This page of our SIE Study Guide provides an overview of the different types of equity securities and key facts about them.
Type of Equities
Equity refers to an ownership position in a company. There are several different types of equity securities available in the market.
Common: The most fundamental way of taking an ownership position in a corporation is to purchase its common stock. The holders of common stock are responsible for voting on corporate policies and electing the board of directors.
- Some companies decide to distribute their net earnings to shareholders in the form of cash or stock dividends as a reward for their investments.
- In the event of liquidation, common shareholders are entitled to company assets (such as cash) only after creditors, bondholders, and preferred shareholders have received theirs. However, they do have limited liability which means they cannot lose more than what they paid for the stock.
Common Stock Equivalents: Securities that can be converted into common stock, typically once the market price of the security is trading above the exercise price. Types of common stock equivalents include convertible bonds, convertible preferred stock, options, warrants, and some bonds. Employee stock option plans (ESOPs) often introduce common stock equivalents by offering discounted options or warrants which can be converted to common stock once vested.
Preferred: Some corporations have preferred stock in addition to common stock. The word preferred means this stock has certain advantages, including fixed cumulative dividends and priority repayment in the event of corporation liquidation.
Pre-emptive Rights: When a corporation plans to raise additional capital by issuing a new round of common stock, they will often offer these shares to their existing shareholders first before the general public (right of first refusal). Though not required, these rights are intended to permit existing shareholders to maintain the share ratio they hold among all total shareholders.
Warrants: Certificate that gives the holder the right to buy common shares directly from a corporation at a fixed exercise price until the warrant expires, typically several years in the future. Unlike call options, when a stock warrant is exercised, the shares are issued directly by the corporation and the proceeds become a source of capital for the corporation.
Stock Options: Like warrants, stock options give the holder the right to buy common shares at a set price until the options expire, but the timeframe is typically shorter than that of a warrant and the set price is often lower. Additionally, unlike warrants, stock options tend to take the form of employee compensation. Like many other forms of deferred compensation, stock options typically follow a vesting schedule.
Repurchase Agreement (Repo): An agreement between two parties where securities are purchased from a seller for a certain amount of time, sometimes overnight, and the seller agrees to repurchase the securities at a slightly higher price than the purchase price. These agreements take the form of short-term loans for tax and accounting purposes. Normally, the instrument traded is of very high quality, like a U.S. Treasury Bond, which enables it to serve as collateral. The Fed may sometimes enter into Repurchase Agreements as part of regulating the money supply.
American Depository Receipts (ADRs): As outlined in the Knowledge of Capital Markets section, ADRs are certificates that represent shares of a foreign company’s stock. Just like domestic shares, ADRs trade on stock exchanges in the United States and are priced in U.S. dollars rather than foreign currency.
Voting: Common shareholders have the right to vote for the Board of Directors of the corporation (one vote for each share owned). Under a statutory system of voting, these votes apply to every open board position. Under a cumulative system of voting, the stockholder could allocate his/her votes disproportionately among the positions.
- If there were six open board positions, a statutory system would give someone with 50 shares 50 votes for each of the six positions, but a cumulative system would give a total of 300 votes (50 shares times the six open positions), which could be allocated to the open position the shareholder chose.
Freely-Tradeable vs. Restricted and Control Stock: Shareholders typically have the right to sell the stock they own without any limitations or restrictions, referred to as freely tradeable. There are, however, some cases in which reselling stock is restricted by SEC regulations:
- Unregistered securities acquired through a private sale, which are thereby designated as restricted securities.
- Control securities are those held by an affiliate of the issuer and, because of resale limitations, are also considered restricted securities.
- SEC Rule 144 permits the resale of restricted securities under certain conditions, including a minimum prior holding period and adequate information being made available to the public before the sale.
Risks of Equity Securities
The risks of investing in equity securities include:
- Market Risk: The risk that in a declining stock market, or a crash, even stocks of profitable and solid corporations may or will drop in market value.
- Business Risk/Sector Risk: If a particular business is suffering poor results due to a declining public demand for their products or bad management, or the overall sector they are in (airlines, energy, etc.) is suffering, then the market value of their stock will suffer.
Order of Payment in Liquidation
When a business is being liquidated in bankruptcy, any applicable domestic support obligations and certain allowable administrative claims are paid first. Next, assets are used to pay off debt. If there is any money remaining after all debts have been paid, then equity gets paid off next, with preferred shareholders getting paid before common shareholders.
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