How does a typical business investment work?

Let's say you have $1,000. You put it in the bank. What happens? If you're in Japan, the company wants to charge you for keeping it, but in most countries, someone gives you some money as interest. At the end of the year your $1,000 is worth $1,010 (1%).

Banks are tightly regulated and backed by the government so there is every likelihood that your $1,000 is still there, available to you.

This begs the question "How can I get more than $10 for that money for a year?"

In the 1400s, the Dutch came up with a system of shares in a company. These were bonds that allowed people other than the founder to have a share in it, both liabilities and proceeds. So if that company paid for a voyage to the East Indies which cost $10,000 (OK the dollar hadn't been invented yet) and ten men funded it with $1,000 each and the ship came back with £110,000 worth of goods, the investors would all share in the $100,000 profit, with $10,000 each - they had just made $10,000 for $1,000 stake. But many times the ship didn't make it back at all and they lost their money. Higher risk, but higher potential gain.

This is called equity investing - the ten men all took equity in the project and shared the proceeds according to their share. Those shares don't have to be equal - one man may have been promised 10% of the profits, but another 25% - perhaps because he owned the ship, provided the crew etc. This brings two things into play - sweat equity - where someone puts in something other than money and preference shares. Perhaps, for example, the guy had offered the first shareholder 20% of the profits for his $1,000, but then found he had 20 men all happy to give him money, all because the first one had invested. He would have to share the remainder among all of them.

He could, of course, have gone to a bank for that money. They don't take risks like equity - they want their money back plus interest. They will also decide whether you are a trustworthy person to loan to - how likely you are to pay it back. From that they will decide what interest to charge. They call that a loan.

They will also look at what you have, which you could give them if you cannot repay. This is called collateral. Some of this is tied up in "fixed assets" such as property, some can be in "liquid assets" such as stock or even monies in the bank. They often ask you to sign away your rights to this collateral if you default on your loan. They can also take shares in the company as collateral and often these are at guaranteed values or shares which get paid first - preference shares.

Most modern ventures are a mixture of loan and equity investment. Both are up for negotiation. As an investor you can go high risk for high reward or low risk for low reward. You can take your profit as a share in the company (equity), or as a loan to pay back with interest. And you have to watch for preferential arrangements with banks and other lenders who may have first call on profits, revenues and even buildings.

Last, but not least, is that those shares, assuming you went the equity route, may have no value. If the company doesn't make a profit, obviously there is nothing to give out. Even if it does, it may decide to retain them in the company, or it may decide to pay a dividend to all shareholders. You may receive your profit from this dividend.

If, however, you can find a buyer, you may profit from the sale of your shares. Let's say you were that Dutch ship investor. You put in $1,000 for 10%. Your venture is highly successful and the company is suddenly worth $1million. Your shares on paper/vellum are worth $100,000. Perhaps, however, you are lucky enough to have been around when the Dutch East India Company created the first stock market, the Amsterdam Bourse. There your shares could be traded to the highest bidder. On a bad day you would get less than your $100k - and the stock market would take a fee, but on a good day you could get more, possibly much more.

Last but not least, you could have an earn-out. Here the person you are investing in agrees that you own 10% of the company, but that when he has repaid you your money and a certain agreed profit, he can have his 10% back. This could be absolute - you're out altogether - or partial - perhaps you took 50%, but the deal is that once your money and interest are repaid you retain 10%.

It is a lot more complex than simply double your money and get out. That is because different companies have different needs, different investors take different views on risk and because when you really need the money you will do any deal you can.

Do the deal you can. And if you don't know what you're getting into, make sure you get advice from someone who does.

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