Debt vs equity investment

by | Sep 22, 2016 | Advisor Tips, Investment Tips

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Debt vs equity: how to decide which is best form of investment for you

While debt and equity investments can both potentially deliver good returns, there are differences which may make one more appealing to you more than the other.

Below is a breakdown of those main differences:

Bonds

Investors in debt financing, often have a different expectation to equity investors as to how they hope their investment portfolio to perform.

e.g.

Some investors have told us that if they put £1,000 into unlisted mini bonds from five different businesses, they may be expecting on average:

3 to generate 8% return per year over five years

1 to pay back what they put in

1 to pay back half of what they invested

Why debt financing

  • Mini bonds can be a less risky proposition than equity and may be a preferred choice if an investor has a large sum to invest. This is especially true if they need a higher likelihood of getting back the money they have invested.
  • Mini bonds can offer a higher return than other less risky investments such as cash or corporate bonds – but they do still carry risk.
  • If convertible, there may be the opportunity at the end of the term to convert the bonds into equity and become a shareholder.
  • Investing in debt may allow you to access tax-free interest via an Innovative Finance ISA (IFISA), which covers loans arranged through P2P lending platforms like Code Investing’s.
  •  Businesses raising debt finance are in general looking to raise larger amounts of capital, this means they’re likely to be more established and possibly less risky than seed businesses.
  • Mini bonds may give investors regular returns until the bond term ends.
  • Mini bonds don’t offer liquidity until the end of the bond term (which may be five years or more). Unquoted debt usually offers lower returns than equity.  A debt financing investor may therefore be hoping to have more of the businesses s/he invests in to succeed than if they were to invest in equity.
  • If secured, there may be the added safeguard of an asset which can be sold to repay some or all of the loan.

Why equity financing

Investors in equity may do so because they are hoping the greater risk will result in greater reward if one or more of the businesses they support does well. They may however expect a higher number of the businesses they invest in to fail compared to a debt portfolio.

e.g. some investors have told us that they might expect that if they invest in 10 businesses, on average:

1 may yield 10x return

2 may yield 2x return

3 not to give any return at all

  • For some types of business, if they succeed it’s possible investors could make 10 times the return over 3-5 years.
  • The Government is keen for investors to support UK SME businesses and offers tax breaks in the form of SEIS and EIS, although not all equity investments are eligible.
  • The motivation to invest in seed businesses is often quite different to that of debt financing and so are the expectations of some investors.  Some may expect on balance to only get back what they invest across their portfolio.
  • The upside is if the business succeeds, investors may get a greater return than they could from debt financing, the flipside being there is a greater risk that the business may fail and the investment is lost.
  • Equity doesn’t offer liquidity until an exit occurs, which may be more than 3-5 years later.

Which is best for you?

Although investing in equity can often carry a more emotionally led motivation to support small businesses to get off the ground, the same can be said of debt financing.  Both are valid forms of helping UK and world economic growth. And both enable investors to support UK industry whilst possibly earning something back.

Any type of investment carries a degree of risk, it’s up to you to work out what level of risk you are comfortable with and whether you can afford it. This is why some investors choose to have a portfolio of debt and equity.

But if you’re unsure about what your risk profile is or which suits your financial goals, it’s best to speak to an independent financial advisor before investing.

debt vs equity investment - one may suit you more than the other

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