What is a security?
In everyday language, "security" refers to a financial instrument that represents some form of financial value — a stock, a bond, a fund share. But in legal terms, the definition is both broader and more specific than most people expect.
The Securities Act of 1933 defines a security to include "any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement," along with a catch-all category for "investment contracts." That last term — investment contract — is where things get interesting, because it's the mechanism the SEC uses to bring novel financial instruments under the securities regulatory umbrella.
If something is classified as a security, it must either be registered with the SEC or qualify for a specific exemption from registration (such as Regulation A or Regulation D). This is the foundation of U.S. securities law: if you're selling a security, investors get disclosure protections.
Source: Securities Act of 1933, Section 2(a)(1); SEC — Definition of a Security.
The Howey Test
The most important legal test for determining whether something is a security comes from the 1946 Supreme Court case SEC v. W.J. Howey Co. The Court established that an instrument is an "investment contract" — and therefore a security — if it meets four conditions:
- An investment of money — the investor commits capital (this can include non-cash consideration)
- In a common enterprise — the investor's fortunes are tied to those of other investors or the promoter
- With a reasonable expectation of profits — the investor expects financial returns
- Derived from the efforts of others — the returns depend primarily on the work of the promoter or a third party, not the investor's own efforts
If all four prongs are satisfied, the instrument is a security regardless of its name, structure, or marketing language. This is why the SEC has been able to classify instruments ranging from orange grove contracts (the original Howey case) to certain cryptocurrency tokens as securities — the label doesn't matter; the economic reality does.
Source: SEC v. W.J. Howey Co., 328 U.S. 293 (1946); SEC — The Howey Test.
Equity instruments
Equity represents ownership in a company. When you buy equity, you're buying a piece of the business — and your return depends on how well that business performs.
Common stock
Common stock is the most basic form of equity ownership. Holders of common stock typically have voting rights (one share, one vote), the right to receive dividends if declared, and a residual claim on the company's assets in a liquidation — meaning common shareholders get paid last, after creditors, bondholders, and preferred shareholders.
In a startup context, common stock is what founders and employees typically hold. Investors in early-stage companies usually receive preferred stock instead, which comes with additional protections.
Preferred stock
Preferred stock sits between debt and common equity in a company's capital structure. Preferred shareholders typically have a liquidation preference (they get paid before common shareholders in a sale or wind-down), may receive fixed or cumulative dividends, and often have anti-dilution protections that shield their ownership percentage from being diluted by future fundraising rounds.
Venture capital investors nearly always receive preferred stock. The specific terms — participation rights, conversion ratios, dividend preferences — vary deal by deal and can significantly affect what an investor actually receives in different exit scenarios.
Stock options and warrants
Options and warrants give the holder the right, but not the obligation, to purchase stock at a predetermined price (the "strike" or "exercise" price) within a certain timeframe. Options are commonly granted to employees as part of compensation; warrants are sometimes issued to investors or lenders as additional upside. Both are derivatives of equity — their value depends on the underlying stock price exceeding the strike price.
Debt instruments
Debt instruments represent a loan from the investor to the issuer. Unlike equity, debt comes with a contractual obligation to repay — including interest payments and return of principal at maturity.
Bonds and notes
Bonds and notes are the most common debt instruments. The key terms include the principal (amount lent), the coupon rate (interest paid, typically quarterly or semiannually), and the maturity date (when principal is returned). Bonds generally have longer maturities (10+ years); notes are shorter-term.
Debt holders are senior to equity holders in the capital structure — in a bankruptcy or liquidation, bondholders get paid before any equity holder sees a dollar. This seniority makes debt lower-risk than equity, but the tradeoff is that debt holders don't participate in upside beyond their contractual interest payments.
Debentures
A debenture is an unsecured bond — meaning it is not backed by specific collateral but rather by the general creditworthiness of the issuer. Because debentures carry more risk than secured debt (if the company fails, there's no specific asset to seize), they typically offer higher interest rates to compensate.
Hybrid instruments
Hybrid instruments blend characteristics of debt and equity. They've become central to startup and private market investing because they let investors and companies defer hard valuation questions while still putting capital to work.
Convertible notes
A convertible note is technically debt — it has a principal amount, an interest rate, and a maturity date — but it is designed to convert into equity at a future priced financing round rather than be repaid in cash. The conversion typically happens at a discount to the next round's price (commonly 15-25%) and may include a valuation cap that sets a maximum price at which the note converts, rewarding early investors if the company's valuation grows significantly.
If the company never raises another round before the maturity date, the note is technically due for repayment — but in practice, this often triggers a negotiation rather than a cash payment, because early-stage companies rarely have the cash to repay.
SAFEs (Simple Agreement for Future Equity)
Created by Y Combinator in 2013, the SAFE simplifies the convertible note by removing the debt characteristics entirely. A SAFE has no maturity date, no interest rate, and no repayment obligation. It is simply a contractual right to receive equity at a future priced round, at a price determined by a valuation cap and/or discount.
SAFEs are founder-friendly because there's no ticking clock (maturity date) and no interest accruing. They're investor-risky because if the company never raises a priced round or gets acquired, the SAFE may never convert — and unlike a note, there's no principal to demand back.
Revenue participation agreements (RPAs)
A revenue participation agreement is a distinct instrument type that doesn't fit neatly into the equity or debt categories. In an RPA, an investor provides capital to a company in exchange for a percentage of the company's future revenue, paid out over time until a predetermined return cap is reached.
How RPAs work
The core mechanics are straightforward: the investor puts in capital, and each period (typically monthly or quarterly), the company pays the investor a fixed percentage of its top-line revenue. Payments continue until the investor has received a total amount equal to the return cap — usually expressed as a multiple of the original investment (for example, 1.5x or 2.0x).
Unlike equity, RPAs involve no ownership transfer. The investor doesn't get shares, doesn't have voting rights, and doesn't participate in a future exit or IPO. Unlike debt, there's no fixed repayment schedule — if the company has a slow revenue month, the investor receives less; if revenue accelerates, the investor reaches the cap faster.
RPAs vs. equity vs. debt
RPAs sit in a unique position. They offer predictable downside (the return cap defines your maximum return, and the revenue-share percentage defines the payout rate), no dilution to founders (no equity is transferred), and returns that are tied to real performance rather than speculative valuation. The tradeoff is that investors don't participate in unlimited upside — if the company becomes a unicorn, RPA investors receive their cap and nothing more.
For a deeper dive into how revenue-based financing works, including its history, mechanics, and evaluation framework, see our full guide to Revenue-Based Financing.
Comparing instrument types
Choosing between instrument types depends on your goals as an investor: how much risk you're willing to take, what kind of return profile you want, and how important liquidity is.
- Equity (common/preferred): Highest potential upside, but highest risk. Returns depend entirely on the company's valuation at exit. Illiquid until an IPO, acquisition, or secondary sale.
- Debt (bonds/notes): Predictable returns through interest payments. Senior in the capital structure. Lower risk, but no participation in upside beyond the coupon.
- Convertible notes: Blend of debt protections and equity upside. Interest and repayment right provide a floor; conversion at a discount provides upside if the company raises at a higher valuation.
- SAFEs: Pure upside bet on a future priced round. No protections if the company never raises again. Founder-friendly, investor-risky.
- RPAs: Returns tied to actual revenue, not speculative valuation. Capped upside, but cash flow starts immediately. No dilution, no equity ownership.
For more on how securities regulation protects investors across all these instrument types, see our guide to Investor Protection & Disclosures.
Frequently asked questions
Under the Howey Test (SEC v. W.J. Howey Co., 1946), an instrument is a security if it involves (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits, (4) derived from the efforts of others. If all four prongs are met, the instrument is subject to federal securities law regardless of what it's called.
An RPA is a financial instrument where an investor provides capital in exchange for a percentage of the company's future revenue, paid out until a return cap is reached. RPAs don't involve equity ownership or fixed repayment — returns are tied directly to the company's top-line performance.
A SAFE has no maturity date, no interest rate, and no repayment obligation — it simply converts into equity at a future priced round. A convertible note is technically debt: it has a maturity date and accrues interest, but is designed to convert into equity rather than be repaid. SAFEs are simpler but offer fewer protections if the company never raises another round.
No private market instrument is "safe" in the way a bank deposit or treasury bond is. But within private investments, debt instruments (bonds, notes) offer the most structural protection because holders are senior in the capital structure and have contractual repayment rights. RPAs offer cash-flow-based returns without equity risk. Equity and SAFEs carry the highest risk because returns depend entirely on future valuations or exit events that may never materialize.