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What is an equity?

What is an equity?

It’s just another name for a share in a company, most usually listed on a stock exchange.

But its name is useful in explaining more accurately how a share comes into existence.

It’s the opposite of debt.

When an entrepreneur wants to launch a company he or she can try to do so with borrowed money, or by issuing equity (selling shares) to potential investors, or with a mix of both.

The huge advantage for the founder of going down the equity route is that while the borrowed money inevitably has to be paid back over a predetermined time frame, the equity is what’s called perpetual. It notionally lasts for ever so there’s no obligation to refund the investor.

So why does anybody buy an equity?

Because they are buying a share in the business which they hope will increase in value, and pay some handsome dividends along the way. A high performing share will outperform most other classes of investment, whether they are bonds, property or cash.

And in that world, the owner can always take the decision to sell the share, or as they say, sell their equity in the business. That’s another reason why we have stock exchanges. Not only do they provide a pricing mechanism for a new float or Initial Public Offering (IPO), but they provide a follow-up opportunity for buyers and sellers to match up long after the IPO has faded into history.

Shares issued in IPOs are usually carefully priced, by the way, to move up in value once they are listed.

So where’s the downside?

They don’t call the vast bulk of issued shares shares “ordinary” shares for no reason. Not all shares go up in value or pay dividends and if the company starts to go broke, and incidentally equity-based companies inevitably carry less debt than companies reliant on the bank, the news is not good for shareholders.

In the ranking of creditors, holders of ordinary shares sit at the very end of the queue: behind staff entitlements, behind the Australian Tax Office, behind the banks, behind bond holders and even behind the holders of any preference shares.

The latter are a relatively rare beast but are so named because they get preference in terms of which class of share gets paid dividends first, and which gets preference in any breakup or liquidation of the company’s assets. Because they pay fixed dividends and have a fixed date by which they must be converted to ordinary shares, they are regarded as being a mix of debt and equity.

 

This article follows on from our How to start investing article. You can find this here.

This is the view of the author, Andrew Main. This article is general in nature and does not take into account your personal circumstances.