138 5 Equity and Shareholders’ Capital
5.2 Share-based Equity and Equity That Is Not Share-based
Not Share-based
As explained above, equity can mean many things. There are various kinds of eq-
uity instruments and therefore also various kinds of holders of equity instruments.
Shareholders of a limited-liability company are holders of one particular class of
equity instruments, i.e. shares issued by the company.
Equity that is not share-based. Depending on the perspective, there can also be
many examples of equity capital that is not share-based. (a) The firm can reduce
the debt-to-equity ratio on its balance sheet without issuing new shares. The firm
can achieve this by opting not to distribute profits or by adjusting the fair value of
its assets. (b) The firm can ensure that it has contract-based funding that will not
have to be repaid in rough times. The most extreme case of such contracts is a
perpetuity.^22 A more common method would be to ask long-term stakeholders to
grant long-term loans. (c) The firm can achieve price segmentation of securities in
many ways. The firm can issue subordinated debt instruments which are perceived
as equity by holders of other debt instruments. Holders of adequately secured debt
instruments may regard unsecured debt instruments as equity for their own pur-
poses. Tranching enables the firm to create waterfall structures within one security
issue. (d) In mezzanine finance, debt mezzanine instruments are often used as a
functional equivalent to shareholders’ capital (section 6.3).
Debt instruments v shares. Although the equity technique enables the firm to
achieve many of the objectives of equity without turning to shareholders, there are
fundamental differences between share-based equity capital and equity capital that
is not share-based. The differences relate to corporate governance, the role of
mandatory constraints on distributions, and other matters (such as accounting and
tax).
Shareholders are an integral part of the governance of the company. Sharehold-
ers participate in the company’s internal decision-making. Their rights and obliga-
tions have mainly been regulated in company law, securities markets law, and the
articles of association of the company. As a rule, the corporate bodies of the com-
pany must comply with the provisions of law that lay down shareholders’ rights
and obligations. The holder of a very large block of shares will always be able to
control the company and decide on the use of its assets.
In contrast, holders of debt instruments are not an integral part of the internal
decision-making of the company. The rights and obligations of holders of debt in-
struments have mainly been laid down in contracts and provisions of contract law
that complement contracts. Although holders of debt instruments might have a le-
gal or de facto right to influence the management of the company by virtue of con-
tracts and covenants, they remain outsiders. The corporate bodies of the company
(^22) A perpetuity is an annuity that has no definite end, or a stream of cash payments that
continues forever. For example, a perpetuity issued by the Lekdijk Bovendams water
board in 1648 still continues to pay interest. Goetzmann WN, Rouwenhorst KG (eds),
The Origins of Value. The Financial Innovations that Created Modern Capital Markets.
OUP, Oxford (2005).