Common Stock

• By forming a corporation, a company can issue stock to raise capital. In doing this, "shares" of stock are created and sold to investors. These investors then "share" both control and ownership of the corporation. For this reason, stock is considered to be an "equity instrument." Equity refers to the usually partial ownership you have invested in an entity, be it a car, house or publicly traded firm.
  
  

Debt

• When companies need to raise funds, but don't wish to issue stock, they may opt for debt instruments. Debt instruments are simply loans, but they take various forms. Unsecured debt involves a legal obligation to repay funds plus interest, of course, but do not entitle the lender to seize assets if the loan becomes delinquent. The personal finance analog to this would be credit card debt or a signature loan. On the other hand, secured debt allows the lender to take possession and legal ownership of specified assets, a plot of land, vehicle or piece of equipment, for example, if the loan becomes too delinquent. Bonds are transferable certificates that entitle the holder to periodic payments from the issuer. When the bond matures, the principle is paid to the bondholder.
  
  

Seniority

• Besides the mechanism by which debt is incurred, the seniority of debt is also important. When endeavors are successful, the seniority of debt is not as important an issue. Seniority becomes vitally important when a firm becomes insolvent, however. When a company is unable to fulfill all its repayment obligations, it pays senior debt first. When all debts of a given seniority are paid, then subordinate debt is discharged. There are various degrees of seniority among debt as well as special categories.
  
  

Effects

• For purposes of accounting, secured debt is considered to be senior debt. However, since secured debt is backed by assets specified in the loan contract, this is mostly a formality. If the interest becomes insolvent, the lender simply seizes those assets and, since the same asset cannot be used to secure multiple loans, no one else will have a similar claim on them. While those assets are "spoken for," any liquid funds the firm has will discharge all senior debt then subordinate debt. When a debt instrument is created, the degree of its seniority will be established, whether it is a bond, secured loan, unsecured loan or other instrument.
  
  

Other Factors

• The seniority of debt has a great impact on the risk accepted by the lender. Because of this, the more senior a debt instrument is, the lower the interest will be, all other things being equal. This is not to say that subordinate debt always pays higher interest. The subordinate debt of a very stable firm may well be less risky and thus provide lower interest than senior debt in a very shaky company. Of course, one should bear in mind that the biggest losers in the liquidation of a company are the owners. Stock holders are paid dividends from company profits and firms facing bankruptcy generally haven't been showing profits. While senior debt is usually paid in full and even subordinate debt gets at least some portion of what is owed, stockholders may recover virtually none of their investment.