Is It Debt or Equity

If you’re a private equity investor, you probably receive investment offers from time to time that look something like this:

The investment is $600k.
This gets you 10% of the company.
The $600k loan will be repaid in full at 6% in equal installments over two years.

If you have a general understanding of private equity investments, you may have just thought to yourself: “Wait. What loan? Isn’t it 10% of the company for $600k?

If you come across the deal like this, chances are that the founders are not entirely familiar with basic corporate finance. That alone should be a red flag! (Besides for the obvious red flag — or at least questions to be raised– by the $6m valuation).

Whether the investor will be a creditor or a shareholder carries substantial implications ranging from voting and other rights within the entity all the way to repayment priority in an insolvency event such as a bankruptcy.

Even within an equity investment there are distinctions in terms of types of equity (membership interests, limited partnership interests, preferred shares, common shares, membership classes, etc). Additionally, there are rights that investors should seek before committing to an investment such as drag along rights, tag along rights, right of first refusal, pro rata rights, to name a few.

Generally speaking, an investment is represented as either a debt or as equity. There are certain investment instruments that convert an initial debt into equity. A common such instrument is a convertible note. There are other ways to achieve this, such as collateral on a loan in the form of equity.

But it seems like a very notable achievement from a financial perspective for specific investment funds to represent both debt and equity position – attributable to the same money!

Private equity investors should always review offerings with an experienced securities attorney, in addition to their financial advisors. Having said that, any investment opportunity that promises to give you a percent of equity but also to “repay your loan” should definitely be reviewed by an experienced securities lawyer.