What is Junior Equity?
Junior equity is shares issued by a company that ranks at the bottom of the priority ladder in terms of ownership structure. Common shares are often called common shares because they are subordinated to preferred shares.
Key points to remember
- Junior equity is shares issued by a company that ranks at the bottom of the priority ladder in terms of ownership structure.
- Common shares are subordinated to preferred shares and are therefore called junior shares.
- In the event of bankruptcy, holders of junior equity securities must wait for bond holders, preferred shareholders and other debt holders to collect first.
- Holders of junior equity securities also play the secondary role against owners of preferred shares with respect to corporate 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 repaid. However, not all shareholders have the same rights. There is a determining hierarchy that can claim the assets of the business first and the owners of restricted shares are at the bottom of it.
This means that in the event of bankruptcy, holders of junior equity securities may receive nothing in return. Ordinary shareholders are only entitled to the assets of a company after the full payment of bondholders, preferred shareholders and other debt holders.
The payment structure of a bankrupt business is governed by the absolute priority rule, which states that in the event of liquidation, certain creditors must be fully satisfied before other creditors receive payments.
Junior shares also occupy a secondary place in the preferred shares in terms of income distribution. Preferred shareholders receive agreement dividend at regular intervals, making them similar to bonds. On the other hand, the board of directors of a company (B of D) may not pay a dividend to ordinary shareholders if it does not generate enough profits. In short, the remuneration of preferred shareholders is a priority for business leaders.
Example of Junior Equity
Larry’s lemonade needs money to buy more lemons in order to fill out a large order form. Management decides to issue bonds as part of a debt program, while simultaneously receiving an inflow of cash from an investment bank (IB), in the form of a high-interest loan .
The business at Larry’s Lemonade then took a bad turn, forcing him to close its doors and declare bankruptcy. Everyone with an interest in the business is eager to collect all of the remaining money. Priority goes first to bondholders, those who lent capital to Larry Lemonade to buy more lemons, followed by the lending institution which granted him a loan at a high interest rate.
It is only after payment from these two groups that holders of restricted common shares have the opportunity to absorb the remaining assets. At this point, there is very little left to collect, leaving them empty.
Benefits of Junior Equity
Fortunately, there are certain advantages to holding junior stocks. The majority of the shares that companies issue are common shares and, over the years, this type of participation has outperformed bonds and preferred shares. When a business is successful, junior stocks are usually the best type of stock to own.
Unlike preferred shares, owning common shares also gives shareholders the right to vote, which means they can have a voice, albeit a very silent one, about how the business is run.
Investors should always consider the risks described above before buying junior shares. It is important to exercise caution, especially when dealing with companies that borrow excessively and operate in sectors in structural decline, such as retail.