Corporate Finance: A Primer

Obtaining Capital Is the Corporation’s Lifeblood

Only with adequate financial resources may a corporation properly finance its operations. The question of how to raise capital is particularly vital for new corporations and those otherwise not profitable enough for their needs.

There are two primary methods by which a corporation can raise capital. The first method is equity financing— in which the corporation sells its stock. The second method is debt financing—in which the corporation borrows money.

A corporation issues securities to those who give it money, property, or other capital resources. A security is a contract between a business and an investor where the investor supplies money and expects to profit from his or her investment. In equity financing the corporation issues equity securities—more commonly known as shares of stock. In debt financing it issues debt securities.

Equity Interests

When a corporation raises capital by equity financing, the investor acquires an ownership interest in the corporation in the form of shares of the corporation’s stock. Thus, the investor becomes a shareholder. The relationship between the corporation and the shareholder is fiduciary in nature. That means the corporation, through its officers and directors, must conduct its operations in the best interests of the shareholders.

An equity interest entitles the shareholder to certain rights. Generally, a shareholder has a right to:

  • A proportionate share of the corporate earnings through dividends
  • A proportionate share of the corporate assets upon dissolution and liquidation of the corporation
  • A right to vote on certain major corporate matters. These rights are a matter of contract and may be altered by agreement between the corporation and investor.

A shareholder primarily recoups his or her investment, and any return or profit on the investment, through dividends from corporate earnings and the ability to sell the interest in the corporation. As such, a major focus of the equity investment is on the growth and continued vitality of the corporation. The more successful the corporation is, the greater its earnings are—and the more valuable its shares become.

Issuance Of Shares

A corporation may issue shares of stock in a variety of circumstances. Shares may be sold outright upon payment of the purchase price. They may be issued upon subscription, which is an agreement to purchase the shares under specific conditions. Shares may be issued pursuant to a share exchange or conversion of existing securities of the corporation into new shares of the corporation.

A corporation may also issue shares pursuant to a share dividend. This is payment of a dividend in shares of stock rather than in cash. It involves the issuance of shares to existing shareholders in proportion to the size of their current holdings, thereby increasing their equity interest in the corporation.

The number of shares which a corporation has authority to issue must be set forth in the Articles of Incorporation. These are called the authorized shares. A corporation may issue any amount of shares up to the authorized amount. The articles may also be amended to increase the authorized amount. A corporation cannot issue shares in excess of the authorized amount without amending its articles.

Corporations may also issue fractional shares and scrip. Scrip is a separate certificate representing a percentage of a full share. The holder of scrip is entitled to receive a share certificate when accumulated scrip equals a full share. Usually, holders of fractional shares have proportionate rights of shareholders. Holders of scrip do not.

Reacquired Shares

After issuance, shares are considered issued and outstanding while they are held by the shareholders. The status of shares which are subsequently reacquired by a corporation generally is a matter of choice. The corporation may retire the shares. In such a case the shares are no longer issued or outstanding. Alternatively, the corporation may hold the shares, in which case they are issued but not outstanding. Such shares held by a corporation are called treasury shares. Because treasury shares are still considered issued, they must be counted when determining how close the corporation is to its authorized amount of shares. Treasury shares frequently do not have the rights of other shares. They are subject to resale by the corporation for any amount determined by the directors.

A growing number of states have eliminated the concept of treasury shares. In these states, shares reacquired by the corporation are automatically retired. If the Articles of Incorporation prohibit reissuance of the shares, the number of authorized shares is reduced by the number of shares reacquired, effective upon amendment to the articles.

Payment For Shares

State law regulates the amount and type of consideration or payment that the corporation may receive before shares may be issued. These matters are regulated in order to prevent watering of the shares and to ensure that the corporation is capitalized on a firm basis. Watered shares result when shares are issued as fully paid when in fact the corporation has received or agreed to receive inadequate value for them.

Largely for the purpose of determining the adequacy of consideration, shares may be designated as par value or no par value. Par value is not market value. Instead, it sets a minimum subscription or original issuance price of a share below which the share cannot be issued. For example, a share with a par value of $5 may not be issued for cash or other consideration with a value of less than $5.

Shares without par value offer greater flexibility concerning the amount of consideration the corporation may receive for their issuance. Generally, no par value shares may be issued for any consideration determined by the directors.

Some states require the Articles of Incorporation to set forth a par value or no par value designation for authorized shares. However, most states do not require such a designation. These laws only require the directors to determine that the consideration for shares is adequate.

Generally, shares may be issued for cash, other tangible or intangible property, labor or services actually performed or promissory notes, contracts for services to be performed and other securities of the corporation.

Share Certificates

The contents of a share certificate are regulated by statute. Typically, a certificate must set forth the name of the issuing corporation, the person to whom the certificate is issued, and the number and class of shares and designation of any series that the certificate represents. In certain circumstances, the certificate must also set forth the preferences, rights and restrictions to which the shares are subject.

Corporations may also choose to issue uncertificated shares. Such a share is issued on the books of the corporation but no certificate representing the share is issued to the shareholder. The corporation must send the holders of uncertificated shares a written statement containing the information required to be set forth on a share certificate.

Share Classifications

Corporations may have more than one class of shares. In turn, each class may be divided into more than one series. The Articles of Incorporation govern the division of a corporation’s authorized shares into classes and series of classes.

There are two major classifications into which shares are frequently divided. They are common shares and preferred shares.

  • Common shares are the ordinary shares of a corporation. They have no special features and give no greater rights than any other shares. All common shareholders enjoy an equal right to dividends and to the corporate assets upon dissolution. Common shareholders frequently have the exclusive or broadest right to vote. Common shares may be further divided into more than one class. Usually this classification involves the voting rights of the classes.  
  • Preferred shares are granted certain rights or preferences over the common shares. The types of preferences frequently granted are a preference to dividends and to the assets of the corporation upon liquidation.

A dividend preference entitles a shareholder to be paid a specific amount on the shareholder’s preferred shares before a dividend may be paid for the common shares. A liquidation preference entitles the preferred shareholder to be paid a specific amount out of the corporate assets upon dissolution before the common shareholders are paid. A liquidation preference, however, generally cannot be satisfied until the corporate debts have been paid.

The voting rights of preferred shares are frequently restricted by the Articles of Incorporation. However, absent a restriction, preferred shares will usually have full voting rights.

Two frequent provisions included in the terms of preferred shares concern the conversion and redemption of the shares. A convertible preferred share gives the holder the right to convert the share to another security of the corporation, frequently to a common share. Redemption is the forced reacquisition of the share by the corporation. Redemption is most often at the option of the corporation.

Debt Financing

Borrowing funds for corporate purposes is widely recognized as being within the powers of a corporation. When funds are borrowed by a corporation, a debt is created. The corporation becomes a debtor and the lender becomes a creditor of the corporation.

A corporation’s debt may be secured or unsecured. Secured debt is created when a corporation borrows funds while at the same time pledging certain property as collateral to secure the debt. If the corporation defaults, the creditor may look to the collateral to satisfy the debt.

Unsecured debt is created when the corporation borrows funds without pledging any property as collateral. In effect, the creditor lends the funds on the strength of the corporation’s ability to repay because there is no specific property to which the creditor can look in the event of default.

Debt Securities

A loan to a corporation is represented by a debt security. The holder of the security is a creditor. There are three principal types of debt securities— debentures, bonds, and notes.

A debenture is a long-term debt security issued mainly to evidence an unsecured debt. A bond is a long-term debt security secured by a mortgage on real property or a lien on other fixed assets of the corporation. A note is a long or short-term debt security intended to be held by the original payee until maturity.

Debt securities may contain redemption or conversion provisions similar to those of preferred shares. In addition, debt securities may contain priority or subordination provisions ranking them higher or lower than other debt securities as far as being paid out of the corporate assets upon default.

Comparison Between Shareholders and Creditors

The relationship between a corporation and its shareholders is different from the relationship between a corporation and its creditors.

One major difference is that a corporation’s shareholders obtain an ownership interest in the corporation. A corporation’s creditors do not. Another difference is that a loan represents a corporate liability that must be repaid by a fixed date. A shareholder’s investment does not have to be repaid.

In addition, the terms of a loan require repayment at a stated rate of interest. Consequently, a creditor’s financial interest in the corporation is limited to the terms of the loan. How successful the corporation is, as long as the loan can be repaid, is irrelevant to the creditor. Conversely, a shareholder is not guaranteed a return on his or her investment. However, there is the possibility that the corporation’s growth and continued success will yield the shareholder a high return on the investment.

A creditor’s financial interest is also given greater protection than a shareholder’s interest. Upon dissolution, all corporate debts must be paid before any distribution may be paid to the shareholders.

In addition, a creditor generally is not entitled to vote or otherwise participate in the corporation’s affairs. Also, a corporation does not owe fiduciary duties to its creditors. Instead, any obligations owed to the creditors are a matter of contract. In contrast, shareholders have the right to vote on various corporate matters. The corporation also owes shareholders a fiduciary obligation—that is, the responsibility to act in their best interests.

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