7 Key Differences Between Structured Equity and Traditional Equity Every Investor Should Know

Last updated on October 10th, 2024 at 03:12 pm

If you are considering various options for financing equity, you might have come across the terms traditional equity and structured equity. Both methods are used to help companies raise capital, and investors get returns, but they operate under different conditions. 

Structured equity offers flexibility and security, making it attractive for investors and entrepreneurs. Investors get a more customized and secure investment option, and the firm can keep the authority within the firm without compromising the owner’s vision. Meanwhile, traditional equity means investors own direct stakes in the company. The owner is willing to accept investors’ involvement in the management and consider everyone’s ideas moving forward. Structured equity aims to balance risk and reward, whereas traditional equity aims at higher profits with higher risk.

Understanding the difference between both options will give a clearer idea of which option you would benefit from. In this post, we will examine how traditional equity differs from structured equity, focusing on elements such as risk, return, ownership dilution, and investor control.

READ MORE Structured Equity 101: What Investors Should Understand

Difference Between Structured Equity and Traditional Equity

1. Risk and Return

The biggest factor influencing every investor’s decision is how much they can make with as little risk as possible, which means evaluating the risk and reward factors for both options.

• Traditional Equity: Traditional equity means the investors get direct ownership of the company, which also means that the investors are going to share the risks and rewards of the company. If the company were to perform well, it has the potential to give unlimited profit; many people who have invested for a long time have earned more than 300% growth on their investment.
  
  On the other hand, if the company were to perform poorly, it means that investors have to suffer a grave loss. It makes traditional equity a high-risk, high-reward option.
  
• Structured Equity: In comparison, this equity has a more controlled risk profile. Structured equity comes with an in-built safety system that helps investors to avoid higher losses. It provides protections such as convertible notes or preferred shares that may offer fixed returns but also puts a cap on maximum returns. Structured equity is ideal for investors who want less risky investments and are fine with a limited return margin.

2. Flexibility in Structure

Another factor to consider is the flexibility of the investment structure. Some firms offer more customizable deals for investors, while others are straightforward but not customizable.

• Traditional Equity: Traditional equity follows the straightforward method. A company issues its shares in the market to raise capital, and investors looking for investment opportunities invest in it to gain possible returns and dividends. The simple structure makes it easier for the company to raise capital and quick for investors to invest.
  
• Structured Equity: This equity provides a more customizable deal for investors and companies, making it more complex yet tailored enough to satisfy both parties’ needs. Structured equity comes in many forms, including convertible debt, preferred stock, and equity with warrants. 
  
  Each of these options could be designed to offer specific outcomes, such as delaying equity conversion until certain milestones are met or providing more protection against the risk of a downturn for investors. The flexibility of structured equity allows it to be used in tricky financial scenarios, like mergers or acquisitions or even corporate restructuring.

READ MORE 7 Fundamental Differences Between Structured Equity and Preferred Equity

3. Control and Ownership

The control and power of an organization can be a critical factor for investors, particularly the ones with a significant stake. Structured equity and traditional equity also differ in terms of the level of power of control and ownership rights they provide.

• Traditional Equity: Investors get certain rights with traditional equity. It means the right to vote in big company decisions where investors deem this could influence their share prices. Voting rights allow investors to influence significant decisions, such as electing board members and approving major corporate actions, such as mergers and acquisitions.
  
  As traditional equity offers a direct stake in the company, it associates investors with company risks; that is why they need to give investors the right to vote because their money is tied to the company; the more invested an individual is, the more influential their votes.
  
• Structured Equity: With structured equity, investors more concerned with returns and want an off-the-management aspect of their investment portfolio would benefit. Investors who invest through instruments like convertible notes or preferred equity don’t have the voting rights of traditional equity investors.
  
  As structured equity is customizable, investors who want voting rights can get them, while the ones who are not interested can opt-out. Investors who select structured equity can also choose to convert their equity into traditional equity to get voting rights.

4. Ownership Stakes

Ownership stakes are an important concern for both investors and the company owners. Giving ownership stakes to investors means giving them control; traditional and structured equity have different working conditions.

• Traditional Equity: For this type of equity, whenever a company issues its shares in the market, the people who invest in the company get ownership stakes per their invested capital. The more capital invested in the company, the more diluted the ownership.
  
  As the company issues more shares, the ownership dilutes more, and the ownership stake of each investor gets less and less, which can be a concern for existing shareholders. In such cases, people with more influential power in the company either had to accept less authority and voting rights than before or invest more to maintain it.
  
• Structured Equity: One of the main advantages of structured equity is the control over how much the ownership stakes are to be distributed, or the owner can keep the firm entirely under their control. Instruments like convertible debt permit firms to increase capital without diluting ownership.
  
  Conversion of structured equity to traditional shares may be delayed until certain conditions are met. This could allow ownership stakes to be kept for an extended period. Additionally, structured equity deals typically have fewer shares issued at the beginning, which can reduce the impact immediately on the dilution of ownership.

5. Investor Profile

Structured and traditional equity have different features; one is risky with higher profit potential, while the other has controlled risk and limited return potential. These varying features attract different types of investors with different goals.

• Traditional Equity: Traditional equities are more popular than structured ones because of their availability on various platforms. It also attracts more investors, from retail investors to institutional investors like mutual funds and pension funds. Its popularity is due to the simple structure and more accessible access from multiple platforms.
  
  Additionally, most investors seek unlimited profits even at the cost of higher risk from their long-term investment, making traditional equity preferable.
  
• Structured Equity: This type of equity is designed for institutional investors and high-net-worth individuals who want a balanced investment opportunity and off-hand management investment. These investors typically seek instruments that offer protection and steady earnings, like preferred convertible or equity and convertible debt, but also allow an equity upside.
  
  Structured equity is usually used by private equity firms and venture capitalists who want a more customized term to achieve specific strategic goals.  

6. Cost of Capital

• Traditional Equity: The cost of capital means how much the firm has to give up when issuing market shares. For traditional equity, the cost of capital is higher because the firm is not just raising capital; it is diluting its ownership, giving power to all major investors, and sharing their profits from potential future earnings in the form of dividends or capital gains.
  
  For investors, the cost is expressed in the value of the stock, which fluctuates depending on the performance of the company and market conditions.
  
• Structured Equity: The Structured Equity option provides greater flexibility in pricing. It is an efficient choice for businesses, particularly if they want to postpone the effect on ownership or provide investors with a fixed return. 
  
  As structured equity is flexible and can be customized, financing terms can be customized to delay the impact of the initial dilution of ownership, making it more controlled for the owner for a more extended period and making it less costly for businesses for a short time.

7. Exit Strategy

The way investors exit their positions could differ based on whether they’ve placed their money in either structured or traditional equity.

• Traditional Equity: Investors who invest in traditional equity typically leave their position by selling their shares in the market or during a liquidity event like a merger or acquisition. Traditional equity investment is more sensitive to price and market timing fluctuations since returns are directly linked to the company’s performance in the stock market at the time of the sale.
  
• Structured Equity: Structured equity typically offers built-in exit strategies that provide more predictability. For instance, convertible debt could have a specified maturity date, and at the end of that date, the debt either converts into ordinary equity or is paid back. 
  
  Structured equity investors can negotiate buyback options or redemption options, allowing them to withdraw their investments at a set price. These options reduce the need to rely on market conditions and provide greater certainty regarding how investors can earn their profits.

READ MORE Structured Equity vs. Mezzanine Equity: Which is Right for You?

Frequently Asked Questions (FAQs)

Final Statement

In the end, both structured and traditional equity are crucial in raising capital for companies and generating income for investors; however, they are geared toward specific financial needs and objectives. Traditional equity can offer the possibility of unlimited profit and directly owned stakes in the company. This makes it attractive to investors who can handle greater risk levels and volatility in the market. This also means more downside risk and possibly diluting ownership for existing shareholders.

In contrast to traditional equity’s high-risk, high-reward approach, structured equity offers a more balanced approach for both entrepreneurs and investors. With the combined features of equity debt, structured equity induces a product that offers the growth feature from equity and security features from debt agreements, making it perfect for business owners who want to avoid handing out their profits and authority at the start. It also gives investors a less risky investment opportunity with the flexibility to choose whether they wish to be included in management. It helps the company raise capital without compromising its vision and control while providing investors the option of getting fixed returns with lower risk.

The 7 points discussed in the post are key factors that every business and investor should consider before deciding whether to opt for traditional or structured equity investment. Whether looking for a more stable and less risky option or a dynamic and risky one, the final decision is yours.