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. Common stock is often referred to as junior equity because it is subordinate to preferred stock.
- 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 subordinate to preferred stock and is therefore referred to as 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.
How Junior Equity Works
Equity, otherwise known as net worth, 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 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. Common shareholders 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 them similar to bonds. In contrast, a company’s board of directors (B of D) may not pay common stockholders a dividend if it is not generating enough profit. In short, compensating preferred stockholders takes priority for company executives.
Example of Junior Equity
Larry’s Lemonade needs money to buy more lemons in order to fulfill a major purchase order. Management decides to issue bonds as part of a debt program, while concurrently receiving an influx of cash from an investment bank (IB), in the form of a high-interest loan.
Trading 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 a high-interest loan.
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
Fortunately, there are some advantages to owning junior equity. 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. When a company thrives, junior equity is generally the best type of stock to hold.
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.
Investors should always consider the risks outlined above before buying junior equity. It is important to exercise prudence, particularly when dealing with companies that borrow excessively and operate in sectors in structural decline, such as retail.