Debt Finance Versus Equity Finance: An Explanation
Debt finance will always take the form of a loan and equity finance tends to mean a profit share with a high net worth individual or a sophisticated investor. As a property investor, whether you choose one or the other will depend on the specifics of the project you are working on and there might be times you decide to use both.
Debt Finance Vs. Equity Finance
Amy: Debt Vs. equity finance, we will discuss next. What do you think is best for property businesses?
Rory: Now, that’s a tricky question.
Amy: We like to ask tricky questions.
Rory: There is a whole host of answers, really. So, why don’t we go back to 101 to understand the difference between debt and equity?
Debt Finance
Rory: If we just start with debt. Debt, essentially, is a loan. It’s as simple as that. You go to a bank or you go to a bridging company and you ask for X-amount of money.
So, we use the theme that we’ve talked about. If you’re getting a bridging loan, 60% of the purchase price is probably what you’re advanced. It’s very, very simple.
You could go to a private individual and you could borrow money on a private loan. It’s not a profit share, it’s a private loan, agree on a formal arrangement through your solicitors and how they get paid.
And that’s debt. So, you’ve not given away a piece of the pie.
Equity Finance
Rory: Now, let’s switch to equity.
Equity gets interesting because equity is essentially… You’re, potentially, giving away a slice of the pie.
So, it could be a profit share. So, you could go to one or two investors, you’re prepared to invest X, for a return of Y.
Now, your question was, what’s the most appropriate piece?
It really depends on the project because if we use our traditional bridging example, if you don’t have enough money, you’ll be advanced 60% of the purchase price. So, you’re now short 40% and, if it’s a development, you can be short, even more.
So, you could be prepared to give away a slice of the pie, as equity, as a profit share.
Profit Sharing
Here’s the thing you need to be very careful about. You can’t stand in a room or go online and promote a profit share to people, who are not the right audience.
It’s illegal and if you did find a private investor and you said you’d give them a profit share and they were not a sophisticated or a high net worth investor and it went wrong, you stand the risk of them, potentially, suing you. So, you’ve got litigation.
Now, I know people think I’m a little bit mad but these are the rules and if you read the FCA rules, it’s crystal clear.
So, I thought it might be worth just…
Amy: It’s best to know them, in advance and not be caught out by them.
Rory: Absolutely.
So, what do we do? We borrow money from investors. It’s very simple. So, we speak to Fred, we might be short £100k. ‘Fred, can I borrow £100k, for projects that we’re funding or projects we’re doing ourselves and I’ll agree to pay you X-amount of interest?’
So, it’s a set rate, for an agreed period of term. That’s fine.
If we are then offering a profit share, let’s just look at the two types of people that we can speak to.
You can research this if you go and look at the FCA website but let’s just get a couple of these clear.
High Net Worth Individuals/Investors
Rory: The first one would be a high-net-worth investor. So, a high net worth investor has, essentially, two key criteria.
One, you need to be earning £100k a year, in income and they can self-certify this. So, you’re high net worth, you can certify and prove that you earn £100k a year.
The other one is you must have £250k in assets, that can’t be equity in your main home or the benefit of a pension or some life insurance policy. So, it will be additional funds and that’s a high-net-worth investor.
So, someone who can self-certify and prove that, they could invest with you for a profit share.
Sophisticated Investors
Rory: The other one would be what we call a ‘sophisticated investor’, so, an ‘SI’.
A sophisticated investor, there are four key criteria there. And, essentially, keeping it simple and there is a lot to remember…
Number one, have they invested in a business, angel network for six months prior to the date of self-cert? So, if they have and they can prove that that’s okay.
Or, have they made one or more investments in an unlisted company, in the two years prior to the date of self-cert?
The third one, then is, have they worked in a professional capacity in the private equity sector, raising money for SME, small to medium enterprises?
Or, finally, have they been a director, in the previous two years, in a company which has a turnover of over a million pounds?
I know it all sounds very complicated but if you get that right and you are promoting to the right high-net-worth or the right sophisticated investor, they can do profit-share.
Buying a Property with No Money Down
Rory: So, you could, actually, potentially, find a project, where you could use, maybe, some debt for the original tranche of money and for the development and then find some high-net-worth or sophisticated investors, who can qualify and they can put the balance in which means you run the whole project but don’t put any money into the pot, potentially.
Amy: Fantastic, thank you. That’s great, thank you.
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