Looking for an Investor? 3 Types of Investment Deals for Small Businesses

The structure of your investment deal depends on a few different factors. First, there are three types of investor funding: debt, equity, and convertible debt. Then, within those broad categories, the deal's structure depends on your business’s viability. The stage, size, and industry of your business, as well as how much you are seeking to raise and the time frame, will all factor into the deal structure. Here are some basic tips for understanding investment deals and their structures.

Three ways investors can fund small businesses

There are three main ways investors can provide funding to your small business: debt investment, equity investment, or convertible debt.

1. Equity investment

With equity investment, an investor will buy a “piece of the pie,” an ownership stake in your business. For instance, an investor might provide $100,000 in cash for a 10% ownership stake, meaning they will receive 10% of whatever profits you make down the road. How you determine the value of ownership stakes depends on your financial projections, balance sheet, assets, and larger macroeconomic trends.

[Read more: A Guide to Raising Venture Capital Funding]

2. Debt investment

Debt investment is different in that an investor loans your venture money in exchange for eventual repayment of the loan, plus interest income. “Debt capital is most often provided either in the form of direct loans with regular amortization (reduction of interest first, then principal) or the purchase of bonds issued by the business, which provide semi-annual interest payments mailed to the bondholder,” described The Balance.

Debt investment is considered less risky for the investor. If your venture fails, debt investors recoup their investment before equity investors. However, debt investors also have no ownership stake, meaning if your business is wildly successful, they won’t see the same escalating profits that an equity investor will.

3. Convertible debt

The third option, convertible debt or convertible notes, is a hybrid of debt and equity investment. Your business borrows money from investors under the agreement that the loan will either be repaid or turned into an ownership share at a later point. This conversion typically takes place after an additional round of funding or once your company reaches a certain valuation.

There are certain advantages to the convertible notes approach for both the investor and your startup. “This allows the original investment to get done more quickly with lower legal fees for the company at the time, but ultimately gives the investors the economic exposure of an equity investment,” wrote Toptal.

Convertible notes are generally quicker and less expensive to execute than traditional equity rounds, as they require less legal documentation and negotiation. Early investors are often rewarded with a discount on the conversion price or a valuation cap, ensuring they receive more equity for their risk if the company succeeds.

However, convertible notes are technically a form of debt until it turns into equity. If the company fails or doesn't reach a trigger event, the notes may need to be repaid as debt, potentially leading to liquidation or bankruptcy.

There are also risks for the investor, too. Convertible note holders do not have shareholder rights or voting power until conversion. This dynamic means investors have less influence over the direction of the company and can’t intervene to determine the trajectory of the business.

Deep dive: equity investment

Equity investment is a broad category, and investment structures take several different forms. Here are just a few common small business equity investment options:

• SBIC: The Small Business Investment Companies (SBIC) is a program offered through the Small Business Administration (SBA) to provide venture capital financing to small businesses. It pools investor money from venture capital firms to invest in startups, possibly high-risk companies.
• Angel investors: Angel investors seek companies where they can not only invest but also provide guidance and mentorship to make sure their ownership stake is profitable.
• Venture capitalists: Where angel investors are typically using personal funds (hence the insistence on providing guidance), venture capital firms will pool money from professional investors to grow startups and small businesses. Venture capitalists will usually seek a seat on your board of directors.
• Equity crowdfunding: Through platforms like Kickstarter, equity crowdfunding involves selling shares of your company to the “crowd” to raise money.

How do you know what shares of your company are worth? It’s best to work with a professional business valuation service that can tell you how many ownership stakes to offer at what price. But to estimate, take the total amount you wish to raise and divide it by how much you, the owner, have already contributed. In this way, you can roughly project the portion of “ownership” available to offer equity investors. For instance, if you need $100,000 and you’ve already contributed $60,000 on your own, there’s 40% ownership available if you choose to rely solely on equity investment.

How do you structure debt investment?

If you decide to use a debt investment, the deal starts with three things: the amount you’re seeking to raise, the rate of interest that you are able to offer, and the time frame in which the loan will be repaid.

In addition, most debt investment structures will need some collateral. Collateral is a concrete, sellable asset that your lenders can take if your venture fails and you are unable to repay the loan. For instance, a car dealership might offer the actual cars or the mortgage on the dealership property as collateral in exchange for a loan.

“Lack of collateral doesn’t completely rule out the possibility of taking out a loan. But if you don’t have any collateral and you don’t plan on signing for the loan personally, your options are mostly limited to smaller loans—usually less than $50,000—that are supported by the U.S. Small Business Association,” wrote one expert.

[Read more: What is an SBA Loan?]

How to find and pitch investors

Start by looking within your personal and professional network to find potential investors. Roshawnna Novellus, CEO of EnrichHER.com, told CO—, "Often, we overlook the possibility of investors being in our own network to scale our initial stages of business. Before doubting your network's potential, use tools like LinkedIn, Crunchbase, AngelList, and Signal to research and craft a strategic plan for outreach."

As you compile a list, research each potential investor’s goals and criteria for funding. Some investors only work in specific industries; others want to support women- or minority-owned businesses.

Once you have a solid list and a baseline understanding of what your investors want, reach out with a brief pitch of your business idea. Focus on a high-level overview of how your business idea addresses a unique problem for the investor. Your initial outreach should focus on getting more time to give an in-depth pitch. A successful elevator pitch opens a longer conversation, but many entrepreneurs focus too heavily on the pitch and fail to prepare for that second step.

[Read more: How to Create the Perfect Elevator Pitch]

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.