Companies use debt and equity to raise additional capital from investors. Equity instruments give the investor a piece of ownership in the company. They provide an opportunity for capital gains through appreciation, and bear the risk of loss if the company's share price drops. Some types of equity instruments also come with voting rights so shareholders can influence the election of the board of directors.
Some of the most common forms of equity instruments include common stock and preferred stock, among others. An equity instrument acts as legally validated evidence of an individual's share of ownership within a firm.
Exploring Common Stock
A share of common stock provides an ownership interest in the company, along with voting rights and possible dividends. Common stock may be divided into classes with different number of votes per share. These classes are typically designated as Class A, Class B, Class C, etc. on the stock market. Dividends are not guaranteed and may be suspended if the company struggles financially. Holders of common stock are the last to be paid if the company liquidates. To account for this risk, the dividend yield is higher than the rate paid on preferred shares.
Defining Preferred Stock
Preferred stock also gives ownership, but does not include voting rights. Holders of preferred stock are the second to be paid in a company liquidation; bond holders are first. If the stock is convertible, the shareholder has the option of converting his shares to common stock. Callable shares give the company the choice of when to make the conversion. Adjustable rate shares have a dividend rate that fluctuates along with the U.S. Treasury Bill rate or another financial index. Participating preferred stock pays an increased dividend when the company is profitable. If you own cumulative preferred shares, you will be entitled to retroactive payment of any suspended dividends.
What Are Warrants?
Warrants offer the right to purchase common stock at a certain price. They are valid only for a limited period of time. The warrant expires if you do not purchase the stock within the specified time frame. Warrants may be offered to existing shareholders or packaged with a new purchase of stock or bonds.
Understanding Your Options
Options are similar to warrants, but the option holder must pay for the right to purchase or sell stock at the specified price. Brokers and private investors may sell their own customized option packages. A call option grants the holder the right to purchase shares, while put options offer the right to sell a certain number of shares. The party selling the option is obligated to complete the transaction if the buyer chooses to exercise. If the option expires without being exercised, the buyer loses the money he paid for the option.