Equity as a Call Option: Why Shareholders Love Risk

Imagine a company not just as a collection of buildings and machines, but as a sort of grand investment portfolio, its total assets. Now, think of who has a claim on this portfolio. There are two main groups: the debt holders, like banks who loaned money, and the shareholders, the owners of the company’s stock.

Debt holders have a senior claim. They are promised a fixed return, the principal and interest on their loans. Shareholders, on the other hand, have a residual claim. They get whatever is left over after the debt holders are paid. This difference in claims is crucial.

Let’s use an analogy to understand this better. Imagine you and a friend are starting a lemonade stand. To get started, you borrow money from your neighbor. Your neighbor, the lender, is promised a fixed amount back, say ten dollars plus a dollar in interest, regardless of how successful the lemonade stand is. You and your friend, the shareholders, get to keep whatever profit remains after paying back your neighbor.

Now, consider two possible lemonade recipes. Recipe A is a classic, reliable recipe. It’s almost guaranteed to bring in twelve dollars in revenue. Recipe B is a new, experimental recipe with exotic fruits. It’s a gamble. It could be a huge hit and bring in twenty dollars, or it could be a flop and bring in only five dollars.

If you use recipe A, you’ll make twelve dollars, pay back eleven dollars to your neighbor, and you and your friend will pocket one dollar profit. Not bad, but not amazing either.

What if you use recipe B? If it’s a hit and you make twenty dollars, you pay back eleven dollars and you and your friend get to keep nine dollars! That’s a much bigger payout. But what if it flops and you only make five dollars? You still have to pay back eleven dollars to your neighbor. In this case, the lemonade stand doesn’t make enough to cover the debt. However, your neighbor, the debt holder, only loses one dollar. They are only out the interest because they still get back nine dollars of the original ten they lent. You and your friend, the shareholders, lose everything. You get zero.

Notice something interesting here. When you chose recipe B, the risky recipe, the downside risk is mostly borne by the debt holder. If things go really badly, they might not get back all their money. But the upside potential, the chance for a big profit, almost entirely benefits you and your friend, the shareholders.

This is where the idea of equity as a call option comes in. Think of the debt as the ‘strike price’ of an option. Just like a call option gives you the right, but not the obligation, to buy an asset at a certain price, shareholders have the right, but not the obligation, to the firm’s assets after paying off the debt.

If the value of the company’s assets, our lemonade stand revenue in the example, is less than the debt, the ‘strike price,’ shareholders can, in effect, walk away. They won’t get anything, but they also won’t owe anything beyond their initial investment. Their loss is limited. However, if the value of the assets significantly exceeds the debt, shareholders capture all that upside, like with the successful exotic lemonade.

This option-like nature of equity creates an incentive for shareholders to favor riskier projects, especially when the company is close to financial distress, meaning its assets are not much greater than its debts. In such situations, the ‘safe’ projects might only generate enough value to just barely cover the debt, leaving little for shareholders. But a ‘risky’ project, while having a higher chance of failure, also has a chance of a huge payoff, potentially exceeding the debt by a large margin and generating substantial returns for shareholders.

This tendency for shareholders to prefer excessively risky projects is called ‘asset substitution.’ Shareholders might be tempted to substitute safer, lower-return investments for riskier, higher-potential-return investments, even if those riskier investments are not in the best long-term interest of the company as a whole or the debt holders. Because shareholders have limited downside and unlimited upside, they are incentivized to ‘swing for the fences,’ particularly when the company’s financial situation is precarious. They are essentially playing with ‘house money’, knowing that the debt holders bear a significant portion of the potential losses, while they, the shareholders, reap the majority of the potential gains.