This article provides readers with an understanding of what is equity, as well as a brief overview of the three basic types of equity that are available.
What Is Equity?
Equity is viewed by the market as an ownership “share” in the revenue stream of a corporation’s income once all prior obligations and debts have been satisfied. The “share” price in an equity definition is the relative value given to the corporation’s earning potential based on a number of factors. These include general economic conditions, both in the industry and in the overall economy, earnings projection, projected corporate growth, corporate stage of development, and financial ratio analysis. When considering a general equity definition there are three major variants of equity to look at.
The Three Basic Types of Equity
Common stock represents an ownership in a corporation. Common stockholders participate in the earnings stream of the corporation through dividends paid and capital gains made on a per-share basis. Owners of common stock are responsible for the election of the Board of Directors, appointment of Senior Officers, the selection of an auditor for the corporate financial statements, dividend policy, and other matters of corporate governance. This may also be done on a proxy basis, whereby a third party may be granted the shareholder’s right to vote on their behalf.
The responsibilities associated with common stock mean the investor participates to a greater extent in the fortunes of the firm. Capital gains, through the increase in market price of the firm’s stock, accrue to a greater extent to the holder of common stock than to the holder of preferred stock.
Common stockholders also have a couple of significant rights should the business be wound down: limited liability to the creditors of the firm and a residual claim on any assets or income derived once all prior claims (mortgages, bondholders, creditors, etc.) have been satisfied.
Preferred shares are stock in a company that have a defined dividend, and a prior claim on income to the common stock holder.
Should the company wind up operations, preferred shareholders are paid any obligations owed to them. Should the Board of Directors suspend a dividend, for whatever reason, the preferred share usually has a cumulative clause in it allowing that any unpaid dividends must be paid fully before any dividends may be declared and paid to holders of common stock. This means that the preferred share is a more secure investment, relatively speaking. The corporation issuing preferred shares may add differing features to the share in order to make it more attractive. These features are similar to those used in the fixed income market and include convertibility into common shares, call provisions, etc. Many have equated preferred shares with a form of fixed income security due to their defined dividend stream.
However, with the added security offered by the guaranteed dividend stream, the holder of preferred shares gives up the right to vote on issues related to corporate governance. Therefore, the preferred holder has little input into corporate policy.
Warrants are a form of option usually added to a corporate bond issue or preferred stock in order to sweeten the deal. A warrant is a long-dated option that allows the owner to participate in the capital gains (losses) of a firm without buying the common stock. In effect, the holder of a warrant has a leveraged play on the corporate common stock.
As a form of option, a warrant has an exercise price and an expiry date. The exercise price is the price at which the holder may convert the warrant into common shares of the issuer. The expiry date is the last date on which the warrant may be converted into common shares. Given that a warrant is generally issued to reduce the cost of a debt issuer, the expiry date is usually more than two years from issuance. This allows warrants to trade separately from the bond with which they were issued, thereby providing the investor with a long-dated option on a firm’s common stock.
Drawbacks of Warrants as a form of Equity
There is a drawback to warrants for those investors concerned with income. As an option, a warrant does not pay a dividend, and is subject to a certain amount of price compression as the underlying stock approaches or surpasses the exercise price. This is only a factor if the investor is purchasing the warrants when the common stock is trading near the exercise price.
Warrant holders have no voting rights until the warrants are converted into common shares. Upon conversion, an active role may be taken in corporate governance. If the warrants provide for conversion into preferred shares, it is unlikely the holder will gain any influence into corporate governance upon conversion.