Sunday, December 05, 2004

Loans vs Equity

There has been some confusion among some of the students in my classes between loans and equity.

Loans are exactly that, a loan of money to a company. A loan consists of a promissory note which states the amount of the loan, the interest rate, the term of the loan and any other conditions. It is a contract in which the borrower promises to repay the loan with interest on the time table stipulated in the note. It is a contract between the borrower and the lender and can be legally enforced. A loan may be secured or unsecured. A secured loan is one in which the borrower pledges an asset as a guaranty that the loan will be repaid. If the borrower fails to repay the loan the lender has the right to sell the asset to recover the amount due. Because there is property with a value equal to or greater than the amount lent, this type of loan carries a lower rate of interest than an unsecured loan. An unsecured loan is just that, a loan that is backed up by nothing more than the borrower's promise to repay it.

Lenders, those loaning the money, can be institutional lenders such as banks, finance companies, etc. or individuals with money to lend. Bonds are a means of borrowing, used by large corporations and governments, to raise a very large sum of money from a large pool of lenders. The lenders in this case can be other businesses, banks and/or individuals. Bonds can be secured by assets or be unsecured.

Equity investments which include shares of stock in the case of a corporation or a property interest in the assets of a partnership. These are not a loan of money but the actual purchase of a portion of the company.

In the case of a loan, the lender makes money available on a temporary basis to the company with the expectation of getting the money back with interest. If the company (or individual in the case of individual loans to consumers to buy a car, house, etc.) goes bankrupt the assets of the company or individual are sold and the proceeds divided up among the creditors with those having secured loans getting paid first, followed by unsecured and other creditors. If anything is left AFTER all creditors have been paid it goes to the owners. In the case of stockholders or partners in a business they get whatever, if anything, is left from the sale of assets after all creditors have been paid.

However, if the company is successful it is the owners of the business, stockholders or partners, who benefit from the increased value. The lenders only get their money back plus interest.

Lenders share in neither the profits nor the liability of a business. A lender is not held liable for legal judgments (i.e., money owed from being sued) or for the payment of other creditors. Lenders only can only lose up to the amount they loaned plus interest. Partners in a partnership are liable for everything the business owes regardless of how much or how little they have invested. In the case of corporations, the limited liability feature of the corporate form of organization prevents the owners from losing more than they have invested. In this way they are like lenders. But there are a couple of differences, the first being that the lender is legally entitled to receive the interest due on the money they loan but stockholders only receive dividends if there are sufficient profits. The other difference is that if the company is successful the stockholders can see their investment increase and can keep the increase while lenders are entitled to only the amount they have lent plus interest.

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