Financing activity for most ventures are either debt financing or equity financing.
Once an investor has decided to engage in financing any business venture or project, he has three concerns to address: risk, protective claim, and return.
These three concerns are essentially hierarchical. The latter two depend on and counterbalance with the first. Higher risk is only attractive when associated with higher returns. The protective claim then acts like a fulcrum to fine tune the balance between risk and return.
Debt Financing
Debt financing. In this mode money is borrowed, and usually the borrower (debtor) gives the lender (creditor) a promissory note. This, usually, obligated the debtor to pay back a certain defined amount at a particular and defined time in the future.
Forms of debt financing can include credit cards, mortgages, signature loans, bonds, IOUs, and HELOCs (Home Equity Lines of Credit) as examples. Treasury debt, savings bonds, corporate bonds are also forms of debt financing.
With debt financing, the creditor’s return is fixed and understandable. It is, quite simply, the agreed upon interest rate for the debt. This rate can vary from a single digit rate to 25% or perhaps even 30% depending on the debtor. Risk is determined by a handful of factors the most significant usually being one’s credit history. The protective claim offered to creditors in debt financing is a claim on the debtor’s assets. Should the debtor fail to repay, the creditor may forcibly take possession of other debtor property and sell it, using the money to offset the loss of the loan. The claim of creditors takes priority over the claim of those who participate in equity financing.
Equity Financing
Equity financing is generally considered less certain than debt financing. Equity financing is also typically where non-cash assets such as equipment, skills, and land are invested alongside regular cash. This is the category in which we also find venture capital, shares of stock, angel investors, and more. The terms that are used to describe the equity financing relationship are more varied and, as such, will be simply dubbed equity investors. Later on, more proper names will be provided which, for the time being, are immaterial.
The return of equity financing is the claim on a business’s profits; not just today’s profits, but in modern companies that issue stock, all future potential profits as well. For this reason, i.e. because most personal finance does not involve the debtor making a profit, almost all of personal finance is debt financing. The exceptions will be noted shortly.
While it’s true that in equity financing, the equity investor still has some claim on the business’ assets, the creditor’s prior claim renders this point moot from a practical standpoint. What protection, then, is offered for equity financing? The claim to management rights. As an equity investor, with a few notable exceptions, you are granted the right to do everything in your personal power along with the other equity investors to make sure that the business goes in a profitable direction.