you invest $100,000 as capital and the other investors pitch in to invest in small companies $900,000, you're entitled to a 10% share of profits and losses. The percentage of ownership and dividends may vary depending on the terms of the investment.
If the expenses exceed the sales, investors will assign the losses to the investors. But if the business is profitable, the returns can be significant.
Debt Investments
Instead of borrowing from banks, debt investments enable small businesses to receive investors' loans. You can invest through direct loans or the purchase of bonds the company issues.
One of the primary benefits of debt investments is that debt investors are prioritized over the stockholders (equity investors). For instance, if you invest in a law firm and you've been given a lien on real estate, you can repossess the property if the business goes south. You should be able to recover your investment by selling the confiscated property.
