A cash investment in someone else’s business can occur in a variety of situations. Some of those situations might be funding an early stage company, an employee buying into the business and a joint venture where one party funds the venture.
An investment of cash can be structured in a number of ways. How the investment is set up and where that investment fits within the overall capital structure of the business being invested in affects the risk/reward profile of the investment, often in ways not fully understood by the investor. For example, structuring the investment as debt is generally perceived as less risky than structuring it as equity. However, consider two investment structures for an investment of $500,000. One is structured as debt. However, the investment is used for marketing costs (as opposed to hard assets) and the company in which the investment is being made has a capital structure which before the investment consists of (i) a $2,000,000 loan, which is secured by all of the assets of the company, and (ii) $200,000 of equity. If this company fails, the investor will likely lose his entire investment. That is because the secured lender will likely take all of the assets to satisfy its loan, leaving nothing left to pay our investor.
Consider on the other hand an investment structured as equity. However, the company in which the investment is being made has no debt and owns a piece of real estate worth $1,000,000. Further, the investor will receive in exchange for the equity investment half of the equity in the company. In this case, the investor has a very low risk investment, since if the business ceased doing business, his ownership interest would entitle him to half the value of a $1,000,000 piece of real property.
Thus, the form of the investment does not necessarily determine its risk. Rather, one needs to examine how the investment fits within the overall capital structure of the business. Consider this carefully when structuring your investments or determining whether you are getting an appropriate return for the risk you are taking.
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