Equity securities is an essential topic for the Securities Industry Essentials exam. This page of our free SIE study guide provides an overview of various types of equity securities and detailed information about each.
Type of Equities
Equity securities represent ownership in a company and entitle shareholders to a proportionate share of its assets and earnings. The typical examples include stocks, which are traded on exchanges, and equity mutual funds, which pool investments in a diversified portfolio of stocks.
There are several types of equity securities available in the market. In this section, we’ll understand the characteristics of those equities.
- Common: The most straightforward way to partially own a company is to buy its common stocks. The common stock shareholders have voting rights on corporate policies and elect the board of directors. Some companies distribute their net earnings among common stock shareholders as cash or dividends as a reward for their investments.
- Common Stock Equivalents: Common Stock Equivalents are securities or instruments, like stock options or convertible bonds, that can be converted into common stock. They offer potential equity ownership benefits, such as capital appreciation and voting rights, while often featuring conditions or conversion ratios specified in their terms.
- Preferred: Preferred stock is a type of equity security that typically pays fixed dividends and has priority over common stock in dividend payments and asset distribution in the event of liquidation. However, preferred shareholders usually have limited or no voting rights in corporate decisions.
- Pre-emptive Rights: Pre-emptive rights, also known as subscription rights, allow existing shareholders to purchase additional shares of a company’s stock before offering it to the public. This will enable shareholders to maintain their proportionate ownership stake and avoid dilution.
- Warrants: Warrants are financial instruments that give the holder the right, but not the obligation, to buy underlying securities (usually common stock) at a predetermined price within a specified time frame. They are often used as sweeteners in debt offerings or as incentives for investors.
- Stock Options: Stock options are contracts that grant the holder the right to buy (call option) or sell (put option) a specified number of shares at a predetermined price within a set time frame. Often used as employee compensation, options provide potential for profit if the stock price exceeds the strike price (in the case of call options) or falls below it (for put options).
- Repurchase Agreement (Repo): A Repurchase Agreement (Repo) is a short-term borrowing arrangement where one party sells securities to another with an agreement to repurchase them at a higher price on a specified date. Repos are commonly used by financial institutions to obtain short-term funding and manage liquidity needs. They provide collateralized loans with securities serving as collateral.
- American Depository Receipts (ADRs): American Depository Receipts (ADRs) are certificates representing shares of foreign stocks traded on U.S. exchanges. They allow U.S. investors to invest in foreign companies without needing to trade directly on foreign exchanges. ADRs simplify buying and selling foreign stocks and provide U.S. investors access to international markets.
Shareholder Rights
- Voting: Voting rights allow shareholders to influence corporate decisions by casting votes on matters such as the election of the board of directors, approval of mergers or acquisitions, and changes to the company’s bylaws. In statutory voting, each share gets one vote per open board seat. In cumulative voting, shareholders can allocate votes across board positions, potentially concentrating influence on specific candidates.
- Freely-Tradeable vs. Restricted and Control Stock: Freely-tradeable stock refers to shares that can be bought and sold in the open market without restrictions. In contrast, restricted stock is subject to certain limitations on its sale, typically imposed by regulatory authorities or contractual agreements.
- Restricted securities are unregistered securities acquired through private sales, subject to resale limitations imposed by regulatory authorities or contractual agreements.
- Control securities are held by affiliates of the issuer and are subject to resale limitations, making them restricted securities. This prevents insiders from flooding the market, ensuring fair and orderly trading.
- SEC Rule 144 allows the resale of restricted securities under specific conditions. These include a minimum holding period and ensuring adequate information is publicly available before the sale. This rule aims to balance liquidity needs with investor protection in secondary markets.
Risks of Equity Securities
- Market Risk: It refers to the potential for losses due to overall market fluctuations, impacting the value of equity securities. Economic conditions, interest rates, and investor sentiment can influence market risk.
- Business Risk/Sector Risk: If a business experiences poor results due to declining demand or mismanagement, or if its sector faces challenges, such as in airlines or energy, its stock market value may fall. Investor sentiment and economic conditions can intensify these issues, which leads to decreased stock price, and shareholders will face losses.
Order of Payment in Liquidation
Domestic support obligations and specific administrative claims take precedence if a company goes bankrupt and is liquidated. Then, assets are allocated to debt repayment. Any remaining funds are distributed to equity holders, prioritizing preferred shareholders over common shareholders for payment.