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Deferred equity refers to any investment vehicle which gives an investor the opportunity to buy common stock from a company at some point in the future. Although the investor does not immediately receive equity shares, he or she may convert their current securities into shares at some point if the underlying stock price moves favorably in their direction. The two most common types of deferred equity are convertible bonds and convertible preferred stock. In both cases, these securities may be traded on the secondary market, with their prices dependent upon how close the current stock price is to the price where conversion becomes profitable.
Many investors would like the opportunity to buy equity of a top company. If they can manage this, they will benefit if the company's fortunes improve and the equity thereby becomes more valuable. Unfortunately, the cost of buying common stock in established companies is often very expensive. One alternative for those investors who wish to buy equity at reasonable prices is deferred equity.
The idea behind deferred equity is that investors have the option to convert the security they have purchased into actual common stock shares at some date in the future. This date may be determined at the outset of the agreement or it can come when the price of the underlying stock reaches a certain price. Investors usually receive some sort of fixed income from the investments until they convert into common stock, if that time actually arrives.
Convertible bonds and convertible preferred stock are two popular types of deferred equity. With convertible bonds, investors receive interest payments from the issuer of the bonds and may convert the bonds into common stock at some point. In the case of convertible preferred stock, the fixed income element of the investment comes from regularly scheduled dividend payments. Preferred stock also promises the investors return of capital before common stockholders should the issuing company ever reach the point where it goes bankrupt or out of business.
No matter what type of deferred equity is chosen, investors must determine the point at which it becomes profitable to convert the securities into equity. If this point is reached, the conversion element of the security is said to be in the money. When it comes to selling these securities on the secondary market, the stock price's proximity to being in the money is the important factor. As the stock price gets closer to being in the money, investors can demand more of a premium.