There are four different types of equity you’re likely to be offered:
Common shares are the most basic form of equity. The shares typically come with voting rights, but common shareholders are last in line (after preferred shareholders and lenders) to get paid if the company goes belly up. If the legal setup is a LLC, the shares are often called "Membership Units".
Preferred shares are a class of stock designed to attract outside investors. They typically pay dividends and give investors priority over common shareholders, but have limited or no voting rights.
A Convertible Note is technically a loan that converts to equity at a later date. It’s popular for early-stage startups because it puts off the challenge of establishing a value for a company (which may have no product or sales yet) until a later date, usually the next major funding round. At that time, you’ll receive equity shares (see Common or Preferred Stock), typically at a discounted price. Until the conversion, the notes may accrue interest like a regular loan.
Agreement for Future Equity (SAFE) is a simplified version of a Convertible Note that originated in Silicon Valley. However, unlike a convertible note, a SAFE is not a loan and does not accrue interest. You simply get dibs on equity shares at a discounted price in a future funding round. So you before you invest in a SAFE you should be pretty confident that the company you’re investing in will be able to raise another round of major financing. One feature of a SAFE to pay attention to is the Valuation Cap. It sets a maximum
value on the company for purposes of determining your future share price. So the lower the number the better.
Most loans have a fixed interest rate and repayment schedule—for example, 5% interest paid to investors quarterly over a three-year term.
These loans have variable repayments that rise and fall with the business’ sales. Instead of a fixed interest rate, the business sets aside a certain percentage of sales until you hit a specified target—for example, 1.5 times the amount of the loan (or $1,500 on a $1,000 loan). Your rate of return as an investor depends on how long it takes the business to repay the loan.
Yes, loans can be interest-free. On some funding sites, such as Kiva, you can loan money to a small business and they pay you back the principal—i.e. your original investment amount—over time. (Your reward is knowing that you’re helping out a deserving entrepreneur.)
Pre-pay arrangements let customers pay a sum of money up front, and get paid back over time in products and services as they spend down your credit. It’s like having a house tab at your favorite local business. The advantages for customers include no-hassle transactions.
You may have heard of Bitcoin, the digital currency based on “blockchain” technology. In the last few years, some startups have begun offering digital tokens similar to Bitcoin in lieu of (or sometimes in addition to) equity shares.