Who Gets Paid First: Stockholders or Bondholders?

When a company encounters financial difficulties, understanding who receives payment first becomes a concern. This priority is particularly important in scenarios of financial distress or liquidation, where the company’s assets may not be sufficient to satisfy all claims. Recognizing this hierarchy of claims is fundamental for investors assessing potential risks and returns.

Understanding Stockholders and Bondholders

Stockholders are individuals or entities that own shares in a company, representing a portion of its equity. They are considered owners of the business, and their financial returns stem from stock appreciation and dividends. As owners, stockholders possess a residual claim on the company’s assets, meaning they are entitled to what remains only after all other obligations and creditors have been fully satisfied.

Bondholders are lenders to the company rather than owners. When an investor purchases a bond, they provide a loan to the company, which promises to pay regular interest payments and return principal at a predetermined maturity date. Bondholders are creditors, holding a contractual right to repayment of their loan. Their claim on the company’s assets is based on this lending agreement, positioning them differently within the company’s financial structure compared to equity holders.

Order of Payment in Financial Distress

When a company faces financial distress or enters bankruptcy, a specific hierarchy dictates the order in which claimants are paid from the company’s remaining assets. This order is governed by the “absolute priority rule” under U.S. bankruptcy law, which mandates that higher-priority claims must be satisfied before any lower-priority claims can receive a distribution.

Secured creditors stand at the top of this payment hierarchy. These creditors have loans backed by specific company assets, such as real estate or equipment. Their claims are satisfied first from the proceeds from selling collateralized assets. If the sale of collateral does not fully cover their claim, any remaining portion of their debt is treated as an unsecured claim.

Following secured creditors, various classes of unsecured creditors are considered. This group includes bondholders, suppliers, employees for unpaid wages, and government entities for taxes. Within the unsecured class, some claims, such as certain tax obligations and employee wages, may be granted “priority unsecured” status. This means they are paid before other general unsecured creditors, including bondholders, but still after secured claims.

Preferred stockholders, if issued, come after all creditors have been paid. Preferred stock offers fixed dividends and has a higher claim on assets than common stock, but it remains subordinate to all debt. Common stockholders are at the very end of the payment line. Due to their residual claim, common stockholders often receive little to nothing in a liquidation scenario, as company assets are frequently exhausted by higher-priority claims.

Investor Considerations

Understanding the payment hierarchy in financial distress is fundamental for investors assessing the risk and return profiles of different securities.

For bondholders, their position as creditors translates to a lower-risk investment compared to stocks. Bonds offer fixed interest payments and the return of principal, and their higher priority in a bankruptcy scenario provides a greater likelihood of recovering their investment. This reduced risk means bonds offer a lower potential return compared to stock appreciation.

Stockholders, particularly common stockholders, face a higher level of risk because they are last in line during liquidation. They might lose their entire investment if insufficient assets remain after creditors and preferred stockholders are paid. Despite this elevated risk, stocks offer substantial capital appreciation and dividend income when a company performs well.

The distinct payment priorities directly influence how investors approach portfolio construction and diversification. Investors seeking stable income and capital preservation might favor bonds due to their senior claim. Conversely, those pursuing growth and willing to accept more risk might allocate a larger portion of their portfolio to stocks.