5 Equity and Shareholders’ Capital..............................................................
5.1 The Equity Technique, Different Perspectives
An entity’s “equity” is usually defined as a residual claim to its net assets. It ranks
after liabilities as a claim to the entity’s assets. “Equity” is contrasted with liabili-
ties. Liabilities are claims that must be met before a distribution can be made to
equity holders in the event of an entity being wound up.
However, “equity” must surely mean more than just a residual claim in the
event that an entity is wound up. An entity will be wound up only once, that is, at
the end of its corporate life. During its corporate life, an entity raises funds from a
wide range of investors and makes many kinds of payments to them.
Equity as a technique, equity mix. In this book, “equity” is defined as a tech-
nique rather than a category of financing. The equity technique consists of three
fundamental elements.
First, it means using waterfall structures to create a ranking of claims and
claims with different risk profiles. The waterfall structures influence the valuation
of claims and the firm’s funding costs. A lower risk means a higher valuation and
lower funding costs. A higher risk means a lower valuation and higher funding
costs. The equity technique enables the firm to choose an equity and debt mix and
to reduce its total funding costs through price segmentation (price differentiation).
Second, such waterfall structures are based on legal constraints on the distribu-
tion of particular assets to investors.
Third, where the distribution of different asset classes to investors or distribu-
tions made to different investor classes are subject to different legal constraints,
the firm can use the legal framework for its own benefit and choose en equity mix
according to its needs. For example, some categories of equity assets are necessary
for accounting reasons (equity on balance sheet), the issuing of some equity in-
struments (shares) will influence the internal decision-making of the firm, and the
use of some equity instruments (shares, subordinated debt, debt instruments be-
longing to a junior tranche) can be necessary if the firm wants to increase the mar-
ketability of senior debt securities to be issued by the firm.
Equity technique from the perspective of the firm. From a functional perspec-
tive, equity capital means more than shareholders’ capital. There are six main rea-
sons to use the equity technique and to create equity capital. To sum up, the firm
needs equity capital: to increase its survival chances and to manage its own risk
level; to manage investors’ perceived risk; to reduce the overall cost of funding;
and for other reasons.
P. Mäntysaari, The Law of Corporate Finance: General Principles and EU Law,
DOI 10.1007/ 978-3-642-03058-1_5, © Springer-Verlag Berlin Heidelberg 2010