Who Gets Paid First: Bondholders or Stockholders?

Companies obtain funding by borrowing money or selling ownership stakes. These methods create different relationships with funders. Understanding whether bondholders or stockholders receive payment first is a fundamental concept in business finance, and this article explains their roles and the order of payment.

Understanding a Company’s Capital Structure

Companies obtain capital through a mix of debt and equity, which collectively form their capital structure. Debt capital is raised by issuing bonds, which function as a loan to the company. When an individual purchases a bond, they are lending money to the company and become a creditor. The company is contractually obligated to pay interest on this loan and return the original principal amount on a specified maturity date.

Equity capital, on the other hand, is raised by issuing stocks, which represent a share of ownership in the company. Stockholders are owners of the business, holding a claim on the company’s assets and future profits. Unlike bondholders who expect fixed interest payments, stockholders’ returns are variable and depend on the company’s performance, potentially coming from dividends or stock price appreciation.

The Hierarchy of Claims in Financial Distress

In situations of financial distress, such as corporate bankruptcy or liquidation, a clear hierarchy dictates the order in which different parties are paid. Bondholders generally have priority over stockholders because debt represents a contractual obligation.

Secured creditors are at the top of this hierarchy. These are lenders whose loans are backed by specific company assets, such as property or equipment, giving them a legal right to those assets if the company defaults. Next in line are unsecured creditors, which include most bondholders. While unsecured creditors do not have specific collateral tied to their loans, they still possess a contractual right to repayment and are paid before equity holders.

After all creditors, including bondholders, have been addressed, preferred stockholders typically receive payment. Preferred stock is a hybrid security that often grants its holders a preferential claim over common stockholders for both dividends and assets during liquidation. Finally, common stockholders are at the very bottom of the payment hierarchy. They receive assets only if funds remain after all creditors and preferred stockholders have been fully compensated, which is a rare occurrence in liquidation.

Scenarios Where Priority Matters

The concept of payment priority becomes particularly relevant when a company faces severe financial difficulties, leading to formal insolvency processes like bankruptcy and liquidation. In these scenarios, a company’s assets are sold, and the proceeds are distributed according to the established order of claims. This process ensures that those with senior claims are paid before those with junior claims.

During normal business operations, bondholders receive their regular interest payments, and stockholders may receive dividends if declared by the company. The “paid first” concept for capital repayment does not directly apply in these routine situations. However, in the event of liquidation, the company’s entire asset base is converted into cash, and this cash is then systematically distributed. The proceeds from asset sales are methodically allocated, first to cover the costs of the liquidation process itself, and then to the various classes of creditors and equity holders in their determined order.

Investor Considerations and Payment Priority

The payment hierarchy directly influences the risk and potential return for bondholders and stockholders. Bondholders, occupying a higher position, generally face a lower risk of capital loss in financial distress. Their contractual right to repayment and priority over equity holders provides protection. This reduced risk often translates to a lower, more predictable rate of return compared to equity investments, as bondholders primarily seek income and capital preservation.

Conversely, stockholders, being last in line for repayment, bear the highest risk of losing their investment if a company liquidates. Common stockholders often receive nothing after creditors and preferred stockholders are paid. Despite this increased risk, common stockholders possess the potential for unlimited upside if the company is successful, through stock price appreciation and significant dividends. This trade-off between higher risk and greater returns is a central consideration for investors.