This week we will talk about securities, which is what you are purchasing when you invest in a startup. While doing your due diligence should come first, some investors tend to stay away from deals that offer a particular security because of the risk involved. While we will get into the importance of diversification down the road, make sure that you understand what you are getting in return for your investment.
Our last post covered the importance of due diligence for startup investors. But we never talked about the actual securities offered in the deal. When an investor makes an investment, what he or she is actually doing is purchasing an equity security (which is like purchasing a piece of the company), or purchasing a debt security (which is essentially lending the company money).
Equity crowdfunding has seen a handful of different types of securities offered so far. Each security carries its own level of risk, which we will get into below. Before you make any investment, make sure you know what type of security is being offered. That will give you an idea of the time it will take to see a potential return, and the risk you take in potentially losing the entire investment. While this does factor into due diligence, you should review the company before you review the security.
Generally speaking if an investor makes an investment with a company offering a common stock security, it is because he or she believes the opportunity for future success vastly outweighs the risk of all or part of the investment.
Unlike the rest of the private sector, equity crowdfunding does not guarantee that common stockholders will receive voting rights.. On top of that, if the business had a liquidation event, you would be sitting at the bottom of the totem pole when it came to receiving compensation from that event. Creditors, preferred shareholders, and debtholders must all be paid in full before you receive a cent.
Be aware that all securities carry a certain amount of risk. With that being said, you can read more about the advantages and disadvantages of common stock here.
S.A.F.E or Convertible Security
SAFE stands for simple agreement for future equity, and was launched by American seed accelerator Y Combinator in February of 2016. The new security was built in an effort to simplify and replace convertible notes.
The SAFE is something like a warrant that entitles investors to shares in a company, only if there is a future valuation event. Future valuation events would include: when the company raises priced equity capital, becomes acquired, or files for an IPO.
Much like convertible debt, SAFE terms can include share-price discounts, valuation caps, and does not present a need for issuers and investors to agree on a current valuation or share price, as those will be fixed at a later date. Unlike convertible debt, there is no debt or maturity date. For investors, this means that they can potentially never receive equity shares, or there might be a long delay in being able to acquire the equity that they paid for.
Startups usually use this security when they have a project that may incur a great deal of loss at one end. It also allows them to lower their borrowing costs, and it gives the investor a value added component with potential in stock. On the risk scale, this would sit below preferred stock. You receive a lower rate of return in exchange for the value of the option to trade down the road.
Be aware that all securities carry a certain amount of risk. With that being said, you can read more about the advantages and disadvantages of this SAFE here.
From a layman’s perspective this security lets the investor act as a lender without the ability to own a piece of the company. Fast growing medium sized business use private debt as a tool to help accelerate their business when they are not able to find funding elsewhere, unwilling to give up stock, or want to stay private.
While there can be different components in how the security is structured, it could involve an interest rate for investors over a particular period of time. But, once the company pays off your debt, you no longer have equity in the business. The other catch for investors is the fact that debt ranks highest in a liquidation event.
If we pit debt against the other securities mentioned above, it may have a lower risk than other security types, when viewed only in the context of a liquidation event, but it carries interest rate risk, default risk, and other risks that may be bigger than equity. You reap the benefits of receiving payments on a structured timeline, you are at the front of the line during a liquidation event, but you don’t receive equity down the road. (And all this is assuming the company is a success and cash flowing….)
Be aware that all securities carry a certain amount of risk. With that being said, you can read more about the advantages and disadvantages of this debt here.
In the security world, you can look at preferred stock as middle child of common stock.
As a preferred stockholder you receive dividends before common shareholders, and in the event of liquidation you would be in line to receive compensation after creditors(debt). On the other side of the coin, you don’t receive some of the benefits other securities do:
- No voting rights (unless otherwise offered by the issuer)
- Gains are typically capped at return of principal or dividend
- If you receive guaranteed dividends you aren’t guaranteed additional compensation or an opportunity to convert your into common shares in the event that the company is sold.
Be aware that all securities carry a certain amount of risk. With that being said, you can read more about the advantages and disadvantages of preferred stock here.
Revenue Participation Note
In layman’s terms, you are betting the company is going to be profitable in the short term, and neither you or the startup are interested in equity.
With revenue participation, equity investors receive a percentage of future gross revenues in exchange for a capital investment. An investor would receive a certain percentage of future gross revenues until they were paid a multiple of the amount that was specified. Although it may sound very similar to debt, investors are not compensated unless the company achieves gross revenue large enough to fund the revenue participation agreement.
As an equity investor, this ranks higher on the risk scale because you can’t receive equity in the company, your pay outs depend on the success of the business instead of something like interest, and your chances of seeing anything in the event of liquidation are little to none.
Be aware that all securities carry a certain amount of risk. With that being said, you can read more about the advantages and disadvantages of revenue participation here.
If you liked this post, and want to know more about investing in startups through equity crowdfunding, you can check out our previous post in our investor series below or subscribe in the box above.