Equity typically has the highest cost of capital. Companies must pay a portion of their profits to equity holders in the form of dividends or increased share values. Debt, however, only requires interest payments and the return of principal. Public companies with strong credit ratings can readily access debt when the markets are liquid. However, equity is the better option in some cases. Contingent equity enables its holder to benefit in both scenarios.
Contingent equity is equity that only becomes such once a contingency, or defined occurrence, happens. Also called contingent capital, it converts into equity when specific triggers are met. Sometimes these triggers are regular events, such as the exercising of stock options or the raising of an additional round of financing. Other times the triggers are crises or catastrophic events, including natural disasters or inordinate losses, as with equity conversions for insurance and reinsurance companies.
Contingent Equity Examples
Contingent equity includes stock options, because they offer the right to buy stock but do not become stock until they're exercised. Stock options are one of the most common types of contingent equity. Debt that can convert into stock is also contingent equity. Once the debt converts, the equity exists and the debt is retired. Convertible notes, including convertible promissory notes, are also a common type of contingent equity, as are warrants. Warrants enable their holders to buy a specified number of shares on or before some future date at a predetermined price. Warrants are often attached to debt.
Contingent Preferred Stock
Preferred stock can also be a form of contingent equity. Preferred stock is equity that approximates a hybrid between debt and equity. It has a more senior claim on assets than common stock and pays a quarterly or annual dividend or interest payments. Some preferred stock contains conversion rights that allow the stock to convert to common stock when a particular event occurs -- for example an initial public offering or sale of the company.
Equity refers to an ownership interest in a company. In corporations, this is evidenced as shares of common or preferred stock. In limited liability companies or limited partnerships, this ownership takes the form of membership interest and partnership interest. With corporations, even if a person owns just one share of the company, that person is a shareholder and has applicable ownership rights. Equity holders are entitled to share in the profits of the company. Some classes of equity may have senior rights or more voting control.
Advantages of Contingent Equity
Contingent equity keeps a company’s cost of capital lower in the near term by classifying the financing as debt, options or some hybrid of the two. Contingent equity can also provide emergency funding. Since debt or preferred shares have mandatory payouts, companies encountering a crisis can convert those to common stock, conserving cash and positioning the company to access additional debt financing if needed.
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