DEFINITION of Junior Equity
Junior equity refers to equity that ranks lower than some other form of equity. It normally refers to the common stock in a company because it is subordinate to preferred stock. Common stock ranks behind preferred stock in its claim on company dividends because dividends on preferred stock must be paid before any dividends are paid to common stock.
BREAKING DOWN Junior Equity
In the event of a bankruptcy, the holders of junior equity have the lowest claim on the company's assets. Junior equity, such as common stock, is subordinate to preferred stock, while preferred stock is subordinate to holders of bonds.
Junior equities are considered to be a subset of junior securities, because the only refer to common stocks, and don’t include any debt holdings. However, the junior equity shareholders are strongly impacted by bondholders, with respect to the pecking order of money paid out, in the event a company files for bankruptcy, subsequent to borrowing large amounts of capital from a bank or other revenue source. For example, it Larry’s Lemonade company needs money to buy more lemons in order to fulfill a major purchase order, it may issue bonds as part of a debt program, while concurrently receiving an influx of cash from an investment bank, in the form of a high-interest loan. If Larry’s Lemonade ends up selling tainted beverages, and consequently shutter its operation and declares bankruptcy, the bondholders would likely be entitled to collect any leftover money, followed by the lending institution. Only after those two groups have been paid, do the junior equity holders of common stock have an opportunity to absorb any remaining assets.
However in most cases, at this point in the process, there are little, if any assets to collect.
Payout Structure in Bankrupcy
They payout structure of a company in bankruptcy is governed by the Absolute Priority Rule, which states that rule stating that, in liquidation, certain creditors must be satisfied in full before any other creditors receive any payments. And just like holders of junior securities, junior equity holders are encouraged to exercise prudence when investing in common stocks of companies that borrow excessively. If they consequently find a company they feel optimistic about—even if it has had a history of taking on new loans, such investors should diversify their holdings in the company, by acquiring shared of senior securities—aka “preferred stocks”, to ensure that at least a portion of their investments have a high priority of getting paid back, in the event of a bankruptcy.