Whether you are considering investing in a new company or creating a startup, you might wonder how do investors get paid back. It is an important question that people on both sides of this issue need to understand going into this relationship of being an investor or being invested in.
Before becoming an investor or accepting investments, it is essential to know exactly how the investment will be paid back, the time frame, and the risks associated with this investment.
4 Common Ways Investors Can Be Paid Back
When you wonder how investors get paid back, you may want to know more details and specifics. So keep on reading to find out 4 different ways investors get paid back from their initial investment in a startup or a newer business.
1. Debt Financing
One of the simplest forms of investment is a loan. Typically in this type of investment, an investor purchases a promissory note and becomes a lender to an individual or a company. Then the lendee has to pay back this loan in a preset amount of time with interest attached.
Most people understand this form of investment pretty readily as it is similar to getting a car or a home loan. Those loans are also forms of debt financing.
This type of debt financing can either been done with a traditional bank or an investor. If you are going the bank route and your business is new, you will need a business plan for consideration. They will also consider your own personal credit history and financial portfolio.
If your business is established, they will want to look at your business credit history and your books. They may ask for other documents as well.
Suppose a business or a startup is getting a loan from an investor outside of the bank. In that case, the investor may want some of the same paperwork before committing.
However, investors are also usually more interested in your business model and whether or not they believe you can become successful.
This is essential if they expect you to pay back the loan. They are looking at the market you are in and your overall ideas and you as a manager and business owner, and how you plan to create repeat business and growth.
This can be considered a good form of investment for the lender as they are more assured that they will get their money back while earning interest. However, the downside for the lender is that if the company does take off, they will not own any part of the company or be entitled to any profits.
It is advantageous for the business or startup as the relationship is over once the loan is paid, and they have not had to lose any percentage of the company. However, the disadvantage is if the company goes under, you still have a debt to pay back.
You may like to read, 25 Best business to start to become a millionaire.
2. Common Stocks
If the form of investment is something more than a simple loan, common stocks are the most customary way to go. The more stocks someone buys from a specific business, the higher the percentage of that business they will own.
Typically stocks are sold in shares where the price is based upon what the business is worth. This is one of the reasons why stock prices between companies vary so much.
As an investor, you want to choose established businesses that you believe are on the rise and just need a little financial assistance to aid in growth and market visibility.
On the other hand, if you invest in a startup, you want to choose a company with a good idea, a better management team, and a solid business plan and approach.
If you believe that your investing in will become profitable, the more money you invest, the more of a stake you will have. For example, think of any significant blue-chip company out in the market today, and just imagine you owned 1% of that company. How much money would that initial investment be worth today?
One of the ways you can make money with stocks is simply selling them high. For example, if you purchase 1000 shares at $5.00 a share and sell when they reach $50.00 a share, you have made a 10X profit.
Many people keep the investment for a lengthy period, but they still make money in other ways. For instance, cash dividends make many stock owners make money throughout the years on their current investments.
Many companies’ boards of directors will decide to give out cash dividends; typically, these go out quarterly. However, some companies do not follow that schedule. Depending on which companies you invest with, you could see dividends monthly, quarterly, annually, or semi-annually.
A cash dividend is when the company distributes funds to stockholders as part of the business’s accumulated profits or current earnings. These are paid in cash (hence the name), but many people choose to use that money to buy additional stocks.
The pros for investors on using stock as the form of payback are having ownership in the company and the possibility of making a lot more money than your original investment. The cons are that even if the company becomes successful, this is a long-term investment.
If the company fails, you could lose your entire investment. However, this is why it is crucial to have a large and diverse stock portfolio. A few good assets can cover the loss of the bad investments, and you can still come out on top.
You can rest assured that you do not need to pay back this money for the business or startup if your business ultimately fails. However, you no longer own the entire company. Therefore, you will need to think about your shareholders in all the decisions you make.
Also, if you do become profitable, whatever percentage you have sold of your company is not your profit. So if you only own 75% of your company, 25% of the profit is no longer yours to keep, spend or reinvest in the company.
Also, read, How much does it cost to start a software company?
3. Convertible Notes
Another common way investors get paid is through something called convertible notes. This is a combination of a loan and an investment. As the investor, you buy debt from the company. You will earn interest on the debt until the maturity date is reached. Once this happens, you will either be paid back in cash or convert to equity in the company.
Equity is the value in cash that would be returned to you if the company’s debts were paid off and all the assets were liquidated. Typically you will see this in startups to convert into stock when the company becomes established enough to receive a correct valuation.
These stocks are usually more than common stocks. They are stocks with preferred rights. Some of these preferred rights could include a seat on the board or veto rights.
Sometimes a startup will give out common stocks to family and friends and even some investors. However, many investors, especially ones with a large financial stake, will not accept common stocks. They want more control over the direction of the company considering the size of their investment.
Whereas this type of investment can be highly favorable for the investor, it can be considerably less desirable for the company getting invested in. This type of investment does not only mean you are giving up a share of the company, but you may also be placing the investor on the board with veto rights. As a startup, you need to really think about what that means for you.
Are you comfortable with others owning a portion of your company? How do you feel about people having a say in the companies’ practices and the direction the company is going? If you can get over these hurdles, this could be a good investment for your company; however, it is still good to learn as much about the specific investor.
You do not want to give power to someone with a bad track record or someone whose goals, values, and vision does not align with your own.
Also, read, 10 Best business to start passive income.
Finally, we come to SAFEs which stands for simple agreement for future equity. This is a form of a convertible note but with less protection for the investor. This type of investment is usually used for startups or a company that is in its earlier stages.
One of the reasons this was created was that it is difficult to assign value to the company in the earlier stages of a business. There is no data to go on, and you do not know how to market will respond to this specific business.
A SAFE allows you to postpone the valuation of the company to a later date. It is essential to understand that this is an investment. There is no debt, no equity, no accruing interest, and no maturity date. Some investors do not like this type of investment due to the lack of protection it provides.
If the company you invest in fails, they will return any money not spent. However, that is it. Your initial investment has no other forms of protection. However, if the company grows, your investment could eventually be transferred over to a company’s share.
Usually, once the company grows and begins to succeed, it will need more capital. At this point, they may find a large investor who is willing to invest a specific for a specific portion of the company.
Let’s assume the new investor is willing to put up $1,000,000 for 10% of the company. Then let’s say the company is now valued at $10,000,000 and stock prices are $1.00 a share.
At this point, your initial investment can be converted to stock. So if you invested $50,000.00, you now have $50,000 shares. Now you can do what you like with these shares – keep them for a long-term investment or sell them. You may also get dividends going forward if you keep the shares.
Also, read, 9 Modern Ways to Get Funding for Your Startup In USA.
Ways an Investor Can Make Money
Now that you understand how investors get paid back, you might be wondering other things, such as if there are different ways for investors to make money with their initial investment into startups and new businesses.
So here are a few ways that people can make money off the investment.
One of the ways an investor can make money is by selling their shares to another investor. They usually do this before the company being evaluated and having a worth added to it – because, at that point, they could just sell the stocks.
If an investor does not want to wait, they can always sell their shares to other investors.
The Startup is Acquired By Another Company
One of the quickest ways for investors to make money back is when the company takes off or is noticed by bigger companies who buy the company. When the company changes hands, investors may make money relatively quickly.
The new owners may pay out any debt on hand plus cash out stocks. As a result, the company could get a new valuation, and the amount owed to the investor could also increase.
The Company Begins To Pay Dividends
As previously mentioned, dividends are a way investors can make money while they hold the original investment. For example, suppose the investor is a shareholder, and the company starts to make a profit. In that case, they may be entitled to dividends – a portion of the profits.
This portion is usually paid out quarterly but could be more or less frequent depending upon the company.
The Startup Goes Public
One final way that investors can make money is if the company goes public. This is commonly referred to as an IPO. IPO stands for initial public offering. The investors received their shares before the stock went public.
Investors make money back on an IPO by getting the difference between how much they paid for a share versus how much the general public pays.
For instance, an investor might have paid $1.00 for a share. IPO’s are usually companies that people expect to make a killing. Instead, they are offering something extraordinary and popular.
Think of major tech companies or social media companies. When they went public, their initial price is usually way higher per share than what the investors paid. Here are 15 popular examples.
- Alibaba – initial offering – $68.00
- Visa – initial offering – $44.00
- Facebook – initial offering – $38.00
- General Motors – initial offering – $33.00
- AT&T Wireless Group – initial offering – $29.50
- Kraft Foods – initial offering – $31.00
- UPS – initial offering – $50.00
- Snap – initial offering – $17.00
- Pinterest – initial offering – $19.00
- Twitter – initial offering – $26.00
- Amazon – initial offering – $18.00
- Apple – initial offering – $22.00
- Papa Johns – initial offering – $13.00
- Disney – initial offering – $13.88
- Dell – initial offering – $8.50
As you can see, there may be a very large difference between what an investor pays for their shares to the IPO price. This is where an investor can really make their money back and a lot more.
You may like the following articles:
- Why Do Most Tech Startups Fail?
- How Tech Start-Ups Make Their Money?
- What should startup know before seeking funding?
- Why do people leave big tech companies for startups?
- What Tech Startups Look for In Employees
Hopefully, you have a better understanding of how investors make their money and how the startups and small businesses pay these investors back. For a quick recap – the investors may participate in the following types of programs:
- Loaning money.
- Investing in exchange for common stocks.
- Investing money in exchange for convertible notes.
- Investing in exchange for SAFE’s.
Besides getting paid back through the above programs, they might also make money through:
- Profit from the company changing hands.
- Selling their shares to other investors.
Bijay is an entrepreneur and start-up founder having more than 14 years of IT industry experience. He is the co-founder of TSInfo Technologies, a SharePoint development company.
A dedicated professional and very passionate about public speaking and also wrote thousands of technical blogs in various technologies. He also wrote a lots of blogs on entrepreneurship, investment, startup, business, manage money tips, etc.