Equity Instrument Features

Nature and Purpose of Equity Instruments

Equity instruments represent an ownership stake in a corporation. Unlike debt, which creates a creditor relationship with contractual rights to interest and principal repayment, equity gives the holder a residual claim on the company’s assets after all other obligations have been satisfied.

Shareholders are not creditors; they are part-owners. This ownership is typically evidenced by shares, which may be publicly traded on an exchange or held privately.

Key characteristics of equity include:

• Indefinite life – The company has no obligation to redeem or repay the capital contributed by equity holders.
• Discretionary payments – Dividends are entirely at the board’s discretion; the company may distribute a portion of net income, reinvest all earnings, or do neither.
• Residual claim – In liquidation, equity holders receive whatever remains after all debts and preferred claims are paid.

Because of this uncertainty and subordinated position, common shares have historically offered higher long-term returns than most other asset classes, albeit with greater volatility. Globally, the market value of publicly listed equity exceeds USD 100 trillion, with the United States accounting for nearly 40% of that total.

Common Shares – Rights and Characteristics

Common shares, also referred to as ordinary shares, are the most prevalent form of equity. They confer both economic rights and voting rights upon their holders.

Economic rights include:

• A proportional share of any dividends declared by the board.
• A residual claim on the company’s net assets upon liquidation, meaning payment only after all debt holders and preferred shareholders have been satisfied.

Voting rights typically operate on a one-vote-per-share basis. Shareholders may vote on matters such as the election of directors, approval of mergers or acquisitions, and ratification of auditors. Voting can be conducted in person at annual general meetings or by proxy, where a shareholder authorises another party to vote on their behalf.

Additional provisions, often specified in the company’s charter or prospectus, may include:

• Preemptive rights – The right of existing shareholders to purchase newly issued shares before the public, allowing them to maintain their proportional ownership.
• Conversion rights – The ability to exchange one class or series of shares for another, if multiple classes exist.
• Share split or subdivision rights – A description of how a share split (for example, a two-for-one split) affects the number of shares held and the price per share, while leaving total market value unchanged.
• Liquidation rights – Detailed order and proportion of any distribution of remaining assets upon dissolution.

Preference Shares – A Hybrid Security

Preference shares combine features of both debt and common equity. They typically pay a fixed dividend, stated as a percentage of the par value. For instance, a 5% preferred share with a USD 100 par value pays an annual dividend of USD 5 per share.

Distinguishing features of preference shares:

• No default on missed dividends – Unlike debt, failing to pay a preferred dividend does not constitute a default.
• Cumulative feature – If dividends are cumulative, any omitted payments accumulate and must be fully paid before any common dividend can be declared. This offers significant protection to preferred investors.
• Liquidation preference – Preferred shareholders rank above common shareholders but below all debt holders in the liquidation hierarchy.
• Limited voting rights – Preferred shares generally carry no voting rights, except in limited circumstances (such as when dividends are in arrears for a specified period).

Contingent features commonly attached to preferred shares include:

• Participating – Holders receive an additional dividend if the company’s profits exceed a predetermined threshold, providing upside beyond the fixed rate.
• Putable – Investors have the right to sell the shares back to the issuer at a specified price, offering downside protection.
• Callable – The issuer can repurchase the shares at a predetermined price, which is advantageous to the company if market interest rates decline.
• Convertible – Holders may exchange preferred shares for a fixed number of common shares at a predetermined conversion price. In exchange for this potential upside, convertible preferred typically carries a lower dividend rate than non-convertible preferred, benefiting the issuer’s cash flow.

Company Life Cycle and Dividend Policy

A company’s stage of development strongly influences whether it pays dividends.

• Start-up and early-growth firms typically generate low or negative net income and reinvest all available funds into expansion. They rarely, if ever, pay dividends, and their investors seek capital appreciation rather than current income. A well-known electric vehicle manufacturer, for example, stated in its IPO prospectus that it had never declared a cash dividend and did not anticipate doing so for the foreseeable future, as all earnings would be retained to fund growth.
• Mature companies experience slower earnings growth, stable cash flows, and fewer profitable reinvestment opportunities. They are more likely to initiate regular dividend payments. This is why mature, established firms—such as those in the utility or consumer staples sectors—often have long histories of steady dividends, while younger technology companies frequently pay none.
• Declining firms may see revenues and cash flow deteriorate, potentially leading to dividend cuts or eliminations.

Question

A biotechnology start-up has no revenue and expects to incur losses for the next three years. The founders want to raise capital without giving up any voting control. They are willing to offer a fixed dividend that can be deferred when cash is tight, and they want to provide investors with the ability to participate in future equity upside if the company succeeds.

Which type of security most accurately meets the founders’ objectives?

1. 1. Participating preferred shares with full voting rights
   2. Non-cumulative common shares with one vote per share
   3. Cumulative, convertible preferred shares with no voting rights

Solution

The correct answer is C.

Cumulative preferred permits the deferral of dividend payments without default, and the cumulative feature protects investors by requiring that any missed dividends be paid before common dividends can be distributed. Convertibility gives investors the right to exchange preferred shares for common shares at a later date, providing upside potential in exchange for a lower dividend rate. The absence of voting rights preserves founder control.

A is incorrect. Participating preferred shares with full voting rights would give investors a say in corporate governance, which the founders wish to avoid. Additionally, preferred participation does not necessarily include a deferral feature or conversion right, and the extra dividend participation does not address the need for a lower cash cost of capital.

B is incorrect. Common shares, whether cumulative or not, carry voting rights. Non-cumulative common shares would give investors one vote per share, directly violating the founders’ requirement to retain voting control. Furthermore, common shares do not offer a fixed dividend that can be deferred; dividends on common are entirely discretionary and non-cumulative by nature.