Two Types of Investments You Can Make In a Small Business

Equity and Debt Are The Choices on the Small Business Investment Menu

When investing in a small business, you need to decide which type of investment you will make: an equity investment or a debt investment. There are pros and cons to each type, so it is important to understand both in order to make a choice that is most compatible with your unique situation and goals.
When investing in a small business, you need to decide which type of investment you will make: an equity investment or a debt investment. There are pros and cons to each type, so it is important to understand both in order to make a choice that is most compatible with your unique situation and goals. Hero Images / Getty Images

Investing in a small business has, is, and most likely will always be one of the most popular ways individuals and families begin their journey to financial independence; a way to create, nurture, and grow an asset that, when intelligently run under the right conditions, throws off surplus cash to provide not only a good standard of living but to fund other investments.  Still, it isn't uncommon, at least in nations with an entrepreneurial history such as the United States, for a small business owner to have never owned a publicly traded share of stock or a mutual fund, opting, instead, to put everything into their restaurant, dry cleaning business, lawn care business, or sporting goods store.

 Frequently, this small business grows to represent the most important financial resource the family owns, other than their primary residence.  

Today, small business investments are often structured as either a limited liability company or a limited partnership, with the former being the most popular structure due to the fact it combines many of the best attributes of corporations and partnerships.  In years past, sole proprietorships or general partnerships were more popular, even though they provide no protection for the owners' personal assets outside of the company.

Whether you are considering investing in a small business by founding one from scratch or buying into an existing company, there are typically only two types of positions you can take: Equity or Debt.  Though there may be countless variations, all investments come back to those two foundations.  

Equity Investments in Small Businesses

When you make an equity investment in a small business, you are buying an ownership stake - a "piece of the pie."  Equity investors provide capital, almost always in the form of cash, in exchange for a percentage of the profits and losses.

 The business can use this cash for a variety of things, including funding capital expenditures to expand, running daily operations, reducing debt, buying out other owners, building liquidity, or hiring new employees.

In some cases, the percentage of the business the investor receives is proportional to the total capital he or she provides.

 For example, if you kick in $100,000 in cash and other investors kick in $900,000, totaling $1,000,000, you might expect 10% of any profits or losses because you provided 1/10th of the total money.  In other cases, especially when dealing with an established business or one put together by a key manager, this would not be the case.  Consider the investment partnerships Warren Buffett ran in his 20's and 30's.  He had limited partners contribute nearly all of the capital, but profits were split 75% to limited partners, in proportion to their overall share of the capital, and 25% to him as the general partner, despite having put up very little of his own money.  The limited partners were fine with this arrangement because Buffett was providing expertise.

An equity investment in a small business can result in the biggest gains, but it comes hand-in-hand with the most risk.  If expenses run higher than sales, the losses get assigned to you.  A bad quarter, or year, and you might see the company fail or even go bankrupt.  However, if things go well, your returns can be enormous.  Virtually all of the research on millionaires in the United States shows that the single biggest classification of millionaires is self-made business owners.

 Statistically, if you want to rank among the top 1% of the wealthy, owning a profitable business in a niche market that churns out dividends each year is your best chance.

Debt Investments in Small Businesses

When you make a debt investment in a small business, you loan it money in exchange for the promise of interest income and eventual repayment of the principal.  Debt capital is most often provided either in the form of direct loans with regular amortization or the purchase of bonds issued by the business, which provide semi-annual interest payments mailed to the bondholder.  

The biggest advantage of debt is that it has a privileged place in the capitalization structure.  That means if the company goes bust, the debt has priority over the stockholders (the equity investors).  Generally speaking, the highest level of debt is a first mortgage secured bond that has a lien on a specific piece of valuable property or an asset, such as a brand name.

 For example, if you loan money to an ice cream shop and are given a lien on the real estate and building, you can foreclose upon it in the event the company implodes.  It may take time, effort, and money, but you should be able to recover whatever net proceeds you can get from the sale of the underlying property that you confiscate.  The lowest level of debt is known as a debenture, which is a debt not secured by any specific asset but, rather, but the company's good name and credit.

Which Is Better: An Equity Investment or a Debt Investment?

As with many things in life and business, there is no simple answer to this question.  If you had been an early investor in McDonald's and bought equity, you'd be rich.  If you had bought bonds, making a debt investment, you would have earned a decent, but by no means spectacular, return on your money.  On the other hand, if you buy into a business that fails, your best chance to escape unscathed is to own the debt, not the equity.  

All of this is further complicated by an observation that famed value investor Benjamin Graham made in his seminal work, Security Analysis.  Namely, that equity in a business that is debt-free cannot pose any greater risk than a debt investment in the same firm because, in both cases, the person would be first in line in the capitalization structure.

The Preferred Equity Debt Hybrid

Sometimes, small business investments straddle the ground between equity investments and debt investments, modeling preferred stock.  Far from offering the best of both worlds, preferred stock seems to combine the worst features of both equity and debt; namely, the limited upside potential of debt, with the lower capitalization rank of equity.  There are always exceptions to the rule.  To learn more about preferred stock, read The Many Flavors of Preferred Stock.​