One of the most important aspects of becoming a bonafide investor is understanding the difference between debt and equity. Each has its use-cases across multiple investments, including the stock market, real estate, content creation, and business.
I’ll try to keep this article from getting out of hand because there is much to discuss. First, welcome back to the Become a Bonafide Investor Series (part I, part II, part III, part IV, part V). It has been over six months since the last episode in this particular series, so I am eager to keep the torch alive. Let’s begin.
What is Debt? Debt is when someone invests in a business or entity by giving a loan. Debt is senior to all equity positions in a company or entity. Because debt is higher on the structure, loans will be paid first if the company goes bust.
What is Passive Income?
Since debt offers more security than equity stakes, you usually receive much less financial compensation for your investments. The old saying “little risk, little reward” rings true here.
When you facilitate giving someone a loan or buying bonds, they pay you via interest payments. I have an entire series on Investing for Interest (101, 102, 103) to help you dig deeper into the topic.
Unlike dividends from equity positions, interest does not receive preferred tax treatments. You will pay the ordinary tax rate for your tax bracket.
What is Equity? Equity is taking a stake in the company where you position yourself to profit from any upside movements. You will not receive your money back via loan payments when you buy equity (or earn through trading time) positions.
You usually buy shares in the company. The shares may appreciate or pay you dividends from profits if the company does well. The more shares you acquire, the more income or value you earn.
Equity positions may pay dividends that have preferred tax treatment. When you buy securities on the stock market, you buy equity positions in large blue-chip companies. However, since there are billions of shares, your 100 or 1,000 shares represent a small percentage of the overall market share.
The Wealth Accumulation Phase
Debt vs. Equity. There are some pros and cons to the overall battle between debt vs. equity. After this, I will get into some of the particulars in each investment category.
For the most part, buying debt does not offer voting rights or profit-sharing in a company. On the other hand, equity can offer voting rights, profits from selling the company, share price appreciation, and dividends.
Business example. If I give my brother a $20,000 loan to start a business at 5% interest, I stand to gain 5% with a successful repayment. If he sold his company for $300,000, I would still only get my 5% return.
If I give my brother $20,000 and assume 50% of his equity shares, we would split the $300,000 fairly. Yes, taking equity seems to be the better position, but 70-80% of businesses fail.
Be Smarter than the Average Bear (Market)
If my brother’s business fails, I lose all of my cash from an equity position. If I give him a loan, I may recoup my money via debt liquidation (he sells his stuff). Debt is the safer position but offers less upside.
Business Owner example. As a business owner, you have to carefully decide when offering debt or equity positions to expand your business. The book “How to Start a Microbrewery” talks about this topic explicitly.
Yes, offering equity shares may sound appealing because you don’t have to pay back these stakes. Investors want results. If they have voting rights or partial ownership, they may proceed against your vision or timeline.
In the above book, shareholders may want to rush your Microbrewery to market faster than you’d like. Or push to expand into more markets, franchise, or outsource things much more quickly than you anticipate.
Giving up a portion of your ownership is a big deal, especially if you are a “Company of One.” On the other hand, taking a loan offers none of these downsides, only the pressure of having to pay it back.
Content Creator example. As a content creator, I build equity with each book, article, and video I create. However, I have to be careful if I want to expand my business.
Passive Income in DeFi 104: Yield Farming
If I went to a book publisher, they would want to own the rights to the books I wrote under their charge. In essence, I am giving them an equity stake in my company. That’s why so many music artists, authors, and filmmakers always fight to control their intellectual property.
You have to understand these debts vs. equity battles and make decisions that you can live with for the long term. It may be beneficial to take a loan and hire an advertiser or consultant to help grow your business versus going to a publisher.
Real Estate example. Debt versus equity is everywhere in the world of real estate. I wrote about some examples in the article “Real Estate Lifestyles 2: Lender vs. Investor.”
Offering debt to real estate investors is an alternate way to invest in the housing market. You can provide hard money or private money loans. You base hard money loans on the project and private money loans on the real estate developer.
Selling Covered Calls for Passive Income
If you have more time and money available, you may want to partner with developers, agents, and general contractors. You can all share in the profits from a successful project.
Once you get into large commercial multi-family housing projects, forming partnerships is almost a must because of capital requirements and downside protection.
You have to ask yourself, do you want to be the bank or the owner? The bank gets your mortgage payment every month at a 3% return. As a homeowner, you get tax benefits and potential upside capital appreciation.
If you are an investor, do you want to be the bank and offer loans or a partner and have partial ownership of the project? Each project and investor is different.
Stock Market example. When you buy shares of large corporations like McDonald’s (MCD) and Starbucks (SBUX), you buy equity positions. You receive a portion of the profits in the form of dividends.
However, not all securities on the stock market are equity positions. Many positions are debt positions, and you receive interest payments. They may look like dividends, but they reflect as interest on your statements.
Orange You Glad Have Passive Income?
A perfect example is a difference between preferred shares and baby bonds. Preferred shares have a higher position on the debt repayment scale than common shares; however, this comes at the cost of voting rights.
Baby bonds (which I’ll write about soon) have a higher level on the debt structure than preferred shares because they are debt, not equity. It is challenging to tell the difference between preferred shares and baby bonds. Sometimes, the interest or dividend designator is the only way to differentiate.
Conclusion. Hopefully, this article gave you a small insight into the importance of debt vs. equity. As I said before, it may be one of the most important aspects of investing.
As we become Bonafide investors, we will want to ask ourselves, do we want to offer loans or take equity stakes in a business.
There is no right or wrong answer, only what is suitable for your lifestyle, risk tolerance, and investment goals—until next time, signing off!
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. All Right Reserved Military Family Investing
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