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By Tamo Zwinge

Clash of the Investment Types: Equity vs. Profit-Participating Loans. Which One Is Better?

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Crowdfunding investors have been debating the best type of start-up investment for a long time. Essentially, the debate has focused on the question whether crowdfunding investments should be made in the form of profit-participating loans (which is also how these investments work on Companisto) or whether these investments should be made in the form of equity.

It is my impression that the debate is, in part, very dogmatic and not always based on facts. Consequently, I have compared equity investments and profit-participating loans in this article and have discussed their pros and cons.

 

What exactly is a profit-participating loan and what is equity?

Before I turn to the differences between the two investment types, however, I would like to provide brief definitions of equity and of profit-participating loans.

An equity investment is a purchase of shares or stocks in a joint-stock company by an investor. Through such a purchase, the investor becomes a co-owner of the company (or of the start-up in our case).

In the case of profit-participating loans, investors do not become co-owners of the start-up but receive a share in the start-up's profits and exit proceeds, so their situation is similar to that of a co-owner. This is why people commonly refer to profit-participating loans as "virtual" or "financial" participations. As they are virtual participations, profit-participating loans can be designed in a relatively flexible manner. Indeed, they have some characteristics that equity does not have, whereas they lack some of the other characteristics of equity. Therefore, profit-participating loans are somewhat different from equity, but both types share the common idea of enabling investors to participate in a start-up's financial success.

This may sound complicated, and it is a little complicated indeed, but investors should not be afraid to deal with this subject. In fact, if they look at the details of both investment types one at a time, even laypeople should not have any trouble understanding the differences relatively well. Through this article, I would like to help people do just that.

 

What are the pros and cons of profit-participating loans and equity?

What exactly are the differences between equity investments and profit-participating loans?

 

Profit and exit participation

Let's begin with the common characteristics: Both investment types entitle investors to a share in the profits of a start-up and, even more important, to a share in the exit proceeds if the start-up is sold one day (an event that is also called "exit"). In other words, investors receive a share in any profits the start-up makes. Moreover, if the start-up is sold, investors receive a share in the exit proceeds in the case of both investment types.

In both cases, the right to profit and exit participation lasts for a lifetime, but for profit-participating loans, this is the case only on Companisto. For detailed information on this, please see my article on lifetime participations.

 

Information rights

Second, both investment types include certain information rights. In the case of equity investments, some of these rights derive from the law, but it is common practice to further clarify the information rights connected to start-up investments (i.e., venture-capital investments) by means of additional agreements. In the case of profit-participating loans, on the other hand, the information rights are part of the loan contract itself.

 

Subordination of the investment

Both profit-participating loans and equity investments are subordinated investments.

But what do "subordination" and "subordinated investment" even mean? Financial liabilities that are subordinated are not settled before other, superordinated liabilities have been settled completely. In the case of equity and profit-participating loans, this means that if a start-up becomes insolvent, all external creditors (e.g., landlords of the office facilities, suppliers, and business partners) receive payments from the assets in the insolvency prior to the start-up's investors, which are last in line to receive such payments. This is true no matter whether the investors have invested through equity or profit-participating loans.

The proponents of equity investments tend to ignore this fact and to argue that the subordination of profit-participating loans is a disadvantage of profit-participating loans that equity does not have. That, however, is not true. Equity is also subordinated, but this subordination is due to the law rather than the participation contract. In fact, equity is always the most subordinated type of capital. Consequently, equity investors are always the last in line to receive payments – if there is still any money left at that time.

 

Voting rights

Now let's look at the differences: Equity investments entitle to voting rights, whereas profit-participating loans do not. A start-up's co-owners, equity investors have limited influence on the start-up's business activities. As total investments in start-ups are often very high, an individual's voting rights are often very limited, for these rights depend on the distribution of voting rights. Usually, voting rights in start-ups are distributed in a way that provides the founders and venture-capital companies with a comfortable majority, thus making other investors' votes irrelevant to decisions.

 

Superordinate profit-participation rights

Profit-participating loans have an advantage over equity in that they provide investors with superordinate profit-participation rights.

In the case of equity investments, the shareholder meeting decides whether a start-up's profits will be paid out to the investors. This means that individual equity investors cannot decide about their profit share independently, but are bound by the shareholder meeting's decision. Consequently, individual investors may not get the dividend they vote for if the majority of votes are against this payout. If that happens, equity investors do not receive any dividend payment.

This is different for profit-participating loans. When a start-up generates profits, it is required to pay out the Companists' profit share no matter whether the other shareholders decide to pay out their share or not. As a result, Companists need not fear a negative vote by the shareholder meeting.

 

Exit proceeds preference

Another advantage of profit-participating loans is that these loans include exit proceeds preference (also called "liquidation preference").

Equity investments in the venture-capital sector, however, follow the principle of "last in, first out." In other words, those investors who last invest in a start-up are the first ones to get their money (including their return) if the start-up is sold. Consequently, equity investors from earlier financing rounds gradually move further back in the value chain as more investors join the start-up over time. Later investors are entitled to "exit proceeds preference" over earlier investors. This is problematic because the later investors (particularly if they are venture-capital companies) often negotiate a minimum return or a fixed interest rate in addition to their regular share. As a result, investors from earlier financing rounds often run the risk of receiving only a small proportion of the sales proceeds (which can be significantly lower than their company share) if the start-up is sold. Those of you interested in this topic can find more information here.

The Companists' profit-participating loans, on the other hand, are protected against such potential disadvantages. The Companists' shares do not move further back in the value chain as more investors join the start-up later. In fact, Companists are even entitled to exit proceeds preference over all other investors. Consequently, Companists always receive their share in the exit proceeds no matter on which distribution and exit proceeds preference the other shareholders agree.

This is particularly interesting to angel investors, who often have disadvantages due to the exit proceeds preference of venture-capital companies – a disadvantage that does not exist in the case of Companisto investments.

 

Termination option after minimum period

As mentioned above, both equity investments and profit-participating loans are lifelong investments. In the case of equity investments, this means that investors cannot simply disinvest. Therefore, equity investors have no option of terminating their investment and having it paid out, which means that the investment is permanent unless the start-up is sold or somebody else agrees to purchase the shares.

Profit-participating loans, on the other hand, enable investors to terminate the loan after the 8-year minimum period. Companists thus have the option of "returning" their shares. In that case, they are repaid their investment, and their participation ends. Start-ups, however, cannot terminate the Companists' loans. In this way, we are making sure that Companists participate in the profits and exit proceeds of a start-up for a lifetime if they decide to do so.

 

Conclusion

Through profit-participating loans, investors almost always achieve a better return than through equity investments because of the superordinate profit-participation rights and the exit proceeds preference.

The only advantage of equity is that it includes voting rights. These rights, however, are so limited in the case of small investments that investors never have significant influence on the company's decisions.

Equity investments do not make shares easier to trade either. On the contrary, the vast majority of German start-ups have the legal form of a GmbH or UG (German types of joint-stock companies). To transfer shares in a GmbH, shareholders need to consult a notary public, which makes such transfers more difficult and more expensive. As a result, in Europe, there is a working secondary market only for stocks in public companies, which are no start-ups.

There are various other advantages of profit-participating loans, for instance the fact that a start-up's losses from previous years do not reduce the Companists' profits in later years. Nonetheless, I want to focus solely on the most important pros and cons in this article, so I have also summarized them in a table below.

 

  Equity Profil-participating loan
Lifetime profit participation X X
Lifetime exit participation X X
Superordinate profit-participation rights   X
Exit proceeds preference   X
Termination option after minimum period   X
Voting rights X  
Information rights X X
Subordination of the investment X X

Comparison of Equity and Profit-Participating Loans

 

What do you as a Companist think about this topic? When investing in start-ups, do you prefer equity investments or the advantages offered by profit-participating loans? Share your thoughts with us! I look forwarding to interesting discussions.

Tamo Zwinge

 

About the author: Tamo Zwinge is the founder of Companisto and used to work as a lawyer specializing in corporate law, corporate transactions and private clients in the major international law firm CMS Hasche Sigle. He was a participant in expert hearings at the Finance Committee of the German parliament on the protection of small investors act and has published international legal essays on corporate governance topics in the U.S. and England. Tamo Zwinge holds a First Class Honors Master of Laws (LL.M) degree in commercial law with a focus on "International Company and Capital Markets Law," "Corporate Governance," and "International Sales and Finance" from Auckland University.



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