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 rights. Its owners are the last in line to receive certain payouts, such as dividends or reimbursements in cases of bankruptcy.
Common stock is a type of junior equity. It is considered subordinate, or junior, to preferred stock.
Key Takeaways
- Common stock is a type of junior equity.
- Its junior status means that its owners are last in line to be repaid in the event of a bankruptcy filing by the company that issued it.
- Bondholders, preferred stock shareholders, and other debtholders collect before junior equity holders.
- 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 its 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 no compensation. 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. Owners of preferred stock shares receive an agreed-upon dividend at regular intervals, making these distributions similar to bonds’ coupon payments.
Owners of common stock may or may not receive a dividend, and its amount fluctuates depending on the company’s earnings. Compensating preferred stockholders takes priority.
Example of Junior Equity
Imagine a flourishing company, Larry’s Lemonade, that’s eager to expand its operations. To fuel its growth, Larry’s Lemonade issues bonds to raise the necessary capital.
Unfortunately, business starts to dwindle, leading it to shut down and declare bankruptcy. Larry’s Lemonade now owes significant sums to employees, suppliers, bondholders, and shareholders. Each party involved is anxious to reclaim what they are owed.
Transitioning into a liquidation phase, the company is compelled to sell off its assets—leftover supplies, operational equipment, warehouses, and office spaces—to meet its liabilities. The bondholders, having lent money for the initial expansion, are the first to be repaid from the money raised by liquidating these assets. Following them, other debtors step in line to collect what they’re owed.
Only if all previous groups have been paid off do the junior equity holders, in this case, the common stock shareholders, have a chance of receiving any leftover assets. Often, the assets remaining are insufficient to compensate these equity holders, making them unlikely to retrieve their initial investment.
Advantages of Junior Equity
Despite the apparent risks associated with junior equity, the potential rewards can be very compelling.
Historically, common stock has outshined bonds and preferred shares in terms of performance. Unlike preferred shares, which usually do not appreciate significantly beyond their initial price, common shares have a much higher potential for price appreciation.
When a company flourishes, holding junior equity commonly proves to be the most rewarding form of investment. Additionally, common stockholders enjoy voting rights, providing them a small but significant voice in corporate governance.
Special Considerations
A parallel concept to junior equity within the debt market is junior debt, also known as subordinated debt. This category includes bonds, loans, or other obligations issued with a lower repayment priority vis-à-vis senior debt claims if the issuer defaults. Due to the higher risks, junior debt reflects higher interest rates to attract investors, relative to senior debt issues.
Related Terms: Senior equity, Preferred stock, Bankruptcy, Dividend, Voting rights.
