3 Types of Securities & How They Are Traded
Most businesses need to borrow money at some stage in their lifetime either for expansion, for asset financing, or just to get them through lean periods.
However a poor business credit score can sometimes make that difficult and see some enterprises struggling to raise the finance they need.
In this post I will examine one of the more complicated areas of asset financing; securities. We’ll look at how securities are used in business loans and how they can help businesses to access lending.
I will examine what are securities in financing, which assets can be used as securities for a loan, and how securities backed loans differ from a regular secured business loan.
What Are Securities In Financing?
Put simply, a security is a tradable financial asset. The exact definition does vary between jurisdictions.
However, when we talk about “securities” we are referring to a fungible, financial instrument that holds an underlying financial value. A security is effectively a token of ownership that can represent a stock, monies loaned or even an option.
Whenever a party assigns a security to another party, they offer some form of collateral. At the least, legal assurance that is more often than not offered in exchange for a line of credit or round of fundraising.
If this is all sounding a bit abstract, don’t worry, it will hopefully become clearer in the next section.
Different Kinds Of Securities
There are a few different types of securities which we shall now look at.
1. Equity Securities
An equity security grants the holder a share of the equity in some kind of entity (usually a company, a trust or partnership) including both common stock and preferred stock.
Holders of equity securities are usually entitled to receive any due dividend payments and also gain some influence and control in the company, trust or partnership over which they hold a security.
To give an example, if we owned a company, we would be able to offer a percentage of its equity as security. The holder would have some voting rights and would be entitled to a share of the profits as per the size of their equity (ie, 5%).
2. Debt Securities
Also known as bonds, deposits or debentures, debt securities represent borrowed money that must be repaid. Usually, the holder of debt securities is entitled to regular payments of either the capital and/or interest.
A holder of a debt security may also hold additional collateral (such as a legal charge against property) but if not, the security itself will still make them a “preferred” creditor in the event of a bankruptcy or insolvency.
The most common example of a debt security is possibly the government bond – IOUs issued by governments for fundraising purposes.
3. Hybrid Securities
As the name suggests, hybrid securities combine some of the characteristics of equity securities, and debt securities.
Common forms of hybrid securities include equity warrants. This give the holder the right to buy stock, at an agreed price, within a set time frame, preference shares, and convertible bonds.
Convertible bonds are bonds that can be converted into stock at the holder’s discretion).
How Securities Are Used
Some securities are traded on the stock exchange, whereas others are traded directly from one investor to another. As well as being sold and swapped, securities can be handed down as inheritance, offered in divorce settlements, or used as payment for debts.
Securities can also be used as a form of collateral for credit such as personal, business or property loans. We will look at using asset-backed financing in the next section,
How Lenders Use Securities
Securities based lending (AKA securities backed lending) is a form of credit lending in which a security is used as collateral for a loan.
Securities based lending is used when a lender is seeking some form of collateral for a debt, but there is no obvious asset to use.
For example, let’s imagine that a Public Limited Company wishes to borrow $1 million. The company doesn’t own any property, its’ only “assets’ ‘ are its computers and staff. Because it’s a PLC, the Directors are not able to offer their homes as collateral.
In this case the company could either seek out an expensive unsecured loan, or could perhaps offer a share of its stock or equity as security for the loan.
The lender would receive a share of the profits during the period it held the equity, and may also be able to sell it if the company defaulted on the loan.
Securities based lending can sometimes help a business with a low credit score obtain financing. As long as the business can demonstrate that the security it is offering has some value (ie, that the company is profitable) then many lenders will consider accepting some form of equity security, and will offer financing at an interest rate that is better than with unsecured lending.
Note that a business with a low credit score is less likely to be able to offer a debt security and also note that not all lenders are willing to accept securities as a form of collateral for lending.
Which Assets Can Be Used as Securities For a Loan
Usually, a lender will want to ensure that the security being offered is equal to the value of the loan. In the case of a well established, profitable company, they may be able to issue equity, stock or convertible bonds as these have some demonstrable value.
In the case of lesser established businesses such as ones with poor credit scores, the process does become a bit tricker as any security they may wish to offer may be hard for a lender to value. For this reason they will usually be limited to equity or stock and even then, may only be able to offer it against part of the loan amount.
Invoice factoring is also sometimes considered as a form of securities based lending. This is when a business offers an outstanding invoice as collateral for a debt.
If the business defaults then the lender inherits the right to collect the invoice. Again, this can prove very helpful for a business with a low credit score that can still demonstrate a healthy income projection.
Securities Backed Lending Vs a Secured Business Loan
Securities backed business lending is not quite the same as a secured business loan. A secured loan is a more conventional form of lending where the money is secured against a tangible asset such as property, a vehicle or equipment.
A secured business loan usually comes with much lower interest rates than other forms of lending as lenders usually prefer a fixed, tangible form of collateral. The classic form of asset financing for business is to secure the lending against the item that the lending was used to procure.
For example, a business loan used to buy a truck would be secure against the truck and the lender would have the right to repossess it in the case of a default.
Final Thoughts on Using Securities For Asset Finance
By now you hopefully have a better understanding of what are Securities in financing.
You also know which assets can be used as securities for a loan, and how they help a business obtain finance- even one with a low business credit score.
This is definitely one of the more conventional forms of asset financing. Any business that is unable to get a conventional secured business loan may still find it better than simply opting for unsecured forms of asset finance.