What Is Junior Equity?
Junior equity is stock issued by a company that ranks at the bottom of the priority ladder in terms of ownership structure. That means it is last to receive certain payouts, such as dividends, or reimbursements in case of bankruptcy.
- Junior equity is stock issued by a company that ranks at the bottom of the priority ladder in terms of ownership structure.
- Common stock is a typical variety of junior equity.
- In the event of a bankruptcy, junior equity owners must wait for bondholders, preferred shareholders, and other debtholders to collect first.
- Holders of junior equity also play second fiddle to preferred stock owners when it comes to company dividends.
- Junior equity does have advantages: Common shares tend to appreciate more in price and they carry voting rights.
How Junior Equity Works
Equity, a form of ownership often represented by shares of stock, represents the amount of money that would be returned to shareholders if all of the company’s assets were liquidated and debts were paid off. Not all shareholders have equal rights, though. There is a pecking order determining who can claim company assets first—and owners of junior, aka subordinate, equity sit at the bottom of it.
That means that in the event of a bankruptcy, holders of junior equity may get nothing in return. These owners of common stock have rights to a company's assets only after bondholders, preferred shareholders, and other debtholders are paid in full.
The pay-out structure of a company in bankruptcy is governed by the Absolute Priority Rule, which states that in liquidation certain creditors must be satisfied in full before any other creditors receive any payments.
Junior equity also takes a back seat to preferred stock when it comes to income distribution. Preferred stockholders receive an agreed-upon dividend at regular intervals, making these distributions similar to bonds' coupon payments. In contrast, common stock's dividends can fluctuate, depending on the company's earnings. In fact, a company’s board of directors may not pay common stockholders a dividend at all, if the firm is not generating enough profit. Compensating preferred stockholders takes priority.
Example of Junior Equity
Larry’s Lemonade, a publicly-traded company, needs money to buy more lemons in order to fulfill a major purchase order. Its management decides to issue bonds as part of a debt program, while concurrently receiving an influx of cash from a bank, in the form of a high-interest loan.
Business at Larry’s Lemonade then takes a turn for the worse, forcing it to shutter its operation and declare bankruptcy. Everyone with a stake in the company is eager to collect any leftover money. Priority first goes to the bondholders, those who lent Larry Lemonade capital to buy more lemons, followed by the lending institution that gave it the financing.
Only after those two groups have been paid, do the junior equity holders of common stock have an opportunity to absorb any remaining assets. At that stage, very little assets are left to collect, leaving them with empty pockets.
Advantages of Junior Equity
While it seems that junior equity is inferior, there are some advantages to owning it. While the potential risks are greater, so are the returns.
The majority of shares that companies issue is common stock and, over the years, this type of equity ownership has outperformed bonds and preferred shares. Preferred shares typically do not reflect appreciation to the same degree that common stock does: The price of preferreds tends to stay around their initial issue price or par value, behaving more similarly to a bond. When a company thrives, junior equity is generally the best type of stock to hold over the long term.
Also, unlike preferred stock, owning common stock also gives shareholders voting rights—meaning they can have a voice, albeit a very quiet one, in how the business is run.
A counterpart to junior equity in the debt world is junior debt. Also known as subordinated debt, it refers to bonds, loans, or other obligations issued with a lower priority for repayment than other, more senior debt claims in the case of the issuer's default. As a result, junior debt tends to be riskier for investors, and thus carries higher interest rates than more senior debt from the same issuer.