What is Junior Equity?
Junior equity refers to the equity or shares issued by a company that ranks below other shares or stocks issued by the same company. The stock issued is said to be subordinate to other stocks issued by an entity and will be paid out last in a liquidation scenario.
Ordinary shares or common stock tend to fall below preferred shares; therefore, common/ordinary stock is considered subordinate to preferred stock/shares.
If a company were to be liquidated, the funds that are expected to be returned to shareholders are referred to as equity. Equity represents leftover funds and is available for return to shareholders after all debt obligations are settled and assets are liquidated and disposed of. As with debt, equity also comes with “liquidation and/or claim preferences.”
The claims on a company’s assets are processed in line with the liquidation or claim preferences, and junior equity normally lies at the bottom of the preferences. In a scenario where a company files for bankruptcy, junior equity holders are likely to get very little funds or nothing in return.
Typically, holders of common shares are repaid after bondholders, preferred shareholders, and other debt holders. Junior stockholders also fall subordinate to preferred shareholders regarding dividend distributions. Preferred shares normally come with a predetermined dividend that is agreed-upon when the shares are issued. The dividend is normally paid out at regular intervals.
- Junior equity refers to the equity or shares issued by a company to a shareholder that rank below other shares or stocks issued by the respective company. The stock issued is said to be subordinate to other stocks issued by an entity.
- Concerning repayment, junior equity falls at the bottom of the priority list regarding an entity’s ownership structure.
- Junior equity normally comes with a higher risk/reward profile to investors because of its subordination to other equities.
Importance of Junior Equity
Junior equity normally comes with a higher return demand by investors because of its subordination compared to another equity holding. Because junior equity lies at the bottom of the “preference list” when it comes to repayment and/or claims on an entity’s assets, junior equity holders could potentially walk away with nothing after all other equity and debt obligations have been taken care of. Hence, investors holding junior shares are likely to demand higher returns.
Ordinary shares of common stocks have been known to outperform bonds and even preference shares or stocks. Junior equity tends to come with voting rights, which may not always be the case with preference shares or stocks.
To better understand the concept of junior equity, consider the following example:
Company ABC requires additional funds to deliver on a purchase order to one of its largest clients. The company’s management team makes the executive decision to obtain funds from an investment bank and also issue bonds. The funds obtained from the investment bank come at a notably high interest rate. Company ABC was able to meet its obligations and fulfill the purchase order; however, due to various factors, the company was forced to discontinue operations and file for bankruptcy.
The company begins its liquidation process, and per the liquidation preferences (as outlined in the relevant agreements), the relevant stakeholders are paid out. Initial and top priority is given to Company ABC’s bondholders – it previously issued bonds to raise additional funds – and they are paid first.
Second in line would be the investment bank, which lent money to Company ABC. Once these parties have been paid, junior equity holders (i.e., holders of ordinary shares or common stock) have a claim to whatever remains (usually very little or nothing at all), in proportion to their shareholding percentage.
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