In a previous article I described why a young company is likely to need finance. In very brief, the answer was to get off the ground, to grow and to improve.
Finance for a business is the same thing as investment - both words describe the money a business is able to spend. Typically, 'finance' is used to describe that money from the point of view of the business which needs it and 'investment' is used to describe that money from the point of view of the person providing it.
Because we're talking about young businesses, I'm going to talk about founders and investors in this article. The founders of a business are the original shareholders of the business; the investors are those who provide the finance the business needs.
An investor doesn't just want its original investment back, of course; an investor wants to make a profit. The money an investor makes back is called the investor's return. When an investor makes an investment, there are two things the investor is worried about: the potential size of that return, and the risk of that return.
An equity investor becomes an owner of the business along with the founders and receives a certain proportion of future earnings in the business. The investor does this by buying ordinary shares in a company - the same type of shares owned by the founders.
As an owner, the investor shares in the ups and downs of the business. The investor can receive very little (or nothing!) if the business does badly; but if the business does well, the investor's returns grow along with the returns to the founders (see Figure 1).
For the founders this means that the equity investor is, in theory, in exactly the same position as they are. Good or bad, the value of the business will be shared between all the owners of the business - the investor shares the risk and (hopefully) shares the reward with the founders. This is the most common and most simple form of investment in young businesses.
fig. 1 - Investment in equity
Debt is something we're all used to - particularly students. When you take out a student loan or, later on, a mortgage, you are taking on a debt. What's special about debt is that the amount to be repaid is set - it will typically be the amount lent plus a certain periodic interest rate.
However well or badly the company performs, the debt investor will receive the same return and the founders will receive what is left over (see Figure 2). That means the founders are taking higher risk than the debt investor, but for a potentially higher return.
Debt is often not appropriate for a company - for instance, when interest payments take up cash flow that should be being spent on helping the business become profitable.
fig. 2 - Investment in debt
Some investors may look to seek additional benefits with their investment when they feel their risk is much higher than that of the founders. This can come in the form of preference shares. There are many complicated structures that can be created and negotiated between investors and founders, but typically preference shares will focus on additional voting rights, order of returns being received (for instance where the investor gets their cash back before founders), rights to appoint directors, rights to buy the company and so on.
Complicated structures can be a necessary evil to keep all parties happy, but any preference share agreements need to be treated with care and all possible scenario outcomes detailed in full - as the last thing you want is to be renegotiating shareholdings as you come to an exit.
You'll note that I've not mentioned the hybrid of debt and equity that is the convertible loan note. The convertible loan note is actually a fairly simple structure that facilitates a lot of investment in young businesses across the globe, but not always in the UK.
A convertible loan note begins as debt and converts to equity at some stage in the future and this means it is not eligible for the Enterprise Investment Scheme or Seed Enterprise Investment Scheme tax benefits that are so useful to investors in young businesses in this country. They are only available with investments in ordinary shares and every young entrepreneur should be aware of them.
The fact is, no financing decision is simple and founders' interests must be weighed against those of investors. The next article in this series will go into more detail about the pros and cons of different types of financing.
Adrian Clark is a founding director of New Model Venture Capital, an investment management company which works with Find Invest Grow to finance growth businesses. Follow him on Twitter @adrianjcclark.