Some fictional stories involve finance, of the high or low varieties. Other stories really ought to mention finance of some kind, due to the way that the setting is constructed, but the author never does—perhaps because the author is not comfortable with the subject. Finance is something that everyone is affected by, but few people understand deeply. Fortunately, the basic concepts are not difficult; and you might find them useful in your writing.
It often happens that someone wants to launch a business venture or some other project needing a lot of money; and other people who have money want to put it to work profitably, but have other people handle the details of executing. When the person with the money (“the investor,” let’s say) funds the person with the venture (“the founder”), hoping to earn a profit, that is what we call “finance.”
The two basic types of investment finance are debt and equity. (There are a few more exotic varieties, but they are fairly marginal and we can safely skip them.) Equity can take a few forms, but essentially, the investor and the founder are joint partners, and the investor is entitled to some fraction of the profits from the business. Exactly how much profit will depend on many factors—not least of which, how easy is it for the founder to find investment capital, and how much risk does either party want to take?
In a pure equity investment, the fortunes of the investor rise and fall with those of the venture. The investor can lose the entire investment if the venture fails, or make incredible amounts of money if the venture takes off. The investor’s interests are therefore closely aligned with those of the founder (at least in broad terms).
Debt, on the other hand, is more adversarial. If the founder borrows money from the investor, he is promising to return the money and the finance charge whether or not the business is profitable. And the investor maximum return is limited by the agreed-upon finance charge; the investor will make the same amount of money if the business is a modest success, spectacularly profitable, or even mildly unprofitable (as long as there is enough to cover the loan payments). Obviously, the investor would prefer that the business succeed, so that the founder has enough money to repay the loan. But a lender’s main interest will be safety, and he will not necessarily pursue the chance of high returns if it means taking high risks. He will also try to get his money back even if it means sucking the venture dry.
Lenders are happier when they can lend against some kind of collateral—some valuable good which can be seized if the loan is not repaid. This could be many things: a house, a car, a horse, family jewelry, or the rights to future royalties from sales of Harry Potter. The better the collateral, the less risk the lender is taking. In a well-functioning society, the lender will therefore charge less interest on a secured loan than an unsecured loan, because the chance of losses is smaller. (That is why you can still get a mortgage in America for less than 10% interest, while credit cards typically charge 15% and up.)
This also means that if you don’t have collateral—for example, if you are starting some sort of business venture and have nothing to show for it yet—it is very hard to get debt financing. Equity finance is better at handling business ventures without tangible assets.
But equity finance poses special problems: how do you keep track of how much money the business made, and the investors are entitled to? It is very easy for the management of a venture to hide profits from the investors, without a very complex infrastructure of laws, public data, and accountants to try and keep people honest. It took centuries of slow accumulated experience and trial-and-error before we arrived at the system for securities markets that we have today, and it is by no means perfect. But in previous times, equity investment was typically limited to partners who knew, and trusted, each other. Equity was thus on a relatively small scale, businesses were very hard to start, economies were relatively stagnant, and economic growth was slow.
Debt, on the other hand, is fairly easy to deal with. How much you owe is fixed by agreement; and the lender doesn’t need to know anything about how you made the money, only that you are able to repay on time. Debt was therefore the most common form of finance by far throughout history; and it is only recently that equity investments have been possible on a large scale.
However, even in ancient times it was possible to combine the two methods of investing. For example, the Babylonian Talmud records a common form of partnership in which half of an investment was considered equity, and half was debt. The founder thus had to repay half (but only half) of the investment regardless of the venture’s success or failure, along with a portion of the profits if there were any. Interests were better aligned between the partners, and the investor still had some degree of safety.
To summarize, when thinking about some sort of business venture that needs investor capital, like a caravan to the Far East, or a merchant ship, or a band of mercenaries sent to plunder the fabled City of Gems, you can think about useful investment structures with the following questions:
- Who is taking the risk of irregular profits, and how much risk?
- How well can the investor monitor the founder?
- What kind of collateral is there?
- Does the legal system or other external structures provide protections for either side, or make one kind of investing more attractive than the other?
(This post is part of Politics for Worldbuilders, an occasional series. Many of the previous posts in this series eventually became grist for my handbook for authors and game designers, Beyond Kings and Princesses: Governments for Worldbuilders. The topic of this post belongs in the planned second book in this series, working title Wealth for Worldbuilders. No idea when it will be finished, but it should be fun!)