Equity instruments are all kinds of contracts that contain information about the rights to the assets of an entity that remained after securing all creditors. In addition, these are the entity's obligations to deliver or issue its own equity instruments, particularly shares, warrants or stock options. In summary, these are all monetary liabilities of one entity relative to another. Commitments may occur in forms of a security or an accounting entry. A capital instrument is a form of monetary liability with a maturity of more than one year (E.F. Brigham, J. F. Houston 2012, p. 51).
Distribution of equity instruments
Equity instruments due to maturity can be divided into (E.F. Brigham, J. F. Houston 2012, p. 218):
- medium-term - maturity, from 1 year to 3 years,
- long-term - maturity, over 3 years,
- bank loans and borrowings, over 1 year,
- transferable securities.
The medium and long-term nature of these instruments means that they are used to raise funds intended primarily for financing investments, but rarely for current needs. The capital market consists of the securities market and the long-term loan market.
Capital market functions
The basic functions of the capital market include raising capital for a long period through the sale of securities. This type of capital is mainly used by entities investing in tangible and intangible assets related to business operations. Entities selling securities are called issuers. Buyers of securities, so-called investors, by lending capital to issuers, are able to raise income from the purchase, holding or sale of securities (M. Levinson 2014, p. 8).
A well-functioning capital market affects the proper functioning of the economy, because it favors the existence of phenomena favorable for its development, i.e.(M. Levinson 2014, p. 9):
- Mobilization and capital transformation, which involves the activation of free financial resources owned by many entities and their transformation into development capital for economic sectors.
- The valuation of securities, which means the assessment of their issuer, and indirectly the method of using the capital they have acquired. This affects the continuous control of the efficiency of the division of capital and the constant shaping of the direction of its flow to those sectors of the economy that are currently the most profitable.
- Effective capital allocation, and thus all capital flows to sectors of the economy, in which it will be used in the most effective way. This will contribute to the development of the entire economy.
- Raising income by investors through their share in trading in securities.
Examples of capital instruments
Having a security is necessary to exercise the rights described in the content of this document. However, the document itself does not decide on the nature of the security. The content presented in this document has an impact on the nature of the security. A security may constitute an independent subject of trade (J.C. Francis 2000, p. 43).
Among the most known securities, there are (E. Farhi, J. Tirole 2008, pp. 4-5):
- Bonds and mortgage bonds- these instruments constitute a debt security paper, which means that they express an obligation of the issuer to their holders to perform a specific monetary or non-monetary payment.
- Depository receipts and shares- these instruments are securities of a shareholder or shareholder nature, which means that their holder has the right to joint ownership of their issuer or its assets.
- Rights to shares and pre-emptive rights- these instruments are a derivative, because their existence and value depends directly on the value of the shares they acquire.
- Certificates and investment credits, participation units and other participation titles - these instruments are associated with institutions that deal with collective investment, while from a legal point of view participating entities do not constitute a security, but are classified as capital market instruments.
Advantages of Equity instrument
Equity instruments provide a range of advantages for both companies and investors. These include:
- Ownership: Equity instruments provide ownership rights to investors, allowing them to participate in the company’s financial and operational success.
- Limited risk: Equity instruments are generally lower risk than debt instruments, as they provide no fixed repayment schedule and no obligation to pay interest.
- Liquidity: Equity instruments can be easily converted to cash, providing investors with greater liquidity.
- Tax benefits: Equity instruments may provide tax benefits to both the company and the investors, such as tax deductions for certain costs related to the issuance of the equity instruments.
- Long-term financing: Equity instruments can provide long-term financing for companies that are looking to expand or restructure their operations.
Limitations of Equity instrument
- Equity instruments are often difficult to value due to their lack of liquidity and the need for complex financial models to properly assess the value.
- Equity instruments are also subject to dilution caused by additional issuances of similar instruments, meaning that the value of the existing instruments can be affected by the new issuances.
- Equity instruments are also subject to the risk of the issuer defaulting on its obligations, resulting in the investor losing all or part of their investment.
- Equity instruments are also subject to market risk, meaning that the value of the instrument can go up or down depending on the performance of the underlying asset or company.
- Equity instruments are also subject to regulatory risk as government regulations can change at any time, affecting the value of the instrument.
Apart from the concept of equity instruments, there are other approaches that can be used to understand the concept better. These include:
- Equity-based compensation - Equity-based compensation is a type of employee compensation where employees are given shares of the company in lieu of a part of their total salary. This is usually done to incentivize employees to stay with the company and benefit from its long-term growth.
- Equity financing - Equity financing is a type of financing where a company raises capital by selling shares of its stock. This type of financing is usually done by companies that are unable to secure debt financing from banks or other lenders.
- Convertible bonds - Convertible bonds are bonds that can be converted into equity at the option of the holder. These bonds are usually issued by companies that have a high potential for growth, as the holder can benefit from the growth of the company by converting the bonds into its equity.
- Preferred stock - Preferred stock is a type of equity with certain special privileges such as a fixed dividend or priority in case of liquidation. Preferred stockholders are always paid before common stockholders and have a higher claim on the company's assets than common stockholders.
In summary, equity instruments refer to any form of monetary liability between two entities, including equity-based compensation, equity financing, convertible bonds and preferred stock. These forms of equity instruments are used to incentivize employees, raise capital and provide a higher claim on the company's assets for certain shareholders.
- Brigham E.F., Houston J.F.(2012), Fundamentals of financial, South-Western Cencage Learning.
- Farhi, E., Tirole J. (2008), Competing liquidities: corporate securities, real bonds and bubbles, National Bureau of Economic Research.
- Francis J.C. (2000), Investments, analysis and management, McGraw-Hill.
- Levinson M. (2014), Guide to Financial Markets The Economist in Association with Profile Books.
- Weiss D.M. (2009), Financial Instruments: Equities, Debt, Derivatives, and Alternative Investments, Penguin Group, United States.
Author: Karolina Kurcz