ADW Draft 2/10/12
AP edits 2/19/12
Chapter 10. Capital Structure
Primary Sources Used in this Chapter
DGCL §§ 151(a), 152, 153, 154, 160
Slappy Drive Industrial Park v. U.S.
Equity-Linked Investors, L.P. v. Adams
Klang v. Smith’s Food & Drug Centers, Inc.
Little v. Waters
Kamin v. American Express Co
Concepts for this Chapter
· Capitalizing the corporation
o Equity: common and preferred
o Debt: compare to equity (D/E ratio)
Tax attributes
Leverage: risk of insolvency
o Options
· Legal capital
o Money in : legal consideration
o Money out: illegal distributions
· Dividend policy
o Board discretion
o CHC vs PHC
Introduction
This chapter gives an overview of the financial structure of corporations – how they are financed (or capitalized) and what rights apply to equity and debt securities. It also looks at the effect of leverage (or debt) on equity returns, the tax deductibility of interest, and the preference of debt over equity in bankruptcy.
This chapter also considers how corporate law regulates the issuance of dividends to equity shareholders – the “legal capital” regime which protects creditors from equity owners siphoning away assets on which the creditors relied.
Finally, this chapter describes the fiduciary duties that apply to the corporation’s dividend policy -- a matter that, under U.S. law, is left mostly to the discretion of the board of directors.
Question: What is Capital Structure?
Answer: Capital structure refers to the way that the company raised the money to get started and to operate. It answers the question of where that money came from. For example, a company may:
· Sell shares of stock (equity)
· Borrow money (debt)
· Issue more complex financial instruments
· Grant stock options
Question: Does capital structure matter?
Answer: Yes. Although theoretically (using the Modigliani-Miller Theorem assumptions) in an efficient market with perfect information and no taxes or bankruptcy costs, the value of a company would not be affected by how it was financed (the mix of debt and equity), this is not true in practice. For example, the managers of a corporation with a great deal of debt may worry about bankruptcy; managers of corporations financed primarily by equity investments may feel pressure to make dividend payments.
Bonus Question: What is the Modigliani-Miller Theorem?
Answer: What is known as the Modigliani-Miller Irrelevance Theorem (M&M) is actually composed of several propositions which Franco Modigliani and Merton H. Miller explained in a series of papers in the late 1950s and early 1960s. The underlying premise of the theorem is that the market value of a firm is determined by its earning power and the risk of the underlying assets, and is independent of its capital structure.
M&M means that under certain conditions a firm’s financial decisions do not affect its value. M&M relies on the assumptions that there are well-functioning markets, neutral taxes, and rational investors.
Financial turmoil in recent years has led to some revival of interest in the question of efficient markets, and in M&M. For example,
John C. Coffee, Systemic Risk after Dodd-Frank: Contingent Capital and the Need for Regulatory Strategies beyond Oversight, 111 Colum. L. Rev. 795 (2011) (discussing arguments that contingent capital requirements are overly complex substitutes for simply requiring the infusion of more equity capital into systemically significant financial institutions)
Richard Epstein, How to Undermine Tax Increment Financing: The Lessons of City of Chicago v. Prologis, 77 U. Chi. L. Rev. 121 (2010) (examining the appropriate level of constitutional protection against outside governments that condemn property located within a local municipality that uses tax increment financing to fund local improvements)
Victor Fleischer, Regulatory Arbitrage, 89 Tex. L. Rev. 227 (2010) (identifying the conditions under which regulatory arbitrage takes place, constraints on arbitrage, and the ways in which it distorts regulatory competition, shifts regulatory costs, and undermines the rule of law, and discussing M&M in the context of tax-avoidance strategies)
Darian M. Ibrahim, Debt as Venture Capital, 2010 U. Ill. L. Rev. 1169 (2010) (reviewing capital structure theories in the context of venture debt)
Michael Knoll and Daniel M.G. Raff, A Comprehensive Theory of Deal Structure: Understanding How Transactional Structure Creates Value, 89 Tex. L. Rev. 35 (2011) (responding to Professor Fleischer’s account of how lawyers think about deal structures in his Regulatory Arbitrage article, and laying out the “reverse” M&M theorem)
For a more comprehensive summary of M&M, including concrete examples, also see
Robert P. Bartlett III, Taking Finance Seriously: How Debt Financing Distorts Bidding Outcomes in Corporate Takeovers, 76 Fordham L. Rev. 1975 (2008)(analyzing bidder financing decisions in the pre-financial crisis takeover boom years)
A. Slicing up the Corporation: Some Details on Capital Structure
1. The Drama of Widget, Inc
Hypothetical: JKL Corporation, made up of Justin, Kathy and Lorenzo, acquires Widget Inc from the Widget brothers.
Seller Financing
· The Widget brothers agree to sell their business for $2 million
· The buyers do not have enough cash, and also want to have some extra cash for expansion
· Terms:
o $1.25 million in cash
o $750,000 10-year note from JKL to the Widget brothers at a 10% interest rate (with all principal due at the end and acceleration upon default)
Bank Financing
· First National Bank will lend $500,000 to finance the acquisition and help recapitalize
· Terms:
o 10-year note at 10% interest rate with $100,000 repayment of principal annually in years 6-10
Owner Financing
Justin
· Lacks cash, but wants some control
· Terms:
o 40% of the common stock
o Pays $100,000 in cash and gives $100,000 note (shares escrowed)
Kathy
· Has more cash, and wants control
· Terms:
o 40% of the common stock
o Pays $200,000
Lorenzo
· Less worried about control but wants steady income
· Terms:
o 20% of the common stock
o Pays $100,000
o Preferred stock which pays a 10% cumulative dividend rate and is cumulative, non-participating and convertible (note this could also be structured as a long-term loan instead of preferred equity)
§ Pays $500,000
The following table summarizes the sources and uses for the financing in the Widget, Inc. hypothetical:
Sources and Uses of Financing for Widget, Inc.
Sources of Capital / Use of ProceedsSellers / $2,000,000
Corp (expansion) / $150,000
Loan (sellers) / $750,000
Loan (bank) / $500,000
Preferred (cash) / $500,000
Common (cash) / $400,000
TOTAL / $2,150,000 / $2,150,000
WHAT HAPPENED TO JUSTIN’S $100,000 NOTE FOR THE REST OF HIS SHARES?
Notice that the $100,000 note that Justin gave for half his shares (which were escrowed) was not a source of financing. That is, Widget could not use the note to buy more inventory or rent new office space. But as Justin pays off this note and receives additional shares from escrow, his payments will constitute new financing to the corporation.
2. Equity Securities
The basics of corporate securities were discussed in Chapter 2, Corporate Basics. This is a good opportunity to review some of those concepts and the accompanying vocabulary.
Question: What is equity?
Answer: Equity is
· A permanent commitment of capital.
· Its return depends on corporate profits.
· It has a residual interest in assets on liquidation.
Recall the following terms, introduced in Chapter 2, relating to the issuance of equity securities:
· Authorized shares
· Unissued shares
· Outstanding shares
· Treasury shares
Question: How much equity does a corporation have to issue?
Answer. Some, but there is not a rule about the precise number of shares that must be issued. One class of equity securities, however, must have voting rights.
Question: What happens if you run out of authorized shares to issue?
Answer: The articles of incorporation have to be amended to authorize more. This may be problematic or at least inconvenient.
Question: How important is the actual number of authorized shares?
Answer: The absolute number of shares is not as important as a shareholder’s percentage ownership. The issuance of additional shares, therefore, may be important because of the possibility of dilution.
Question: How might an existing shareholder protect herself from dilution of her ownership percentage?
Answer: Preemptive rights. This would give her the right to maintain her percentage interest by purchasing a proportionate share of the newly issued stock. Preemptive rights have to be provided for specifically.
Question: What are the typical characteristics of common stock?
Answer: Typically, common stock:
· Holds exclusive power to elect the board of directors (making the common stockholders the beneficiaries of the board’s fiduciary duties);
· Has a residual claim on current income (after the corporation satisfies creditors and senior securities), usually in the form of dividends, unless the board determines that reinvestment would generate greater returns for the company
· Has a residual claim on assets of the corporation in liquidation, after creditors and senior securities have been satisfied; and
· Is a permanent commitment of capital, with exit by sale.
Question: What are the typical characteristics of preferred stock?
Answer: Preferred stock varies more than common stock, and so it is harder to generalize. Often, preferred stock:
· Includes economic rights senior to common stock;
· Pays dividends before (senior to) common stock. Dividends may be
o Cumulative: If the dividend for a period is not paid, the right accumulates and arrearages must be paid before the common stock may be paid; or
o Non-Cumulative: if the dividend for a period is not paid, the right to a dividend for that period expires; and/or
o Participating: meaning that the preferred stockholders receive whatever the common stockholders receive, or more;
· Offers a liquidation preference: although still subordinate to debt holders, preferred stock holders’ claims on the residual assets of the corporation comes before that of the common stockholders;
· Is sometimes a permanent commitment of capital (with exit by sale) but sometimes not. Preferred stock may be redeemable, by either the stockholder or the company, in an amount usually equal to the liquidation preference.
· Has limited or no voting rights. Often the preferred stock will have a say only on matters such as changes in the corporate structure or situation in which its dividend has not been paid.
· May be convertible into common stock, or even debt, upon the occurrence of certain specified events. This kind of preferred stock feels like a hybrid with both common stock and debt characteristics. Note: if the preferred stock is convertible into common stock then the corporation needs to have authorized sufficient shares.
Question: Why is preferred stock the favorite way for venture capital firms to finance start up or early stage businesses?
Answer: As explained in the breakout box on p. 262, a firm that provides “venture capital” is providing money to start-up or early stage businesses that it thinks have long-term growth potential. For the start-up companies, venture capital financing is important because, without a proven track record, they may have a hard time getting loans or accessing the capital markets. VC firms often accumulate a fund or pool of capital from sophisticated, wealthy and institutional investors. For the VC firms, start-up companies entail above-average risk, but also the possibility of above-average returns.
Using preferred stock, VC firms may arrange for, for example, special dividend terms, a say in certain company decisions and the possibility of converting their preferred stock into common stock in the event that the start-up company is successful and goes public.
3. Debt Securities
Question: What are the types and characteristics of common debt securities?
Answer: Debt securities:
· Come in several flavors, including notes, debentures and bonds (which are more long-term);
· Typically do not offer voting rights;
· May be secured or unsecured;
· May be publicly traded or sold privately;
· May be redeemable or callable for a fixed price at the option of the corporation;
· May be convertible into common stock (note that convertible debentures may resemble convertible preferred stock, discussed above):
· May be issued by the corporation’s board of directors without shareholder approval (unless the articles of incorporation specify otherwise); and
· Typically have rights and obligations contractually specified.
Question: What are the arrangements typical of corporate bonds?
Answer: The bond is offered using a contract known as an indenture that specifies the rights and obligations of the bondholders and the corporation. There is typically an indenture trustee, which is the agent of the corporation (the bond issuer) and handles all the administrative aspects of the bonds, including making sure that the corporation, as the borrower, complies with all of the terms of the indenture.
The debt contract (indenture) specifies terms such as:
· Principal amount that the corporation must repay;
· Interest (which must be paid at fixed intervals regardless of corporate profits);
· Maturity date;
· Events of default (which may cause acceleration, and the assertion of the bondholders of legal remedies); and
· Covenants (which require the company to refrain from taking certain actions that might jeopardize the position of the bondholders)
4. Options
Question: What are options?
Answer: An option is simply the right to buy or sell something in the future. Stock options are the right to buy stock at a specified time and price. They are a right, not an obligation. They are separate from the underlying stock, although they may derive their value from that stock (options are, in fact, a kind of “derivative”). They cost a lot less than the stock itself.
If, when the stock option is able to be exercised, the underlying stock is trading for more than the price specified by the option, then the option holder will exercise the option and buy the stock at the low option price (and make money on the difference). If, however, when the option is able to be exercised, the underlying stock is trading for less than the price specified by the option, then the option holder will not exercise the option. If he wants to buy the stock, it would make more sense to buy it in the market for less. The option in that case is essentially worthless, and is not exercised. The option holder is out the cost of the option.