Securities and Small Business Finance

An equity security represents an ownership interest in a company, often called stocks, shares, or membership interests. Such securities can have differing terms, depending on the ownership allocation, share class, corporate governance, contractual agreements, and legal entity structure of the company:

• Common Stock
• Generally held by founders, directors, chief executive officers, or managing partners.
• Limited company controls through voting rights. 
• Subject to dilution.
• May have dividend rights.
• Preferred Stock
• Generally held by early-stage or lead investors.
• Dilution protections.
• Rights to invest in future funding rounds.
• Rights to dividends.
• Liquidation preference. 
• Limited company controls and voting rights.
• Membership interests
• Represents ownership interest in a limited liability company (LLC).
• Subject to the governance and operating agreements of the company.
• Stock Options
• Typically reserved for employee compensation.
• Usually requires vesting thresholds.
• Companies often issue “Restricted Stock Units” to employees as a written right to receive stock once the vesting conditions are met.
• Limited, if any, control provisions or voting rights.

A debt security is a contractual obligation of the issuing entity to repay borrowed funds in an agreed-upon timeframe, with interest. Debt securities:

•  Are most commonly issued by corporate, municipal, and government entities.
• Typically have a fixed rate of return.
• Interest is typically paid in agreed-upon installments throughout the timeframe of the debt.
• Can only be redeemed once the agreed upon timeframe has been reached and the debt has reached maturity or upon resale to another investor prior to maturity.
• Debt securities can be redeemed and paid in full prior to maturity. This possibility is contingent upon the terms of the offered debt security.
• Can have greater priority in a liquidation event.

A convertible note is a hybrid security that originates as debt and converts to another type of security upon triggering events. Depending on the stage of the company and/or note, convertible notes can have the same terms as a debt security until it is converted to equity. Convertible notes often have a valuation cap that sets a maximum price for security once it has converted to an equity share.

A capitalization table is a visual representation of the ownership allocation of a company at a specific point in time. It memorializes what entities/individuals own what amounts of the company and allows the company management, board of directors, and prospective investors to see, at a glance, who the owners are and how much of the company they own. A capitalization table generally contains:

• The names of a company’s equity security holders
• Allocated membership interest (if applicable)
• Percentage of equity owned
• Number of shares or units held
• Class(es) of securities held
• Price per share or unit upon purchase
• Date of purchase of each share or unit
• Outstanding shares or units in the company (if any)
• Shares or units reserved for employee stock options

A pro-forma capitalization table shows how selling more equity would affect the company’s ownership allocation.

Dilution

Dilution occurs when newly issued shares of a company result in a smaller percentage of ownership in the company for previous shareholders which may also lower the price of each share. 

Valuation

Valuation is the overall worth of a company as determined by an analyst or the company’s investors and is often subject to market demand.

Dividends

Dividends are payouts issued by the company to shareholders and can be in the form of cash or additional company stock.

Liquidity

Liquidity is the capacity for an asset to be bought or sold in a transaction. 

Investments into private companies are generally considered illiquid and resale restrictions may apply depending on the exemption under which the securities were sold. However, if a company enters the public market, the existing securities can be sold or traded on a public exchange. Or, if the issuing company has a buyback program, the existing securities may be sold back to the issuing company. Private secondary markets can also provide a means for investors to sell their securities to other investors. It is important to note that many securities issued in a private placement offering can’t be resold without the permission of the issuing company.