When we talk about private securities, they can be split into two basic categories: Debt & Equity.
While there are many many, different flavors of each, every savvy investor needs to have a solid grasp on what makes one more appropriate than the other—especially before purchasing. We put together a slightly exhaustive overview of both for anyone wanting a quick refresher:
- Companies can raise capital by issuing Securities called Promissory Notes, Senior Notes, Senior Secured Notes or Subordinated Notes. These terms indicate the underlying credit structure of a given debt Security and are described below.
- Companies can raise debt financing through Private Placement offerings in amounts from less than $100,000 to well over $1,000,000,000.
- Maturities (i.e., when the Principal is due to be repaid) can be short-term (say, 90 days) to over 10 years. In many cases, Amortizing Principal repayment is established when the debt Security is issued. Amortization involves the scheduled, partial return of Principal over the life of the debt Security.
- A debt security’s repayment schedule should match the issuer’s projected cash flow as long as the debt Security is outstanding. If matching, the company can afford to repay the borrowed Capital when it becomes due.
- The debt’s Maturity should also match the Issuer’s intended use of the funds. For example, funds to be used for short-term working Capital (such as financing Accounts Receivable or Inventory accumulation) should generally involve a Maturity of less than one year. Conversely, funds for Capital Expenditures (including equipment acquisition, property acquisition or facility enhancement, to name a few) will generally involve a Security with a Maturity of greater than one year.
- Debt Securities are also referred to as Fixed Income Securities because they provide Investors with a specified rate of return through payment of an annualized interest rate. This, typically, is paid by the Issuer monthly or quarterly on the outstanding Principal balance. Equity Securities, on the other hand, provide Investors with a share of the Issuer’s profits, but only after the Issuer’s payment obligations of all debt Securities or loans have first been satisfied.
- Interest rates may be fixed for the life of the Security, or they may set in relation to a recognized index, such as the U.S. bank Prime Rate or the London Interbank Offered Rate (‘LIBOR’). The rate paid for such floating rate notes will, therefore, fluctuate as the underlying indexed rate changes due to overall credit market shifts.
- Lower credit quality Issuers should pay a higher rate of return to Investors than stronger credit quality Issuers.
- Longer maturity Securities typically require a higher interest rate than do shorter term Securities of a comparable credit Issuer.
- The credit strength of a debt Security and the related Investor demand can be enhanced by Collateralizing the Security. Here, a Lien on the Issuer’s assets is filed in the state the Issuer and the assets are located. In the event that the Issuer cannot otherwise meet Its redemption obligation, these assets can be Foreclosed upon for sale by Investors to achieve a return of their investment. Such Securities are referred to as Secured Notes.
- To generate a greater potential return to the Investor, debt Securities may also incorporate Warrants, a form of purchase option for equity Securities of the Issuer. Including Warrants with a debt offering may be necessary to generate Investor demand given the risk profile of the debt Security being offered.
- Debt Securities can also be issued whose repayment priority is specifically subordinated to other debt Securities of the Issuers. These are referred to as Subordinated Debt and also as Mezzanine Financing. Investors typically offered higher Total Returns than in Senior Debt Securities which have seniority in the event of a liquidation of the Issuer.
- Not paying the Principal or interest when due on a debt Security results in a Default event. This triggers events that can restrict the Issuer’s operations until the default is “remedied,” potentially forcing the Issuer’s bankruptcy and liquidation. Consequently, debt should only be offered by companies having a base of operation that generates sufficient cash flow to meet the Principal and interest payments specified by the Security offered.
- Debt Securities can be structured for continual issuance, sometimes in Tranches, when there is an ongoing need for debt financing by an Issuer and not all the Capital is required at one time.
- Credit ratings on a specific private debt Security, which can be assigned from third parties such as a nationally recognized rating service (i.e., Moody’s Investors Service, Standard and Poor’s Corporation or the NAIC), can significantly increase Investor demand while reducing the interest rate required by Investors. Credit ratings are only available for the debt Securities of larger, well-established companies.
Now, on to information about equity investing:
- Companies raise capital in the form of equity.
- Equity represents an ownership interest in a for-profit company where the Net Equity Value of the company (i.e., total assets less indebtedness) and any ongoing profits are owned proportionately by the holders of the equity. Equity Securities are a form of permanent Capital for a company.
- Debt, on the other hand, represents temporarily borrowed funds by a company and, in return for borrowing capital, the Issuer must meet specific obligations under the terms of the debt for the periodic payment of interest and the scheduled repayment of the borrowed funds (Principal).
- U.S. companies are incorporated at the state level into C or S Corporations which issue shares or, in the form of a Limited Liability Corporations, which allocate Membership Interests (sometimes also expressed in the form of Units).
- Equity shares or membership Interests can be in either common or preferred form, whose rights are defined in the company’s Articles of Incorporation, if the company is a C or S Corporation, or in the company’s Operating Agreement, if the company is a Limited Liability Company.
- If a company is sold or must be liquidated, debt obligations are Senior in liquidation priority (i.e., repayment) to equity Securities. If all the debt obligations are not fully satisfied when a company’s assets are sold through liquidation, equity holders will receive nothing.
- Preferred equity is Senior in liquidation to common equity. Preferred equity typically will have specific preferred dividend payment obligations, as well as other preferred return on investment-related obligations, which are in “preference” to common equity.
- Preferred equity is often issued through Private Placement Offerings by Venture-stage companies (i.e., pre-cash flow) or as part of a strategic plan by more mature companies needing expansion capital or acquisition finance.