innovations in equity instruments

8/8/2019 Innovations in Equity Instruments

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K eiretsu

A Japanese term descri b ing a loose conglomeration of firms sharing one or more common denominators. Thecompanies don't necessarily need to own e qu ity ineach other.

This term has been in the news every now and then,especially when they talk a bou t Silicon Valley. One

example wo u ld be the close relationship between AOLand S un Micro. The 2 firms don't have ownership ineach other, bu t they work closely on vario us projects


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Pub lic Private Partnership

P3s are legal agreements betweenGovernment and Private sector for

the purpose of providing Public

Infrastructure, Community facilities,and related Services.


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Resource Risk Reward Responsibility ( RRR)

Reso urce SharingRisk Sharing

Reward SharingResponsi b ility Sharing

Sharing the Commercial benefit with Stakeholders Revise PPP with P ub lic Private Commercial Partnership


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L IMITED L IABIL ITY PARTNER SH IP ( LL P)

Parliament on 12.12.2008 has passed the LLP Act 2008 andthe r u les under the act have been framed and are madeeffective from 01.04.2009.

Salient feat u res of the act and r u les are as under:

LLP will be an alternative corporate business vehicle that wo u ldgive the benefits of limited lia b ilitybu t wou ld allow its mem bers the flexi b ilityof organising their internal str uctu re as a partnership based on anagreement.

Bill is for the benefit of any enterprise which f u lfills the re qu irements of the Act. There can also be a foreign LL P .

Every person having the capacity to contract can be a mem ber of LLP.The capacity may be nat u ral or legal. No minor or a simple partnership firmor any entity which is not a body corporate can be a partner in a LLP.


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While the LLP being a separate legal entity is liab le to the f u llextent of its assets, its partners will be lia b le only to the extentof their agreed contri bu tion in the LLP. F urther no partner willbe lia b le for the independent or una u thorized actions of other partners there by shielding the partners from the joint lia b ilitycreated by the other partners' wrongf u l bu siness decisions or miscond uct.

LLP shall be a corporate body and a legal entity separate fromits partners. It has a perpet ual s uccession. Indian Partnership Act shall not be applica b le to LLP and the min no. of partnersof a LLP is two and there is no upper limit to the number of partners.

An LLP will be under o b ligation to maintain ann ual acco untsreflecting tr ue and fair view of its state of affairs.

LLP can also take actions like mergers amalgamations.Similarly there are provisions for winding up and dissol u tion.


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Every LLP sho u ld have 2 "Designated partners" at least one of whom should be a resident Indian satisfying the conditionsstipu lated by the Central Govt. They sho u ld apply and o b taindesignated partner identification n umber (DPIN) and digitalsignat ure certificate from the designated a u thority.

An intending unlimited lia b ility partnership firm seeking toconvert itself into a LLP is re qu ired to apply to the Registrar as

per form 17 which sho u ld be accompanied by written consentfrom all creditors.

When once the Registrar accepts and registers the firm itcomes into force and all the assets and lia b ilities wou ld be

transferred to the new LLP.The Central government by a notification in the Gazette canapply any provisions of the Companies act to LLP either f u lly or with certain modifications. Perhaps these wo u ld cover the timeframe within which charges are re qu ired to be registered, theforms for this, the inter se priority of charges etc.


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Equity versus salaried Partner

An Equity partner is a part owner of the bu siness , and isentitled to a proportion of the distri bu tab le profits of thepartnership.

S alaried partner are paid a salary , bu t do not have any

underlying ownership interest in the bu siness and will not sharein the distribu tions of the partnership (altho ugh it is qu itecommon for salaried partners to receive a bonus based uponthe firm's profita b ility).

Although they are both regarded as partners, in legal andeconomic terms, e qu ity partners and salaried partners havelittle in common other than joint and several lia b ility. The degreeof control which each type of partner exerts over thepartnership depends upon the relevant partnership agreement .


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Type of Equity partnership

Equ ity partners enjoy a fixed share of the partnership ( bu t notalways an e qu al share with the other partners).

Most common forms are "lockstep" and "eat-what-yo u-kill"

L ockstep involves new partners joining the partnership with acertain no. of "points". As time passes, they accr ue additionalpoints, until they reach a set max. The length of time it takes toreach the max is often used to descri be the firm (so, for eg, onecou ld say that one firm has a 7 year lockstep" and another hasa 10 year lockstep" depending upon the length of time it takesto reach max e qu ity).

Eat-what-you-kill Each partner receives a share of thepartnership profits up to a certain amo unt, and any additionalprofits are distri bu ted to the partner who was responsi b le for the"origination" of the work which generated the profits.


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S trategic Alliance

is a formal relationship between 2 or more parties to p urs ue aset of agreed upon goals or to meet a critical bu siness needwhile remaining independent organizations

SA with reso urces s uch as prod ucts, distri bu tion channels,

man ufacturing capa b ility, project f unding, capital e qu ipment,knowledge, expertise, or intellect ual property.

SA is a cooperation or collaboration which aims for a synergywhere each partner hopes that the benefits from the alliancewill be greater than those from individ ual efforts.

SA often involves technology transfer (access to knowledgeand expertise), economic specialization , shared expensesand shared risk.


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S hirkah

An Islamic finance term that descri bes a partnership between 2or more individ uals. The parties involved com b ine a portionof their capital or la bor in order to share in profits/losses of thebu siness.

divided into 2 categories:

Shirkah- u l-milk: Joint ownership between the partiesinvolved, where each party has provided capital in order topurchase a partic u lar property.

Shirkah- u l-'aqd: A partnership created thro ugh a contract.This can also be translated to mean a type of joint commercialenterprise.


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Cooperative relationship of Shirkat- u l-milk can becreated 2 ways;

V oluntary , in which there is a prearrangedagreement, or

Automatically . For eg Shirkah- u l-milk cancommence a u tomatically by inheriting the partnershipthro ugh the death of a family mem ber. Profit and

losses are usually shared according to theinvestor's predetermined portion of the investment.


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Shirkat- u l-'aqd is f urther divided into 3 s ub categories:

Shirkah- u l-amwal: Each party provides capital to a vent ure.Similar to how shareholders provide capital to a Corp thro ughan IPO.

Shirkah- u l-A'mal: Each party provides labor instead of capital.In this case, all wages earned by the partners wo u ld be placedinto a wage pool, which is then shared amongst all parties.

Shirkah- u l-wu jooh : This partnership is based on goodwill.Each party p urchases commodities at a deferred price, by wayof a loan. They then share the profits after selling thecommodities at the spot price.


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M usharakah

A joint enterprise/Partnership str ucture with profit/ loss sharingimplications instead of interest- bearing loans.

Portion of the act ual profits earned , according to apredetermined ratio.

U nlike a traditional creditor, the financier will also share in anylosses.

For eg, s uppose that an individ ual (A) wants to begin a bu sinessbu t has limited f unds. Individ ual (B) has excess f unds andwishes to be the financier in m usharakah with A. The twopeople wo u ld come to an agreement to the terms and begin abu siness in which both share a portion of the profits and losses.This negates the need for A to receive a loan from B.


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C onsortium

Group made up of 2 or more individ uals, Cos or Govts that work together toward achieving a chosen o b jective.

Each entity is only responsi b le to the gro up in respect to the o b ligationsthat are set o u t in the consorti um's contract.

Every entity remains independent in its normal business operationsand has no say over another mem ber's operations.

Often used within the non-profit sector , specifically with ed ucationalinstitu tions. They often pool reso u rces s uch as li b raries and professors and

share them among the mem bers of the gro up. Several gro ups of North American colleges and universities operate under consorti ums.


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A merican Depositary Receipt - A DR

A negotia b le certificate iss ued by a U .S. bank representing aspecified no of shares (or one share) in a foreign stock that istraded on a U .S. exchange.

Denominated in U .S. dollars, with the underlying sec urity heldby a U .S. FI overseas.

Excellent way to bu y shares in a foreign Co while realizing anydividends and capital gains in U .S. dollars. However, ADRs donot eliminate the c urrency and economic risks for theunderlying shares in another co untry. For eg, dividendpayments in e uros wo u ld be converted to U .S. dollars, net of conversion expenses and foreign taxes and in accordance withthe deposit agreement. ADRs are listed on either the NYS E ,

AMEX or Nasda q .


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A merican Depositary S hare - A DS

A U .S. dollar-denominated e qu ity share of a foreign- based company availa b lefor pu rchase on an American stock exchange.

Iss ued by depository banks in U .S. under agreement with the iss u ing foreigncompany; the entire iss uance is called an ADR and the individ ual shares arereferred to as ADSs.

Co may either list its shares OTC with low reporting re qu irements or on amajor exchange like the NYS E or Nasda q . Listings on the latter exchangesgenerally re qu ire the same level of reporting as domestic companies, andalso re qu ire adherence to GAAP acco unting r u les.

For U .S. investors, ADSs offer the opport unity to invest in foreigncompanies witho u t dealing with c u rrency conversions and other cross-border administrative hoops.


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Global Depositary Receipt - GDR

1. A bank certificate iss ued in more than one co untry for

shares in a foreign company. The shares are held by a foreignbranch of an international bank. The shares trade as domesticshares, bu t are offered for sale glo bally thro ugh the vario usbank branches.

2. A financial instr ument used by private markets to raisecapital denominated in either U .S. dollars or e uros.

1. A GDR is very similar to an American Depositary Receipt.

2. These instr uments are called EDRs when private marketsare attempting to o b tain e uros.


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C ommon S tock


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W atered S tock

Stock that is iss ued with a val ue m uch greater than the val ue of the iss u ing company's assets. Watered stock can be ca usedby excessive stock dividends, overval ued assets and/or largeoperating losses.

Assets can be overval ued for several reasons, incl uding inflatedacco unting val ues or excessive iss ue of stock (thro ugh adividend or ESOP).

Term is tho ught to originate from ranchers who wo u ld feedtheir cattle large amo unts of water before market day to makethem heavier, fetching a price higher than their worth.


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Z akat

ob ligation that an individ ual has to donate a certain proportionof wealth each year to charita b le ca uses s uch as corporateresponsi b ility or environmental iss ues.

The most common level of zakat on wealth from cash, e qu itiesand gold is 2.5% of the total val ue.


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Treasury S tock (Treasury S hares)Portion of shares that a Co keeps in their own treas u ry.

may come from a bu yback from shareholders ; or it may have never been iss ued to p ub lic in the first place.

These shares don't pay dividends, have no voting rights, and sho u ld not beincluded in shares o u tstanding calc u lations.

Often created when shares of a Co are initially iss ued. In this case, not allshares are iss ued to the p ub lic, as some are kept in Cos treas u ry to be usedto create extra cash sho u ld it be needed. Another reason may be to keep acontrolling interest within the treas u ry to help ward off hostile takeovers.

Can be created when a Co does a share bu yback and p u rchases its shareson the open market. This can be advantageo us to shareholders beca use itlowers the no of shares o u tstanding. However, not all bu ybacks are a goodthing. For eg, if a company merely bu ys stock to improve financialratios s uch as EPS or P/ E , then the bu yback is detrimental to theshareholders, and it is done witho u t the shareholders' best interests in mind.


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Reverse/Forward S tock S plit

A stock split strategy that incl udes the use of a reverse stocksplit followed by a forward stock split. A reverse/forward stocksplit is usually used by Cos to cash o u t shareholders with aless-than-certain amo unt of shares. This is believedto c u t administrative costs by red ucing the no. of shareholderswho re qu ire mailed proxies and other doc uments.

For eg, if a Co declares a reverse/forward stock split, it co u ldstart by exchanging one share for 100 shares that the investor

holds. Investors with fewer than 100 shares wo u ld not be a b leto do the split and wo u ld therefore be cashed o u t. The companywou ld then do a forward stock split for 100 for 1, which willbring shareholders that were not cashed o u t to their originalnumber of shares.


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S tory S tock


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L eprechaun L eader

A corporate manager or an exec u tive who, like thefab led Irish elf, is a mischievo us and el usive creat uresaid to possess bu ried treas ures of money and gold.

Location of hidden treas ure is revealed only when theleprecha un is ca ught. In the case of a leprecha unleader, the " bu ried treas ure" is not usually bu ried, bu t

rather in a protected offshore acco unt!

Examples Exec u tives of Enron, who stowed awaymillions of dollars until they were finally ca ught.


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Equity Options


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Pooled Investment V ehicles


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Index Futures and Index Options


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W arrant

A derivative sec urity that gives the holder the right topurchase sec urities ( usually e qu ity) from the iss uer at aspecific price within a certain time frame. Warrants are oftenincluded in a new de b t iss ue as a "sweetener" to enticeinvestors.

Main diff between warrants & call options is that warrantsare iss ued and g uaranteed by the company, whereas optionsare exchange instr uments and are not iss ued by thecompany. Also, the lifetime of a warrant is often meas ured inyears, while the lifetime of a typical option is meas ured in

months.


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C all W arrant

A warrant that gives the holder the right to bu ythe underlying share for an agreed price, on or before a specified date.


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C overed W arrant

A type of warrant that allows the holder to bu y or sell aspecific amo unt of e qu ities, c urrency or other financialinstr uments from the iss uer, usually a bank or asimilar financial instit u tion, at a specific price and time.

Main differences between normal warrants and covered warrants are:

1. CW can have a wide variety of underlying financial prod ucts. Normal warrants onlyhave a Co's stock as their underlying financial prod uct.

2. CW are only iss ued by FIs. Normal warrants are only iss ued by the Co that iss ued theunderlying e qu ity.

3. CW can have a variety of exercise prices depending on the conditions set forth byeach iss ue. Normal warrants generally have only one exercise price.

4. CW allow the warrant holder to bu y or sell the underlying asset. Normal warrantsallow the warrant holder only to bu y the underlying e qu ity.


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C um

W arrant

A condition in which the bu yer of a sec urity isentitled to a warrant that has been declared,bu t not distri bu ted.

Essentially the same as a c um dividend, bu tfor warrants.


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Ex - W arrant Mean

Trading of shares when a warrant has been declaredbu t not distri bu ted.

In this case, the distri bu tion wo u ld still belong tothe seller rather than someone looking to bu y

the shares.


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Detachable W arrant

A derivative that is attached to a sec urity and gives the holder the right to p urchase an underlying sec urity at a specific pricewithin a certain time frame. A detacha b le warrant is oftencom b ined with vario us forms of de b t offerings and can be

removed by the holder and sold in the secondary marketseparately.

Many companies choose detacha b le warrants when iss u ing bondsbeca use it makes a de b t offering more attractive and can be an effectivemethod of raising new capital. The expos u re to the right given by thedetacha b le warrant can often gain the attention of investors who do notusually participate in the fixed-income markets.

A detacha b le warrant can be traded independently of the package withwhich it was offered, and is similar to a call option.


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Put W

arrant

A warrant that gives the holder the right to sell theunderlying share for an agreed price on or before a

specified date.

Basically, it's a warrant that gives the right to sell.


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W arrant C overage

An agreement between a Co and its shareholders where by the Co iss ueswarrants e qu al to some percentage of the dollar amo unt of theshareholder's investment.

For eg, if an investor p u rchases 1,000,000 shares of stock at a price of $5per share (a $5,000,000 investment), and the Co grants 20% warrantcoverage, the company iss ues to the investor $1,000,000 in warrants or,in technical terms, warrants 200,000 additional shares at an exercise priceof $5 per share.

This wo u ld not give the investor any additional downside protection as theunderlying shares wo u ld be iss ued at the same price that is c u rrently paidfor the stock. However, the warrant coverage wo u ld give the investor additional upside in the event that the company goes p ub lic or is sold at aprice a bove $5 per share.


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W arrant Premium

The premi um paid for the rights associated with awarrant.

Like a derivative option, warrants will have anintrinsic val ue and extrinsic val ue. For a warrant, theintrinsic val ue is the difference between the warrant'sexercise price and the market price of theunderlying. The premi um is anything paid a bove theintrinsic val ue for the warrant. Typically the premi umwill decrease as the price of the warrant rises andthe time to expiration decreases.


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L egal Ownership Instruments

Common share

Perpet ual preferred share

General partnership interest


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Common share

Mandatorily redeema b le or

Pu ttab le at fair val ue or

A formu laic amo unt designed to approximate fair value


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Equ ity Share

Mandatorily redeema b le at a fixed price


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Equity S hare

Converti b le into mendatorily redeema b le or pu ttab le Preferred share regardless of the way theamo unt is determined and form of settlement (cashor shares)


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Equity Instrument

that converts mandatorily into a varia b le n umber of basic ownership instr uments with a fixedmonetary amo unt (for eg, share-settled de b t)


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Option,Warrant,Share-settled stock appreciation right (SAR), &Employee stock option settled with shares


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S tock A ppreciation Right - SA R

A right, usually granted to an employee, to receive a bonusequ al to the appreciation in the company's stock over aspecified period. Like employee stock options, SARs benefitthe holder with an increase in stock price; the difference isthat the employee is not re qu ired to pay the exercise price(as with an employee stock option), bu t rather j ust receivesthe amo unt of the increase in cash or stock.

For eg, say an employee is given 100 SARs. Good fort une

shines and the stock increases $50 per share over threeyears. As a res u lt, the employee gets $5,000 (100 SARs x$50 = $5,000). The main benefit with SARs is that theemployee does not have to p urchase anything to receive theproceeds.


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Performance S hares

In the case of stock compensation, shares of company stockgiven to managers only if certain company wideperformance criteria are met, s uch as EPS targets.

Ob jective to tie managers to the interests of shareholders.

Their goal is similar to ESOPs, as they provide an explicitincentive for management to foc us their efforts onmaximizing shareholder val ue.

Note that in the case of performance shares, the manager receives the shares as compensation for meeting targets, asopposed to ESOPs where employees receive stock optionsas part of their us ual compensation package.


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C amouflage C ompensation

Compensation that is granted to upper echelon employees,directors, cons u ltants and related parties that is not f u llydisclosed in mandatory company filings. In other cases, compensation is f u lly disclosed, bu t in s uch a way that it is

very difficu lt for the average investor to decipher the tr uevalue of gross pay compensation.

Non- qu alified deferred compensation plans, S ERPs,

stock options, SAR and share grants are all potentialplaces where compensation can be hidden fromanalysts and shareholders.


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Net-cash-settled written call option andcash SAR


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Warrant to p u rchase a basic ownershipinstr ument for one cent when ass uming thefair value of the basic ownership instr ument isSub stantially higher than one cent


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Written call option with a s ub stantiveregistration rights penalty


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Physically, net-cash-settled or net-sharesettled Forward p urchase contract at a

fixed price


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Prepaid forward p urchase contract for afixed n umber of shares (or a note

receiva b le for a fixed n umber of shares)


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Physically, net-cash-settled or net- sharesettled written p u t option


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Prepaid written p u t option


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Share p u tta b le at a fixed price

Share p u tta b le at fair val ue

Converti b le de b t for fixed n umber of shares

Calla b le common share (fixed price)

Calla b le preferred share (fixed price)


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Converti b le into a fixed n umber of basic ownership instr uments

Preferred share p u tta b le, calla b le, andconverti b le


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Note receiva b le settled with cash or a varia b lenumber of shares

De b t indexed to shares (for example,converti b le de b t for which the entireconversion val ue is settled in cash)

Varia b le share forward sales contract iss uedin conj unction (separately) with commonshare that is p u tta b le at a fixed price


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Innovations in Equity RelatedInstruments

innovations in equity instruments

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