Startups often require external capital to grow and scale their businesses, and in doing so, they issue different types of securities to investors. The term "security" is broadly defined under federal securities laws and encompasses various forms of investment interests. Many investors and founders commonly refer to "equity" when discussing ownership in a startup, but the landscape of startup securities is diverse. Understanding the different types of securities is crucial for entrepreneurs, investors, and employees involved in early-stage companies. Each security type carries distinct characteristics, advantages, and risks, which must be carefully analysed before issuance or investment.
Stock represents an ownership interest—or equity—in a corporation. Stockholders, or shareholders, hold shares that grant them certain rights, including voting power and financial participation in the company's success. Stock can be further classified into different categories based on the rights and privileges granted to its holders.
• Common Stock: Typically issued to founders, employees, and early-stage contributors, common stock provides voting rights, allowing shareholders to influence company decisions. However, common stockholders are usually last in line to receive financial returns if a company is liquidated or acquired. Despite these risks, common stockholders benefit the most if the company experiences exponential growth and achieves a high valuation.
• Preferred Stock: Issued primarily to external investors, such as venture capitalists and institutional investors, preferred stock often carries benefits that common stock does not. These benefits include dividend preferences (where preferred stockholders receive payouts before common stockholders), liquidation preferences (ensuring they get repaid before common stockholders in case of company dissolution), and anti-dilution protections (safeguarding their ownership percentage if new shares are issued at a lower valuation). Preferred stock is generally structured with predefined terms that make it more attractive to investors looking for downside protection while maintaining upside potential.
For startups structured as limited liability companies (LLCs), ownership is represented through membership interests rather than shares. Members (owners) hold units that define their ownership percentage and governance rights. LLCs use an operating agreement instead of corporate bylaws to outline ownership and management structure.
Unlike corporations with a rigid ownership and tax structure, LLCs provide greater flexibility in allocating profits and losses among members. Membership interests can be structured in various ways, with different levels of voting power, capital contributions, and economic entitlements. Some startups choose to structure their LLCs with multiple classes of membership interests, similar to common and preferred stock in corporations, to attract investors while maintaining founder control.
A stock option grants the holder the right, but not the obligation, to purchase shares of company stock at a pre-determined price (strike price) after meeting specific vesting conditions. These are commonly issued as part of an employee compensation package to align their interests with the company's long-term growth. Stock options come in two primary forms:
• Incentive Stock Options (ISOs): Granted to employees, ISOs receive favourable tax treatment under the Internal Revenue Code, provided certain conditions are met. Employees do not owe taxes at the time of the grant or vesting; they may benefit from capital gains tax treatment if they hold the shares long enough after exercising.
• Non-Qualified Stock Options (NSOs): Issued to employees, advisors, and consultants, NSOs do not qualify for the same tax advantages as ISOs. Taxes are typically due when the options are exercised, based on the difference between the exercise price and the fair market value of the shares at that time.
Restricted stock is another common form of employee compensation and comes in two primary forms: Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs). These instruments are issued with specific vesting conditions that must be met before the recipient gains full ownership rights.
• RSUs: Represent a promise to deliver company shares in the future, subject to conditions like employment duration or performance milestones. RSUs are commonly used by mature startups or publicly traded companies, as they help employees build equity in the company over time.
• RSAs: Provide immediate ownership but restrict the holder from selling or transferring shares until certain conditions are met. This approach is beneficial for early-stage startups, as it allows them to attract top talent while preserving liquidity.
The key advantage of restricted stock is that it provides employees with an actual ownership stake in the company, incentivising long-term commitment and reducing turnover.
Convertible instruments are hybrid securities that begin as either debt or agreements but have the potential to convert into equity based on predefined conditions. These are commonly used in seed-stage financing when valuing a startup is challenging.
• Convertible Notes: These function as short-term loans that automatically convert into preferred stock at a future financing round, often at a discount to the following investment valuation. Convertible notes typically have an interest rate and maturity date, ensuring that investors receive some return even if the company does not raise additional funding.
• SAFE (Simple Agreement for Future Equity): A SAFE allows investors to provide capital in exchange for a future equity stake, converting upon a triggering event such as a subsequent funding round or acquisition. Unlike convertible notes, SAFEs do not accrue interest or have a maturity date, making them more founder-friendly.
Convertible instruments provide flexibility for startups needing funding without determining a valuation, making them popular in early-stage fundraising rounds.
Debt financing is another avenue for startups to secure capital. A startup may issue loans with a fixed repayment schedule and interest or structured debt that has the potential to convert into equity under agreed terms. While some debts are classified as securities, others remain standard loans that do not provide an ownership stake.
• Venture Debt: A form of debt financing specifically tailored for startups with venture capital backing. It provides additional runway between funding rounds without diluting equity ownership.
• Revenue-Based Financing: Instead of fixed interest payments, the repayment structure is based on a percentage of future revenue, making it attractive for startups with predictable cash flow.
Startups and early-stage companies leverage a range of securities to attract funding, incentivise employees, and structure their ownership efficiently. Whether through equity, stock options, convertible instruments, or debt, each type of security carries different rights, risks, and benefits. Entrepreneurs must carefully consider the implications of issuing these securities, while investors must assess how each type aligns with their risk tolerance and expected returns. Understanding these investment vehicles is essential for all stakeholders navigating the startup ecosystem. OceanMerge can assist will all aspects of your valuation and capital raising initiatives.
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