Junior Equity

A type of share in a company inferior to the other categories.

Junior equity is a type of share in a company inferior to the other categories. These are shares that rank below other shares issued by the same company. An example of Junior equity is common stock since common shareholders are entitled to repayment after the preferred ones.

Junior equity

In the case of junior equity, if a company goes bankrupt, the latter's shareholders are at a high risk of getting zero return on investment. This is because owners of common stock are only entitled to an organization's assets after bondholders, preferred shareholders, and other debtholders are paid.

Junior equity is also at the bottom of the pyramid regarding income distribution. 

While preferred shareholders receive a fixed income dividend at equal intervals, holders of common stock are not always assured of a regular income as it depends upon the performance of the company they've invested in.

Among the various types of equities, junior equity usually yields the highest return for investors due to the high-risk level. However, junior equity investors risk walking away with zero return since they lie at the bottom of the list when repayment time comes.

This is why they always demand a higher return from the borrower/ company. 

Real-life example

We will go through a small illustration to better understand how Junior Equity/common stocks work.

Airbus requires additional funds to acquire 40 turbofan engines from General Electric. To obtain the necessary amount, management at Airbus decides to receive funds from Goldman Sachs ( Investment Bank ) and by issuing bonds.

Airplane

After the funds were obtained, Airbus managed to meet its obligations and complete the purchase order of its engines. Nevertheless, due to the COVID-19 Pandemic, Airbus experienced significant losses and was forced to discontinue its operations and file for bankruptcy.

As the liquidation process starts, the stakeholders get compensated for the period of their shares. In such a situation, priority is given to Airbus's bondholders. Goldman Sachs would then follow by getting paid as they lent part of the funds.

Only after those two parties have been paid in full can the Junior/ Common shareholders claim back whatever is left. In that instance, it might be possible that nothing is left; hence, Junior Equity holders are at risk of not getting compensation.

On the other hand, in an instance whereby Airbus is thriving in terms of profits, in that situation, Junior Equities are likely to receive higher interest payments given the risk they are exposed to.

Advantages of junior equity

Following are the advantages:

1. Junior equity offers a higher earning potential.

The returns on investments in common stock are typically higher even though there is a chance that they carry greater risk than more secure choices like certificates of deposit or money market accounts. 

Since returns are not guaranteed as a shareholder, there is no limit on the number of gains.

2. Common stocks can be purchased on virtually any trading platform.

Virtually any trading platform will allow someone to open an account to purchase common stock anytime. In addition, most of the industry has shifted to a zero-fee approach for trades; hence, it doesn't cost anything to buy or sell. 

The ease of this investment is an easy way to diversify a portfolio.

3. Common stocks can provide dividends.

Certain companies will pay dividends when one purchases common stock and holds it for a specific time. These businesses are willing to pay a particular amount based on the number of shares that a person holds in the company.

Dividends

4. It is a great way to minimize inflation-related problems.

On average, the inflation rate in the United States hovers around 3%. Considering that common stocks have averaged an annual return of 10% historically, this means that the value of a common stock portfolio has the scope to grow at a net rate of 7% annually.

5. The value of the common stock can be leveraged as collateral.

For someone planning to purchase a high-value item, the value of his common stock can be used as collateral for a loan or line of credit. But, again, it's the liquidity of this item that makes this leverage possible.

Lenders can also use the stock to pay off a future debt if the borrower fails to pay back his debt obligations. 

The fact that it significantly reduces the overall risk of lending money to a client makes it viable to secure a lower interest rate when buying a new car or an item holding significant value.

6. It can be bought and sold all around the world.

Trading common stock can be done from all over the world with good internet connectivity and a computer/ laptop. Several markets in numerous countries are open for trading when an individual secures an online account with an appropriate level of access.

This means that the money invested can work for the individual around the clock.

Investment

7. You can invest in companies with limited liability

When an individual purchases common stock in a company, his assets are not at risk in the event the organization goes bankrupt. Only the amount invested into the organization shall be the liability for the individual investor.

That's good news for an investor if the stock goes wrong and the business loses creditors a significant amount of money.

Disadvantages of junior equity

Following are the disadvantages:

1. Common shareholders are paid last during a company liquidation.

If the company goes bankrupt and somebody holds common stocks, he will be the last person to get paid. So most shareholders of this option do not receive any money in this instance.

To negate the effects of this setback, individual investors should diversify their portfolios to limit those risks.

2. Companies are not required to pay dividends on common stocks.

Even if specific organizations regularly pay dividends on common stocks, there is no obligation on their behalf to take such actions. Individuals using this investment vehicle are not favored to receive a chunk of a company's profits.

For an investor, it means that part of his risk factor in selecting this investment option is that he can lock a loss for a thinly traded stock in fast-moving markets without realizing what they are involved in. 

This is why mutual funds are a better option for beginner investors.

3. An investment in common stock can sometimes be an emotional rollercoaster.

The prices of common stock fluctuate regularly. As a result, trading that takes place all over the globe directly impacts the results of common stockholders investor's equity value at any given point in time.

Such investors should avoid buying high when the market appears strong and selling low when the market conditions are unfavorable. It is therefore recommended to avoid looking at the constant price fluctuations.

Instead, the investor should monitor his portfolio's performance and ensure the latter meets his financial goals.

shareholder

4. Investing in common stock implies competing with professional traders.

Professional traders and institutional investors have more time to analyze the stock market and research companies. It implies that they have the edge over normal investors.

While beginners tend to approach the stock market through guesswork, which is risky for their overall profitability, expert traders possess sophisticated trading tools and advanced financial models that significantly make their investment decision safer and more accurate than beginner investors.

5. The portfolio can lose substantial value in a single day.

The stock markets across all seven continents are currently experiencing high volatility, and frequent price swings of several percentage points are likely to happen in a single trading day.

While an investor's portfolio can make substantial gains over a single day, the risk of losing a significant amount of money is also present.

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Researched and authored by Alvin | LinkedIn

Edited by Colt DiGiovanni | LinkedIn

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