A simple loan works well when a company needs to finance the purchase of asset (real estate, equipment, etc) that will produce earned revenue to repay the loan.

Benefits

A loan is the simplest way to invest and you will typically get your money back sooner than with an equity investment. Plus, it doesn’t dilute ownership for founders, which can be a benefit if one of the goals of the investment is creating wealth in impoverished communities

Downside

Investors’ return is capped and it offers less flexible payment options for the company.

When you make an equity investment, you become an owner of the company. There are several types of equity ownership, called classes. Owners of corporations are called shareholders and owners of an LLC are referred to as members.

Common equity gives you the right to vote in decisions of shareholders/members. Preferred equity, also sometimes called limited partner interests, does not have a voting right but does carry the right to get its investment returns before the common shareholders. This right to early returns is called “preference” or “pref rights”.

Things to consider:

Pre-money Valuation – an unscientific estimate of what the company thinks it is worth before raising additional capital. This directly affects how much equity will be allocated to new investors.

Does the company have an exit strategy? In other words how will you get your money back? Sometimes companies plan to make dividends to equity owners and other times they plan to sell the company within a certain number of years. Beware of making an equity investments if the company does not have a plan to get investors’ money out.

A convertible note is a type of debt that has the right to convert into equity when a company hits an agreed-upon milestone, typically the next round of funding. If the milestone isn’t hit, the company owes the investors their original capital plus interest.

Things to consider:

1. Valuation cap—The valuation cap sets the maximum value of the company when the convertible note turns into equity. This affects the amount of equity you will own only if the company is priced HIGHER than the valuation cap in the next round. Read more.

2. Discount rate—A conversion discount is a mechanism to reward the noteholders for their investment risk by granting to them the right to convert the amount of the loan, plus interest, at a reduced price (in percentage terms) to the purchase price paid by later investors (typical discount 20%). Read more.

Benefits

a. Works well when a company is early stage and it’s difficult to decide on an enterprise value.

b. Flexibility on providing return to investors; repayment not required right away.

Downside

Only works if the company plans to raise another round in the future because that is the triggering event for conversion to equity.

A SAFE, or Simple Agreement for Future Equity, is “an agreement between an investor and a company that provides rights to the investor for future equity in the company similar to a warrant, except without determining a specific price per share at the time of the initial investment.” It’s like a convertible loan without the possibility of repayment.

SAFEs can be great in certain situations, where (1) the company and investors understand the effect of conversion on the future cap table, (2) in a high growth company where an equity round will follow closely behind the SAFE round. In many others, many feel they create an unfair disadvantage for investors who risk capital in a very early-stage company. This article explains the pros and cons well.

The most common types of funds:

• Private equity fund (PE) – a pooled investment vehicle where multiple investors (called limited partners or LPs) contribute, and a manager (sometimes called the General Partner or GP) makes individual investment decisions. A private equity fund usually invests in later-stage companies (later than venture or angel). Sometimes a PE fund will only take minority positions; others only take controlling positions.

PE almost always means the fund takes equity positions, as opposed to making loans.

• Venture capital fund (VC) – a pooled investment structure similar to a PE fund but focused on early stage, often technology companies.

• Debt Fund: a pooled investment vehicle in which the manager makes only loans, not equity investments.