Hybrid financing instruments are those sources of finance that possess characteristics of both equity and debt. Some well-known hybrid financing instruments are preference shares, convertible debentures, warrants, options, etc.
A preference share is also a long-term source of equity finance. It is commonly known as a hybrid financing instrument because it also shares certain debt characteristics.
Like debt has a fixed interest rate, preference shares have fixed dividends, and they also have a preference of payment at the time of liquidation, just as debt holders get. They do not have any say in the management in the form of voting rights. And do not have any share in the residual profits.
Certain attributes of preference shares resemble equity shares.
The preference dividend is also paid out of net profits after taxes, but the only difference is that the dividend is fixed. In weak financial situations, management may consider not paying the dividend to preference shareholders. If the shares are cumulative preference shares, the said dividend may be postponed but will have to pay if the following year’s financials are good. A specific type of preference share, i.e., irredeemable preference share, does not have a certain maturity.
These are different types of debentures which are also categorized as hybrid financing. In addition to the normal debenture features, convertible debentures have the option to convert the debenture into equity on certain terms and conditions.
These debenture holders enjoy the regular income of interest until they exercise their right or the option of converting it into equity shares.
Similar to debentures, warrants also have the right to purchase equity shares of a company. Warrants are not a debenture or equity till the time they are exercised, and equity is purchased. They are just a right or option to purchase equity that the holder has.
There are debt instruments that accompany options that may be a call or put. These options convert the debt into equity. This kind of instrument remains in debt at the time of issue until the time they are exercised. The post they are exercised, they become equity. A call option allows the holder of the option to buy something at a certain price and on or before a certain date, whereas a put option allows selling.