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This is “Legal Aspects of Corporate Finance”, chapter 15 from the book The Law, Corporate Finance, and Management (index.html) (v. 1.0).
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Chapter 15
Legal Aspects of Corporate Finance
L E A R N I N G O B J E C T I V E S
After reading this chapter, you should understand the following:
- The general sources of corporate funds
- The basics of corporate bonds and other debt leveraging
- What the various types of stocks are
- Initial public offerings and consideration for stock
- What dividends are
- Some of the modern trends in corporate finance
A corporation requires money for many reasons. In this chapter, we look at the methods available to a corporation for raising funds, focusing on how firms generate large amounts of funds and finance large projects, such as building a new factory.
One major method of finance is the sale of stock. A corporation sells shares of stock, often in an initial public offering. In exchange for consideration—usually cash—the purchaser acquires stock in the corporation. This stock may give the owner a share in earnings, the right to transfer the stock, and, depending on the size of the corporation and the number of shares, power to exercise control. Other methods of corporate finance include bank financing and bonds. We also discuss some more modern financing methods, such as private equity and venture capital. Additional methods of corporate finance, such as commercial paper (see Chapter 19 "Nature and Form of Commercial Paper" and Chapter 20 "Negotiation of Commercial Paper"), are discussed elsewhere in this book.
over stockholders because a bond is a debt, and in the event of bankruptcy, creditors have priority over equity holders.
Equity Securities
The third source of new capital funds is equity securities—namely, stock^3. Equity^4 is an ownership interest in property or a business. Stock is the smallest source of new capital but is of critical importance to the corporation in launching the business and its initial operations. Stock gives the investor a bundle of legal rights—ownership, a share in earnings, transferability and, to some extent, the power to exercise control through voting. The usual way to acquire stock is by paying cash or its equivalent as consideration. Both stock and consideration are discussed in more detail in Section 15.3.2 "Par Value and No-Par Stock" and Section 15.4 "Initial Public Offerings and Consideration for Stock".
Other Forms of Finance
While stock, debt securities, and reinvested profits are the most common types of finance for major corporations (particularly publicly traded corporations), smaller corporations or start-ups cannot or do not want to avail themselves of these financing options. Instead, they seek to raise funds through private equity^5 , which involves private investors providing funds to a company in exchange for an interest in the company. A private equity firm is a group of investors who pool their money together for investment purposes, usually to invest in other companies. Looking to private equity firms is an option for start-ups—companies newly formed or in the process of being formed—that cannot raise funds through the bond market or that wish to avoid debt or a public stock sale. Start-ups need money to begin operations, expand, or conduct further research and development. A private equity firm might provide venture capital^6 financing for these start-ups. Generally, private equity firms that provide a lot of venture capital must be extremely savvy about the start- up plans of new businesses and must ask the start-up entrepreneurs numerous challenging and pertinent questions. Such private equity firms expect a higher rate of return on their investment than would be available from established companies. Today, venture capital is often used to finance entrepreneurial start-ups in biotechnology and clean technology.
Sometimes, a private equity firm will buy all the publicly traded shares of a company—a process commonly termed “going private.” Private equity may also be involved in providing financing to established firms.
Another source of private equity is angel investors, affluent individuals who operate like venture capitalists, providing capital for a business to get started in
- An ownership interest in a corporation (synonymous with shares ).
- Ownership interest, such as stock, in property or a business.
- Finance conducted through private investors, either individuals or firms.
- Financial capital provided to early-stage, high-potential, high-risk start-up companies by investors who often expect a return on the investment by an eventual sale of the company or by taking the firm public.
15.1 General Sources of Corporate Funds 612
exchange for repayment with interest or an ownership interest. The main difference between an angel investor and a venture capitalist is the source of funds: an angel investor invests his or her own money, while venture capitalists use pooled funds.
Private equity firms may also use a leveraged buyout (LBO)^7 to finance the acquisition of another firm. Discussed further in Chapter 18 "Corporate Expansion, State and Federal Regulation of Foreign Corporations, and Corporate Dissolution" on Corporate Expansion, in the realm of private equity, an LBO is a financing option using debt to acquire another firm. In an LBO, private equity investors use the assets of the target corporation as collateral for a loan to purchase that target corporation. Such investors may pursue an LBO as a debt acquisition option since they do not need to use much—or even any—of their own money in order to finance the acquisition.
A major drawback to private equity, whether through a firm or through venture capital, is the risk versus return trade-off. Private equity investors may demand a significant interest in the firm, or a high return, to compensate them for the riskiness of their investment. They may demand a say in how the firm is operated or a seat on the board of directors.
K E Y T A K E A W A Y
There are four main sources of corporate finance. The first is plowback, or reinvesting profits in the corporation. The second is borrowing, commonly through a bond issue. A corporation sells a bond, agreeing to periodic interest payments and repayment of the face value of the bond at maturity. The third source is equity, usually stock, whereby a corporation sells an ownership interest in the corporation. The fourth source is private equity and venture capital.
E X E R C I S E S
- What are the main sources of corporate finance?
- What are some of the legal rights associated with stock ownership?
- Describe private equity. What are some similarities and differences between private equity and venture capital?
- The acquisition of another company using a significant amount of borrowed money to pay for the acquisition. Often, the assets of the company being acquired may be used as collateral for the loans.
15.1 General Sources of Corporate Funds 613
is much larger than the stock market and bonds are highly liquid and less risky than many other types of investments.
Another advantage to the corporation is the ability to make bonds “callable”—the corporation can force the investor to sell bonds back to the corporation before the maturity date. Often, there is an additional cost to the corporation (a call premium) that must be paid to the bondholder, but the call provision provides another level of flexibility for the corporation. Bonds may also be convertible; the corporation can include a provision that permits bondholders to convert their bonds into equity shares in the firm. This would permit the corporation to decrease the cost of the bonds, because bondholders would ordinarily accept lower coupon payments in exchange for the option to convert the bonds into equity. Perhaps the most important advantage to issuing bonds is from a taxation standpoint: the interest payments made to the bondholders may be deductible from the corporation’s taxes.
A key disadvantage of bonds is that they are debt. The corporation must make its bond interest payments. If a corporation cannot make its interest payments, the bondholders can force it into bankruptcy. In bankruptcy, the bondholders have a liquidation preference over investors with ownership—that is, the shareholders. Additionally, being highly leveraged can be risky: a corporation could load itself up with too much debt and not be able to make its interest payments or face-value payments. Another major consideration is the “cost” of debt. When interest rates are high, corporations must offer higher interest rates to attract investors.
K E Y T A K E A W A Y
Corporations often raise capital and finance operations through debt. Bank loans are one source of debt, but large corporations often turn to bonds for financing. Bonds are an IOU, whereby the corporation sells a bond to an investor; agrees to make periodic interest payments, such as 5 percent of the face value of the bond annually; and at the maturity date, pays the face value of the bond to the investor. There are several advantages to the corporation in using bonds as a financial instrument: the corporation does not give up ownership in the firm, it attracts more investors, it increases its flexibility, and it can deduct the interest payments from corporate taxes. Bonds do have some disadvantages: they are debt and can hurt a highly leveraged company, the corporation must pay the interest and principal when they are due, and the bondholders have a preference over shareholders upon liquidation.
15.2 Bonds 615
E X E R C I S E S
- Describe a bond.
- What are some advantages to the corporation in issuing bonds?
- What are some disadvantages to the corporation in using bonds?
15.2 Bonds 616
When a value is specified on a stock certificate, it is said to be par value. Par value is established in the articles of incorporation and is the floor price of the stock; the corporation may not accept less than par value for the stock.
Companies in most states can also issue no-par shares. No-par stock may be sold for whatever price is set by the board of directors or by the market—unless the shareholders themselves are empowered to establish the price. But many states permit (and some states require) no-par stock to have a stated value. Corporations issue no-par stock to reduce their exposure to liability: if the par value is greater than the market value, the corporation may be liable for that difference.
Once the universal practice, issuance of par value common stock is now limited. However, preferred stock usually has a par value, which is useful in determining dividend and liquidation rights.
The term stated capital describes the sum of the par value of the issued par value stock and the consideration received (or stated value) for the no-par stock. The excess of net assets of a corporation over stated capital is its surplus^14. Surplus is divided into earned surplus (essentially the company’s retained earnings) and capital surplus (all surpluses other than earned surplus). We will return to these concepts in our discussion of dividends.
Preferred Stock
The term preferred has no set legal meaning, but shareholders of preferred stock^15 often have different rights than shareholders of common stock. Holders of preferred stock must look to the articles of incorporation to find out what their rights are. Preferred stock has elements of both stock (equity) and bonds (debt). Thus corporations issue preferred stock to attract more conservative investors: common stock is riskier than preferred stock, so corporations can attract more investors if they have both preferred and common stock.
Preference to Dividends
A dividend is a payment made to stockholders from corporate profits. Assume that one class of preferred stock is entitled to a 7 percent dividend. The percentage applies to the par value; if par value is $100, each share of preferred is entitled to a dividend of $7 per year. Assuming the articles of incorporation say so, this 7 percent preferred stock has preference over other classes of shares for dividend payments.
- The excess of net assets of a corporation over its stated capital.
- A variety of stock that differs from common stock in provisions for dividends and/ or preference upon liquidation.
15.3 Types of Stock 618
Liquidation Preference
An additional right of preferred shareholders is the right to share in the distribution of assets in the event of liquidation, after having received assets under a liquidation preference—that is, a preference, according to a predetermined formula, to receive the assets of the company on liquidation ahead of other classes of shareholders.
Convertible Shares
With one exception, the articles of incorporation may grant the right to convert any class of stock into any other at the holder’s option according to a fixed ratio. Alternatively, the corporation may force a conversion of a shareholder’s convertible stock. Thus if permitted, a preferred shareholder may convert his or her preferred shares into common stock, or vice versa. The exception bars conversion of stock into a class with an asset liquidation preference, although some states permit even that type of so-called upstream conversion to a senior security. Convertible preferred shares can be used as a poison pill (a corporate strategy to avoid a hostile takeover): when an outsider seeks to gain control, convertible shareholders may elect to convert their preferred shares into common stock, thus increasing the number of common shares and increasing the number of shares the outsider must purchase in order to gain control.
Redeemable Shares
The articles of incorporation may provide for the redemption of shares, unless in doing so the corporation would become insolvent. Redemption may be either at an established price and time or by election of the corporation or the shareholder. Redeemed stock is called cancelled stock. Unless the articles of incorporation prohibit it, the shares are considered authorized but unissued and can be reissued as the need arises. If the articles of incorporation specifically make the cancellation permanent, then the total number of authorized shares is reduced, and new shares cannot be reissued without amending the articles of incorporation. In this case, the redeemed shares cannot be reissued and must be marked as cancelled stock.
Voting Rights
Ordinarily, the articles of incorporation provide that holders of preferred shares do not have a voting right. Or they may provide for contingent voting rights, entitling preferred shareholders to vote on the happening of a particular event—for example, the nonpayment of a certain number of dividends. The articles may allow class voting for directors, to ensure that the class of preferred stockholders has some representation on the board.
15.3 Types of Stock 619
Buyback
Corporations often reacquire their shares, for a variety of reasons, in a process sometimes called a buyback^18. If the stock price has dropped so far that the shares are worth considerably less than book value, the corporation might wish to buy its shares to prevent another company from taking it over. The company might decide that investing in itself is a better strategic decision than making other potential expenditures or investments. And although it is essentially an accounting trick, buybacks improve a company’s per-share earnings because profits need to be divided into fewer outstanding shares.
Buybacks can also be used to go private. Private equity may play a role in going- private transactions, as discussed in Section 15.1.5 "Other Forms of Finance". The corporation may not have sufficient equity to buy out all its public shareholders and thus will partner with private equity to finance the stock buyback to go private. For example, in early 2011, Playboy Enterprises, Inc., publisher of Playboy magazine, went private. Hugh Hefner, the founder of Playboy, teamed up with private equity firm Rizvi Traverse Management to buy back the public shares. Hefner said that the transaction “will give us the resources and flexibility to return Playboy to its unique position and to further expand our business around the world.”Dawn C. Chmielewski and Robert Channick, “Hugh Hefner Reaches Deal to Take Playboy Private,” Los Angeles Times , January 11, 2011. http://articles.latimes.com/2011/jan/ 11/business/la-fi-ct-playboy-hefner-20110111.
Corporations may go private to consolidate control, because of a belief that the shares are undervalued, to increase flexibility, or because of a tender offer or hostile takeover. Alternatively, an outside investor may think that a corporation is not being managed properly and may use a tender offer to buy all the public shares.
Stocks and Bonds and Bears, Oh My!
Suppose that BCT Bookstore, Inc. has become a large, well-established corporation after a round of private equity and bank loans (since repaid) but needs to raise capital. What is the best method? There is no one right answer. Much of the decision will depend on the financial and accounting standing of the corporation: if BCT already has a lot of debt, it might be better to issue stock rather than bring on more debt. Alternatively, BCT could wish to remain a privately held corporation, and thus a stock sale would not be considered, as it would dilute the ownership. The economy in general could impact the decision: a bear market could push BCT more toward using debt, while a bull market could push BCT more toward an initial public offering (discussed in Section 15.4.1 "Sale of stock") or stock sale. Interest rates could be low, increasing the bang-for-the-buck factor of debt. Additionally, public stock sales can be risky for the corporation: the corporation could
- A process whereby a corporation reacquires or repurchases its shares (the shares then become treasury shares).
15.3 Types of Stock 621
undervalue its stock in the initial sale, selling the stock for less than what the marketplace thinks it is worth, missing out on additional funds because of this undervaluation. Debt may also be beneficial because of the tax treatment of interest payments—the corporation can deduct the interest payments from corporate profits. Thus there are many factors a corporation must consider when deciding whether to finance through debt or equity.
K E Y T A K E A W A Y
Stock, or shares (equity), express an ownership interest in a corporation. Shares have different designations, depending on who holds the shares. The two main types of stock are preferred stock and common stock, each with rights that often differ from the rights of the other. Preferred stock has elements of both debt and equity. Holders of preferred shares have a dividend preference and have a right to share in the distribution of assets in liquidation. Holders of common stock have a different set of rights, namely, the right to vote on important corporate decisions such as the election of directors. A corporation may purchase some of its shares from its shareholders in a process called a buyback. Stock in the hands of the corporation is called treasury stock. There are a variety of factors that a corporation must consider in determining whether to raise capital through bonds or through stock issuance.
E X E R C I S E S
- What are some key rights of holders of preferred shares?
- What is the major difference between preferred stock and common stock?
- Why would a corporation buy back its own shares?
- What are some factors a corporation must consider in deciding whether to issue stock or bonds?
15.3 Types of Stock 622
compensation may be in the form of stock, such as in an employee stock ownership plan. Investors also seek common stock, whether in an IPO or in the secondary market. While common stock is a riskier investment than a bond, stock ownership can have tremendous upside—after all, the sky is the limit on the price of a stock. On the other hand, there is the downside: the price of the stock can plummet, causing the shareholder significant monetary loss.
Certainly, an IPO has some disadvantages. Ownership is diluted: BCT had very few owners before its IPO but may have millions of owners after the IPO. As mentioned, an IPO can be expensive. An IPO can also be undervalued: the corporation and its investment banks may undervalue the IPO stock price, causing the corporation to lose out on the difference between its determined price and the market price. Being a public corporation also places the corporation under the purview of the SEC and requires ongoing disclosures. Timing can be problematic: the registration review process can take several weeks. The stock markets can change drastically over that waiting period. Furthermore, the offering could have insufficient purchasers to raise sufficient funds; that is, the public might not have enough interest in purchasing the company’s stock to bring in sufficient funds to the corporation. Finally, a firm that goes public releases information that is available to the public, which could be useful to competitors (trade secrets, innovations, new technology, etc.).
As mentioned, one of the main disadvantages of going public is the SEC review and disclosure requirements. The Securities Exchange Act of 1934 governs most secondary market transactions. The 1934 act places certain requirements on corporations that have sold securities. Both the 1933 and 1934 acts require corporations to disseminate information to the public and/or its investors. These requirements were strengthened after the collapse of Enron in 2001. The SEC realized that its disclosure requirements were not strong enough, as demonstrated by the accounting tricks and downfall of Enron and its accountant, Arthur Andersen.For a full discussion of Enron, see Bethany McLean and Peter Elkind, Enron: The Smartest Guys in the Room (New York: Portfolio, 2004).
As a result of Enron’s accounting scandal, as well as problems with other corporations, Congress tightened the noose by passing the Sarbanes-Oxley Act of 2002.Sarbanes-Oxley Act can be viewed at University of Cincinnati, “The Sarbanes- Oxley Act of 2002,” Securities Lawyer’s Deskbook , http://taft.law.uc.edu/CCL/SOact/ toc.html. This act increased the disclosure of financial information, increased transparency, and required the dissemination of information about what a corporation was doing. For example, Section 302 of Sarbanes-Oxley requires that a corporation’s chief executive officer and chief financial officer certify annual and quarterly reports and state that the report does not contain any material falsehoods and that the financial data accurately reflect the corporation’s condition.
15.4 Initial Public Offerings and Consideration for Stock 624
Nature of the Consideration
Consideration^20 is property or services exchanged for stock. While cash is commonly used to purchase stock, a stock purchaser may pay with something other than cash, such as property, whether tangible or intangible, or services or labor performed for the corporation. In most states, promissory notes and contracts for future services are not lawful forms of consideration. The case United Steel Industries, Inc. v. Manhart , (see Section 15.7.1 "Consideration in Exchange for Stock"), illustrates the problems that can arise when services or promises of future delivery are intended as payment for stock.
Evaluating the Consideration: Watered Stock
In United Steel Industries (Section 15.7.1 "Consideration in Exchange for Stock"), assume that Griffitts’s legal services had been thought by the corporation to be worth $6,000 but in fact were worth $1,000, and that he had received stock with par value of $6,000 (i.e., 6,000 shares of $1 par value stock) in exchange for his services. Would Griffitts be liable for the $5,000 difference between the actual value of his services and the stock’s par value? This is the problem of watered stock^21 : the inflated consideration is in fact less than par value. The term itself comes from the ancient fraud of farmers and ranchers who increased the weight of their cattle (also known as stock) by forcing them to ingest excess water.
The majority of states follow the good-faith rule^22. As noted near the end of the United Steel Industries case, in the absence of fraud, “the judgment of the board of directors ‘as to the value of consideration received for shares’ is conclusive.” In other words, if the directors or shareholders conclude in good faith that the consideration does fairly reflect par value, then the stock is not watered and the stock buyer cannot be assessed for the difference. This is in line with the business judgment rule, discussed in Chapter 16 "Corporate Powers and Management". If the directors concluded in good faith that the consideration provided by Griffitts’s services accurately reflected the value of the shares, they would not be liable. The minority approach is the true value rule: the consideration must in fact equal par value by an objective standard at the time the shares are issued, regardless of the board’s good-faith judgment.
A shareholder may commence a derivative lawsuit (a suit by a shareholder, on behalf of the corporation, often filed against the corporation; see Chapter 16 "Corporate Powers and Management"). In a watered stock lawsuit, the derivative suit is filed against a shareholder who has failed to pay full consideration under either rule to recover the difference between the value received by the corporation and the par value.
- The surrender of any legal right (a detriment) in return for the promise of some benefit in return.
- When consideration is inflated such that the property given for consideration in exchange for shares is in fact less than par value.
- Directors’ judgment as to the value of consideration received for shares is deemed conclusive.
15.4 Initial Public Offerings and Consideration for Stock 625
15.5 Dividends
L E A R N I N G O B J E C T I V E S
- Discuss several types of dividends.
- Review legal limitations on distributing dividends.
- Define the duties of directors when paying dividends.
Types of Dividends
A dividend^23 is a share of profits, a dividing up of the company’s earnings. The law does not require a corporation to give out a specific type of dividend.
Cash Dividend
If a company’s finances are such that it can declare a dividend to stockholders, a cash dividend always is permissible. It is a payment (by check, ordinarily) to the stockholders of a certain amount of money per share. Under current law, qualified dividends are taxed as a long-term capital gain (usually 15 percent, but the figure can be as low as zero percent under current law). These rules are set to expire in 2013, when dividends will be taxed as ordinary income (i.e., at the recipient’s ordinary income tax rate).
Stock Dividend
Next to cash, the most frequent type of dividend is stock itself. Normally, the corporation declares a small percentage dividend (between 1 and 10 percent), so that a holder of one hundred shares would receive four new shares on a 4 percent dividend share. Although each shareholder winds up with more stock, he realizes no personal net gain at that moment, as he would with a cash dividend, because each stockholder has the same relative proportion of shares and has not sold or otherwise transferred the shares or dividend. The total outstanding stock represents no greater amount of assets than before. The corporation may issue share dividends either from treasury stock or from authorized but unissued shares.
Property Dividend
Rarely, corporations pay dividends in property rather than in cash. Armand
- A share of a corporation’sprofits. Hammer, the legendary financier and CEO of Occidental Petroleum Corporation,
recounts how during World War II he founded a liquor business by buying shares of the American Distilling Company. American Distilling was giving out one barrel of whiskey per share as a dividend. Whiskey was in short supply during the war, so Hammer bought five thousand shares and took five thousand barrels of whiskey as a dividend.
Stock Split
A stock dividend should be distinguished from a stock split. In a stock split^24 , one share is divided into more shares—for example, a two-for-one split means that for every one share the stockholder owned before the split, he now has two shares. In a reverse stock split, shares are absorbed into one. In a one-for-two reverse split, the stockholder will get one share in place of the two he held before the split.
The stock split has no effect on the assets of the company, nor is the interest of any shareholder diluted. No transfer from surplus into stated capital is necessary. The only necessary accounting change is the adjustment of par value and stated value. Because par value is being changed, many states require not only the board of directors but also the shareholders to approve a stock split.
Why split? The chief reason is to reduce the current market price of the stock in order to make it affordable to a much wider class of investors. For example, in 1978, IBM, whose stock was then selling for around $284, split four for one, reducing the price to about $70 a share. That was the lowest IBM’s stock had been since 1932. Stock need not sell at stratospheric prices to be split, however; for example, American Telnet Corporation, whose stock had been selling at $0.4375 a share, declared a five-for-one split in 1980. Apparently the company felt that the stock would be more affordable at $0.0875 a share. At the opposite end of the spectrum are Class A shares of Warren Buffett’s Berkshire Hathaway, which routinely trade for more than $100,000 a share. Buffett has rebuffed efforts to split the Class A shares, but in 2010, shareholders approved a fifty-for-one split of Class B shares. BusinessWeek covers many stock splits and reverse splits in its finance section, available at http://www.businessweek.com/finance.
Legal Limitations on Dividends
The law imposes certain limitations on cash or property dividends a corporation may disburse. Dividends may not be paid if (1) the business is insolvent (i.e., unable to pay its debts as they become due), (2) paying dividends would make it insolvent, or (3) payment would violate a restriction in the articles of incorporation. Most states also restrict the funds available for distribution to those available in earned
- Increasing the number of a firm’s outstanding shares by issuing more shares to current shareholders, adjusting the price to keep the firm’s market capitalization the same.
15.5 Dividends 628
