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Equity claims represent a stockholder's entitlement to earnings, which essentially are profits, from a company once the company's other debts have been satisfied. Also known as a residual claim, an equity claim typically is relevant in the event of a corporate bankruptcy or liquidation. Equity investors receive last priority to be compensated behind debt holders and preferred stock investors, all of whom are paid only after suppliers are reimbursed for losses.
An investor obtains an equity stake in a company by purchasing common or preferred stock in the financial markets. By doing so, investors are placing themselves in a position for the most rewarding gains should the stock price appreciate. This is because equity stockholders are rewarded from capital appreciation in a stock price coupled with other benefits, such as dividend payouts from retained earnings.
In the event that the company fails, however, equity investors are exposed to the most risk. Based on regional laws surrounding debt and equity, equity claims receive the least amount of priority. This means that in the event that a company is closing its doors and there is no financial restructuring ahead, all assets are liquidated. The proceeds from an asset sale go first to suppliers, followed by creditors, including debt holders.
Equity claims are last to be honored. If there are proceeds left for equity holders, these shareholders are paid in accordance with the amount of company stock they owned. In a worst-case scenario, not only are stock profits lost, but the face value of the original investment also gets wiped out.
Throughout a bankruptcy reorganization, the ramifications are less severe. A company's management team searches for a way to reduce the debt load and has intentions to return the business to profitability. In this situation, debt is reorganized under more manageable terms, and there is no complete liquidation. Equity claims have a better chance of being fulfilled. Once a company emerges from bankruptcy, a company might decide to issue new stock under a different trading symbol as a way to separate it from the bankruptcy.
Debt holders are entitled to ongoing interest payments from loans extended to a company, and if those payments are missed, large bondholders are sometimes in position to take control of the company. Once bondholders are reimbursed, preferred shareholders and common stockholders are able to file equity claims. If there are no earnings left, equity holders receive nothing.
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