What the heck is a security?
If you remember in our previous article, "Is Investment Crowdfunding Right for Your Business?", you’re selling a ‘security’ in exchange for investment in your company. A security according to Investopedia is, “a fungible and tradeable financial instrument used to raise capital in public and private markets.’ It may sound confusing, so let’s talk about specific types of securities that are commonly used to make it clearer.
What types of securities are commonly used in investment crowdfunding?
Equity Securities = for example a priced rounds w/ a set valuation
This is when you sell an ownership interest in your company, generally by selling preferred or common stock. Shareholders are not entitled to regular payments but may receive them through what are called dividends if the company elects to pay them. Usually, investors who buy equity securities are looking for the value or their shares to appreciate so their shares and book what’s called a ‘capital gain.’
Tends to be a good fit for: Companies with potential to grow quickly in large markets where risk is very high
Debt Securities = for example a term or revenue sharing note
Debt is very different from equity. Debt s when you borrow money from investors that must be repaid according to the terms of the loan. Debt comes in many forms, including term notes, rev share notes, and the interest rates offered vary quite significantly, depending on the risk of defaulting, which means you’re unable to repay. Unlike equity, once the debt is repaid and the terms are fulfilled, the investors are no longer entitled to future gains unless otherwise stated.
Tends to be a good fit for: Companies that scale linearly, like most small businesses, that have cash flow to repay debt, but are not likely to become huge mega companies in the future.
Hybrids Securities = for example a convertible note
These securities have features of equity and debt in the same instrument. These come in many forms, but one of the most common is called a convertible note. Convertible notes are generally like term notes that you can repay with interest, but that convert to equity if you’re unable to repay at predetermined terms. They can also be structured to convert to equity intentionally, but to compensate investors with interest for the time it took to return their money as a benefit for investing early.
Tends to be a good fit for: Early-stage companies that are looking to further incentivize investors to back their company. Convertible notes tend to be considered more investor friendly then SAFEs (see next paragraph for description of SAFEs)
Derivative Securities = for example a SAFE (simple agreement for future equity)
Derivatives are neither equity nor stock. An example of an increasingly popular type of derivative is a SAFE, that was developed initially by Y-combinator to solve the problem of allowing founders to access funds from investors without having to immediately agree on a valuation. Typically, SAFEs have a valuation cap (ceiling) and discount to reward early investors. The safe converts to equity (or whatever is specified) once the next valuation is determined in a subsequent funding round.
Tends to be a good fit for: Early startups that have trouble valuing their company because there’s not enough data yet. SAFEs to tend to be considered founder friendly.