Understanding Junior Equity: Risks and Returns

Junior equity refers to the equity or shares issued by a company that ranks below other shares or stocks issued by the same company. The stock issued is said to be subordinate to other stocks issued by an entity and will be paid out last in a liquidation scenario.

Ordinary shares or common stock tend to fall below preferred sharesPreferred SharesPreferred shares (preferred stock, preference shares) are the class of stock ownership in a corporation that has a priority claim on the company’s assets over common stock shares. The shares are more senior than common stock but are more junior relative to debt, such as bonds.; therefore, common/ordinary stock is considered subordinate to preferred stock/shares.

If a company were to be liquidated, the funds that are expected to be returned to shareholders are referred to as equity. Equity represents leftover funds and is available for return to shareholders after all debt obligations are settled and assets are liquidated and disposed of. As with debt, equity also comes with “liquidation and/or claim preferences.”

The claims on a company’s assets are processed in line with the liquidation or claim preferences, and junior equity normally lies at the bottom of the preferences. In a scenario where a company files for bankruptcyBankruptcyBankruptcy is the legal status of a human or a non-human entity (a firm or a government agency) that is unable to repay its outstanding debts, junior equity holders are likely to get very little funds or nothing in return.

Typically, holders of common shares are repaid after bondholders, preferred shareholders, and other debt holders. Junior stockholders also fall subordinate to preferred shareholders regarding dividend distributions. Preferred shares normally come with a predetermined dividend that is agreed-upon when the shares are issued. The dividend is normally paid out at regular intervals.

Summary

• Junior equity refers to the equity or shares issued by a company to a shareholder that rank below other shares or stocks issued by the respective company. The stock issued is said to be subordinate to other stocks issued by an entity.
• Concerning repayment, junior equity falls at the bottom of the priority list regarding an entity’s ownership structure.
• Junior equity normally comes with a higher risk/reward profile to investors because of its subordination to other equities.

Importance of Junior Equity

Junior equity normally comes with a higher return demand by investors because of its subordination compared to another equity holding. Because junior equity lies at the bottom of the “preference list” when it comes to repayment and/or claims on an entity’s assets, junior equity holders could potentially walk away with nothing after all other equity and debt obligations have been taken care of. Hence, investors holding junior shares are likely to demand higher returns.

Ordinary shares of common stocks have been known to outperform bonds and even preference shares or stocks. Junior equity tends to come with voting rightsVoting SharesVoting shares are shares of a company that entitle the shareholder to vote on key issues of the company. It is generally one vote per share. The shares, which may not always be the case with preference shares or stocks.

Practical Example

To better understand the concept of junior equity, consider the following example:

Company ABC requires additional funds to deliver on a purchase order to one of its largest clients. The company’s management team makes the executive decision to obtain funds from an investment bank and also issue bonds. The funds obtained from the investment bank come at a notably high interest rate. Company ABC was able to meet its obligations and fulfill the purchase order; however, due to various factors, the company was forced to discontinue operations and file for bankruptcy.

The company begins its liquidation process, and per the liquidation preferences (as outlined in the relevant agreements), the relevant stakeholders are paid out. Initial and top priority is given to Company ABC’s bondholders – it previously issued bonds to raise additional funds – and they are paid first.

Second in line would be the investment bankList of Top Investment BanksList of the top 100 investment banks in the world sorted alphabetically. Top investment banks on the list are Goldman Sachs, Morgan Stanley, BAML, JP Morgan, Blackstone, Rothschild, Scotiabank, RBC, UBS, Wells Fargo, Deutsche Bank, Citi, Macquarie, HSBC, ICBC, Credit Suisse, Bank of America Merril Lynch, which lent money to Company ABC. Once these parties have been paid, junior equity holders (i.e., holders of ordinary shares or common stock) have a claim to whatever remains (usually very little or nothing at all), in proportion to their shareholding percentage.

More Resources

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• Dividend Payout RatioDividend Payout RatioDividend Payout Ratio is the amount of dividends paid to shareholders in relation to the total amount of net income generated by a company. Formula, example
• Junior DebtJunior DebtJunior debt, also referred to as subordinated debt, is debt that is considered to be of a lower priority in the debt and debt repayment
• Share ClassShare Classshare classes are usually created from various types of shares in a company. The type of shares and share classes that a company can create
• Voluntary LiquidationVoluntary LiquidationVoluntary liquidation is when a company decides to dissolve itself on its own terms, as approved by the shareholders of the company. The decision usually