What’s a Security?
A security generally refers to a negotiable financial instrument that holds some form of monetary value and can often be traded.
The entity which creates securities for sale is known as the issuer and those who buy the securities are investors. Securities can be broken down into four main categories:
- Equity Securities
- Debt Securities
- Hybrid Securities
An equity security represents an ownership interest in an entity (such as a business, a partnership or a trust). This “ownership interest” usually takes the form of ordinary shares in a business. A shareholder can receive dividends – a share of the company’s profits. Alternatively, a shareholder may profit from capital gains. A capital gain is when a shareholder buys shares and then sells them for a higher value than what they initially bought them for.
Shares can be ordinary or preferred. If, as an investor, you have preferred shares, that means your shares take priority over ordinary shares. Depending on the shareholders agreement, this may mean that if the business were to become insolvent, your claim to its residual assets is greater than a shareholder with ordinary shares. Often preferred shares have no voting rights – meaning less say in the business’ decisions and a fixed return.
A debt security (loan) represents funds which have been borrowed and must be repaid. A borrower (issuer) sells a debt security to a lender (investor) for a specific amount. Therefore, a loan can represent the borrower’s promise to pay back the principal (the fixed amount of borrowed money) and interest (often at a specified rate). Loans also have a “maturity date”. This is the date where the total amount must be paid by.
The lender holding a loan generally receives regular interest payments and the full repayment of the principal, as well as any other rights they contracted for.
Loans can be secured or unsecured. A secured loan is one that is backed by collateral. Collateral is a borrower’s asset which can be taken by the lender if the borrower is unable to make the necessary payments. Think: when you default on your mortgage and your property goes to the bank to be sold. An unsecured loan is one that is not backed by collateral.
Hybrid securities are those securities which have the characteristics of both equity and debt. Two examples of hybrid securities are convertible notes, capital notes and mezzanine finance.
A convertible note is a type of loan which converts into equity. Often, this conversion occurs with a future financing round. With a traditional loan, a lender would receive back the principal and interest, however with a convertible note, the lender receives equity in the business.
Convertible notes are advantageous because they often rank ahead of ordinary shares from a security perspective, and there is a fixed repayment date/conversion to ordinary equity. Before a convertible note reaches maturity, an investor could be offered opportunity for reinvestment, or their convertible notes could convert into ordinary shares or be paid back in full to the lender with interest.
If you’re interested in investing in capital notes, get in touch!
A Capital Note is similar to a convertible note however the right to convert is in the hands of the borrower company.
Mezzanine finance uses a range of hybrid debt and equity financing securities with options attached, giving the lender/investor the right to acquire an equity interest in the businesses often regardless of whether the initial loan has been repaid. Such investments are unsecured and usually subordinated to the businesses bank borrowings.
These investments often have a mix of a more secure debt style return and a riskier equity style return. Therefore, despite having high risk, they also have very high rewards. With mezzanine finance, businesses can issue debt which has a variety of structured terms to suit different investor’s needs. For example, security could be periods of interest only, a blend of interest and equity, equity convertibility and aspects of profit sharing and payments in kind.
Investors looking into mezzanine financing look at the business’ history of earnings and growth, as well as their reputation in the industry. Good cash flow is usually important. Often a business will use mezzanine finance to help fund an acquisition rather than issue shares with an aim to repay the mezzanine finance as fast as possible.
If you are interested in mezzanine financing, click here to find out more information on Armillary Mezzanine Capital, and get in touch!
Derivatives can be a more complex area of investing, usually used by experienced investors. A derivative is a financial security whose value is derived from an underlying asset or group of assets. The derivative itself is a contract between two or more parties. A derivative gets its price from fluctuations in the underlying asset(s). Derivatives are highly complex but also highly liquid.
Common underlying assets can be shares, bonds, commodities, currencies, interest rates and market indexes.
For more information on derivatives see: Investopedia