OMG Digital Magazine OMG Issue 337 27th December 2018 | Page 20

OMG Digital Magazine | 337 | Thursday 27 December 2018 • PAGE 20
Business
TWO TYPES OF
INVESTMENTS YOU
CAN MAKE IN A
SMALL BUSINESS
Equity and Debt Are The Choices on the Small Business Investment Menu
BY JOSHUA KENNON
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. buying out other owners, building liquidity, or hiring new
employees.
Frequently, this small business grows to represent the
most important financial resource the family owns, other
than their primary residence. 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.
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,
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.
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.