What are securities? (for startups and investors)

Securities are tradable financial instruments with a monetary value. A security, which represents ownership in the form of bonds, debt, or options, can be traded for money or a stake in a business. 

Private investors use them to diversify their investment portfolios and partake in a company's success and failures by buying and selling securities.

Types of Securities

Depending on the company's requirements and investors' risk appetite, they can choose among the multiple types of securities to fit their needs.

Equity securities

Equity securities, commonly known as stocks or shares, represent ownership in a company. Investors holding equity securities have a claim on the company's assets and earnings. 

Equity financing is critical in the entrepreneurial ecosystem, providing the necessary funds to fuel growth and innovation. Startups are often characterized as high-risk ventures that require significant investment. Equity securities offer a mechanism for them to raise capital without incurring debt. 

This type of financing can be a win-win for both founders and investors, as the company's success is tied to the performance of its equity securities. 

Debt securities

Debt securities, including bonds and debentures, signify a loan made by an investor to the issuing entity. Private investors can lend money to startups through bonds, earning periodic interest payments and the return of the principal amount at maturity. 

Businesses can raise funds for their operations, capital expenditures, or other strategic initiatives by issuing bonds and debentures. This allows them to leverage their financial position and expand their business operations without diluting their equity or ownership stake.

Debt fundraising is uncommon for early-stage startups, as they usually lack sufficient financial traction over a prolonged period. This type of security is also more suitable for certain businesses with consistent cash flows that have high working capital requirements.

As most early-stage startups reinvest profits back into the business to double down on R&D and expansion, monthly interest payout conditions as part of these debt securities need to be carefully assessed by the promoters. Hence, there is always a trade-off between equity vs debt fundraises.

As per PitchBook Venture Monitor, Q4, 2022 report, between 2017 and 2022, the US venture debt market went from 10% of the size of the US VC market in 2017 to 14% in 2022.

A Houlihan Lokey report of 2024 showed that the ratio of market volume on the venture debt market to the venture capital market in Europe rose from 10%–15%, observed between 2016 and 2021, to 24% in 2022.

Per the venture debt firm Stride Ventures report, venture debt financing crossed $1.2 billion in 2023, a compound annual growth rate (CAGR) of about 34% from 2017 to 2023. In India, venture debt is 3% of the total equity financing as per last available comparisons.

Derivative securities

Derivative securities have their value based on an underlying asset or benchmark. These underlying assets include commodities, stocks, bonds, currencies, market indexes, etc. The most common types of derivative securities include options, futures, swaps, and forwards. 

Investors use derivatives to manage risk, speculate on price movements, and gain exposure to assets that might otherwise be difficult to invest in directly. They’re also used for speculation on the future performance of startups or broader market indices.

Another good example of derivatives is employee stock options. Stock options are the rights granted to employees to purchase the company’s equity shares at a predetermined discounted price on a future date. These are vested over a period of time.

Hybrid securities

Hybrid securities represent a unique blend of equity and debt instruments, offering startups a flexible and innovative means of raising capital. By incorporating elements of both equity and debt, these hybrid securities cater to a diverse range of investor preferences and risk profiles, thereby enhancing the attractiveness of the startup's investment proposition. 

Some typical hybrid securities include convertible notes, which initially function as debt, accruing interest over a specified period. However, the notes can convert into equity at a predetermined future date or milestone event, such as a subsequent funding round at a predetermined valuation. 

There are also SAFE Notes which are financial instruments that startups use to secure investment from early-stage investors. SAFE Notes allow investors to convert their investment into equity at a later event, such as a future funding round or exit. 

Another popular hybrid security is preferred equity. These preferred equity holders typically have priority over common shareholders in receiving dividends and liquidation proceeds, similar to debt holders. However, they also have equity-like features, such as voting rights and the potential for capital appreciation. 

One of the hybrid securities gaining steam is revenue-based financing (RBF). In RBF, investors provide capital to startups in exchange for a percentage of the company's future revenues over a specified period. This structure is similar to debt, as investors receive regular payments based on revenue, but it also aligns with equity principles since payments fluctuate depending on the startup's performance.

Bottom line

It is imperative to understand and leverage various financial instruments to build a business effectively. Each type of security offers distinct advantages and considerations, allowing startups to tailor their fundraising strategies to suit their specific needs and circumstances.

Equity securities align the interests of founders and investors, as both parties stand to benefit from the company's success. Debt securities provide startups with an alternative funding source without diluting ownership stakes. In contrast, hybrid securities offer a balance between equity-like and debt-like features, appealing to a diverse range of investors.