Businesses typically raise financial capital in one of two ways. They either borrow money through debt instruments or raise money through equity instruments. The differences between debt and equity instruments are subtle in some ways but legally important. Both instruments involve an outside source (investor, bank, etc.) giving the business money. With both instruments, the outside source expects something in return. For debt instruments, banks expect payments of principal and interest. For equity instruments, investors expect ownership in the company, dividends and a return on their investment over time. Regardless of how the business raises financial capital, several types of debt and equity instruments exist.
Debt instruments are typically agreements where a financial institution agrees to loan a borrower money in exchange for set payments of principal and interest over a set period of time. Debt instruments typically involve loans, mortgages, leases, notes and bonds. Basically, anything that obliges a borrower to make payments based on a contractual arrangement is a debt instrument. Debt instruments can be secured or unsecured. Secured debt involves placing an underlying asset (like property) as security for the loan where, through legal process, the lender can take possession of the underlying asset if the borrower stops making payments. Unsecured debt is based only on the borrower’s promise to pay. If a business files for bankruptcy, creditors take priority over investors. Within the creditors, secured creditors take priority over unsecured creditors.
Equity instruments are papers that demonstrate an ownership interest in a business. Unlike debt instruments, equity instruments cede ownership, and some control, of a business to investors who provide private capital to a business. Stocks are equity instruments. Two main types of stocks exist. The first type is preferred stock. The second type is common stock. Businesses issue stock in shares and, typically, the greater the amount of shares a single investor possesses, the greater the ownership interest in the company. Equity holders incur greater risk than debt holders because equity holders do not enjoy priority in a bankruptcy proceeding. However, equity holders earn greater returns if the business succeeds. Where credit instruments provide set payments over a set time period, equity instruments typically provide a variable return based on the business' success. Therefore, if the business does extraordinarily well, equity investors may see a much healthier return than creditors.
Preferred stock is different than common stock. Preferred stock typically carries a fixed dividend paid quarterly and can denote a greater ownership than common stock holders. For instance, one share of preferred stock may be worth ten shares of common stock. In addition, in a bankruptcy proceeding, preferred stock holders take priority over common stock holders. Common stock simply denotes a fractional ownership interest in a business. It functions the same as preferred stock, but is simply of lesser value and priority.
An attorney and founder of ScrofanoLaw, a general practice law firm in Washington, D.C., Joseph Scrofano has been writing on legal issues since 2008. He holds a Juris Doctor from the Washington College of Law, a Bachelor of Arts with special honors from the University of Texas and a master's degree in international affairs from American University's School of International Service.