What is An Equity Instrument?

Businesses that rely on shareholders to fund their operations require equity instruments to act as a way to fund operations and provide proof of ownership. This type of documentation does not require a dividend return as it is based on the specific terms of the business and subsequent profits.

There are several types of equity investments that have specific meanings and cannot be interchanged. They include:

  • titled common stock
  • preferred stock
  • LLC membership interest or LLC membership unit (also described as unit)
  • warrant or option

Common Stocks Explained

When a public company needs to raise funds, common stock is provided to act as equity instruments. The shareholder who offers to fund the business receives co-ownership in exchange. Additionally, this ownership gives the right to vote at shareholders meetings in proportion to their ownership. Co-ownership affords the shareholder the right to be part of important decisions that affect the success of the company such as raising capital to fund dividends and decide on future business mergers. Shareholders also have the opportunity to purchase new shares when the company has improved their overall financial standing or a new shareholder allocation is issued.

It is important to note that common stocks don't guarantee dividends. If there are financial struggles that lead to liquidation, the last to be paid will be common stockholders. This risk is balanced by a higher dividend yield than that of the rate paid for preferred shares. Common stocks, which define partial ownership, function identically to preferred stocks but have a lower value and priority.

A convertible debenture, a different type of equity instrument similar to a common bond, can be converted into common stock based on rates and prices laid out in the prospectus. A convertible debenture is a popular alternative to common bonds due to an increased rate of return.

Preferred Stock as an Equity Instrument

Preferred stock is another type of equity instrument that is similar to common stock. The difference between the two is that preferred shareholders receive capital repayment before common stock shareholders but do not have voting rights.

In the event of a liquidation, preferred stock shareholders are paid second, after bondholders. Conversely, if the company is profitable, preferred stocks will receive an increased dividend. If cumulative preferred shares are owned, a retroactive payment of suspended dividends is offered. Preferred stock is quite flexible, which is why it is a common investment.

Dividends Simplified

A dividend is the agreed upon amount that is to be paid per share. This can be for the face value or the price paid for the preferred stock, which is often the same amount. Dividends can be in the form of:

  • return on investment expressed as a percentage per year
  • return of investment as a percentage of all net profits until the principal investment is paid
  • a combination of both return on and return of investment

While structured similar to a debt instrument, dividends are subject to legal implications and rules that take precedence over the equity holder. State corporate laws require solvency to pay creditors prior to dividends.

Dividends are most frequently paid quarterly or annually, although they can be paid at any time. However, a dividend may not be paid when expected or promised. The dividends on preferred stock are paid in full prior to common stocks or other junior securities.

Types of Debt and Financial Instruments

Debt instruments, typically referred to as loans, mortgages, leases, notes, and bonds, act as a contractual agreement between a financial institution and a borrower. Debt instruments fall into two designations: secured and unsecured.

Secured debt requires another asset (such as a house) as collateral for the loan. If the loan isn't repaid, the lender has legal access to take possession of the asset to fulfill the debt. Unsecured debt, in comparison, has no backing and is based on the promise of the buyer to repay the loan.

In comparison, financial instruments offer the ability to trade assets or packages of capital. Cash instruments and derivative instruments are two examples. Cash instruments can be transferred easily, are determined by the markets, and can be deposits and loans that are agreed upon by borrowers and lenders. Derivative instruments' values are dependent on underlying conditions like interest rates, indices, or assets.

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