Chapter 10 Corporate Financial Structure

Corporations:A Contemporary Approach

Chapter 1Introduction to the Firm

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Alicia Martin, Book Sculptures (2013)


Chapter 10Corporate Financial Structure

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• Capitalizing the corporation– Equity: common and preferred– Debt: compare to equity (D/E ratio)

• Tax attributes • Leverage: risk of insolvency

– Debt-equity mix• Legal capital

– Money in : legal “consideration”– Money out: illegal “distributions”

• Dividend policy– Board discretion– CHC vs PHC

Module IV – Corporate Finance

Citizen of world

Citizen of world

Law profession

Law profession

Corporate practice

Corporate practice

Bar examBar

exam


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1. Fundamentals– Introduction to firm– Corporate basics

2. Corporations and policy– Corporate federalism– Corporate social responsibility – Corporate political action

3. Corporate form– Organizational choices– Incorporation– Locating corporate authority

4. Corporate finance– Numeracy for corporate lawyers– Capital structure

5. Corporate externalities– Piercing corporate veil– Corporate environmental liability– Corporate criminal liability

6. Corporate governance – Shareholder voting– Shareholder information rights– Public shareholder activism

7. Fiduciary duties– Shareholder litigation– Board decision making – Board oversight – Director conflicts– Executive compensation – Corporate groups

8. Stock trading– Securities markets– Securities fraud class actions– Insider trading

9. Corporate deals– Sale of control– Antitakeover devices– Deal protection

10. Close corporations– Planning– Oppression

1. Fundamentals– Introduction to firm– Corporate basics

2. Corporations and policy– Corporate federalism– Corporate social responsibility – Corporate political action

3. Corporate form– Organizational choices– Incorporation– Locating corporate authority

4. Corporate finance– Numeracy for corporate lawyers– Capital structure

5. Corporate externalities– Piercing corporate veil– Corporate environmental

liability– Corporate criminal liability

6. Corporate governance – Shareholder voting– Shareholder information rights– Public shareholder activism

7. Fiduciary duties– Shareholder litigation– Board decision making – Board oversight – Director conflicts– Executive compensation – Corporate groups

10. Close corporations1. Planning2. Oppression




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Capital (money in)



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Capital - attributes

Interest deductible

Low• no growth potential• not secured

Principal + interest • from current ops• K - not discretionary

Notes

(ST debt)

Interest deductible

Moderate / low• no growth potential• sometimes secured• personal guarantees

Principal + interest • from future ops• K – not discretionary

Bonds

(LT debt)

Double corporate tax

Moderate / high• participating (growth)• cumulative (certain)• contingent voting

Fixed dividends • from earnings • before pay common

Preferred stock

Double corporate tax

High • growth potential• voting rights

Variable dividends• from earnings • board’s discretion

Common stock

TaxRiskReturn



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Financing an acquisition(recapitalizing a business)



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Widget, Inc.

Widget Bros(sellers)

First National Bank

Justin(buyer)

Kathy(buyer)

Lorenzo(buyer)

JKL CorporationACQUIRESACQUIRES



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Seller financing

Widget Bros agree to sell their business for $2.0 million. The buyers don’t have enough cash (and also want some extra cash for expansion).

Terms: $1.25 million in cash + $750,000 (10-year note @ 12% (with acceleration upon default).

By the way, isn’t their debt really a kind of “contingent ownership”?



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Bank financing

First National Bank will lend $500,000 to finance the acquisition and help recapitalize.

Terms: 10-yr note (12% interest / $100,000 repayment of principal in years 6-10)



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Owner financingJustin lacks cash, but wants some control.

Terms: 40% common for $100,000 in cash and $100,000 note (escrow shares)

Kathy has more cash, and wants control

Terms: pays $200,000 for 40% common

Lorenzo is less worried about control, but wants steady income

Terms: Pays $600,000 in cash for 20% common + $500,000 preferred (10% dividend rate, cumulative, non-participating, convertible – like VC)



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Sources / uses of financing

Sources of capital

Use of proceeds

Sellers $2,000,000

Corp (expansion) 250,000

Loan (sellers) $750,000

Loan (bank) 500,000

Preferred (cash) 500,000

Common (note) 100,000

Common (cash) 400,000

TOTAL $2,250,000 $2,250,000



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Balance Sheet(JKL Corporation – before acquisition)

ASSETS LIABILITIES

Current assets (inc $) $2,830 Current liabilities $1,750

Prop, plant, equip $4,000 Long-term debt $2,000

Accum depreciation ($1,620)

Intangible assets 50

Total assets $5, 260 Total liabilities $3,750

EQUITY $1,510

Total Liab + Equity $5,260



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Balance Sheet(JKL Corporation - as of acquisition date)

ASSETS LIABILITIESWidget pre-acquisition Widget pre-acquisition

assets $5,260 liabilities $3,750New assets New liabilities Note receivable 100 New note (sellers) 750 New cash (expansion) 150 New note (bank) 500 Acquisition goodwill 490 Total liabilities 5,000

EquityPreferred stock 500Common stock Paid-in 500

Total equity 1,000

Total assets $6,000 Total Liab + Equity $6,000



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What is leverage?

Outside debt– Financial returns– Effect on business

Inside debt– Tax– Bankruptcy

“Equity is soft, debt is hard”



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Compare two capital structures …

Corporation Corporation

Owners Owners Debt

All Equity Leveraged (D/E = 4/1)

$1,000,000 equity

$800,000 debt(10% interest)

$200,000 equity



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Favorable results (“the good”)

All equity(no leverage) ($1,000,000

invested)

Leveraged(D/E = 80/20)

($200,000 invested)

Operating income

$180,000 $180,000

Interest -- $80,000

Net income (dividends)

$180,000 $100,000

Return on equity

18%($1,000,000 invested)

50%($200,000 invested)



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Moderate results (“the bad”)


invested)


($200,000 invested)

Operating income

$100,000 $100,000

Interest -- $80,000


$100,000 $20,000

Return on equity

10%($1,000,000 invested)

10%($200,000 invested)



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Unfavorable results (“the ugly”)


invested)


($200,000 invested)

Operating income

$40,000 $40,000

Interest -- $80,000


$40,000 ($40,000)

Return on equity

4%($1,000,000 invested)

minus 20%($200,000

invested)



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Effect of outside leverage

Return on equityAll equity

(no leverage) ($1,000,000 invested)

Leveraged(D/E = 80/20) ($200,000 invested)

Good results 18% 50%

Moderate results 10% 10%

Bad results 4% (20%)



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What if owners take on debt …

Corporation Corporation

Owners Owners

All Equity Leveraged (D/E = 9/1)

$500,000 equity

$450,000 debt(20% interest)

$50,000 equity



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Tax advantage of inside debt

$93,500$170,000Net income (pay dividends)

$16,500$30,000Corporate tax (15% rate)

$183,500$170,000Total return (interest + div)


(D$450,000 / E$50,000)

All equity(no leverage) ($500,000 invested)

36.7%($500,000 invested)

34% ($500,000 invested)

Return on investment (equity + inside debt)

$110,000$200,000Income before taxes

$90,000(20% interest on $450,000)

--Interest

$200,000$200,000Operating income



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Too much inside debt …(IRS and bankruptcy)

(1) IRS recharacterizes

• Inside debt treated as equity

• Remedy: interest not deductible

(2) Bankruptcy court recharacterizes

• Inside debt treated as equity – “equitably subordinated”

• Remedy: outside creditors reclaim place in line– Deep Rock doctrine

• Facts– Company in dire straights– Preferred vs common (BoD)– Preferred doesn’t want new debt

• Issue– Duties of board when on “lip of

insolvency”?– BJR or special duty to preferred/debt?

• Holding – Judicial review: Until “point corporation

must be liquidated is …BJR”• Analysis

– Short-term interests of preferred vs long-term of common

– “no duty owed to preferred … protections contractual in nature”

Equity-Linked Investors, LP v Adams (Del Ch 1997)



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Legal Capital

“Validly issued, fully paid and non-assessable”

(money in)

Legal distributions(money out)



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Issuance of equity securities

(money in)

Hypothetical #1

JKL Corporation has 1,000 no-par common shares that are authorized, and were issued to Justin, Kathy and Lorenzo.

– If the company wants to issue new common stock, what must it do?

– What are treasury shares? Can they be issued?

– At what price must the company sell the stock?



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Protect proportionality

Hypothetical #2

JKL Corporation shares are held as follows: Justin (400), Kathy (400) and Lorenzo (200). Kathy and Lorenzo, a majority shareholders and a majority of the board, decide to authorize and issue 600 new shares – 400 to Kathy and 200 to Lorenzo.

– Can they do this without offering Justin his proportionate share?

– What protection does Justin have against dilution?

Preemptive rights

• What are they?– shareholder right to purchase

newly issued shares – proportionate voting and

financial rights• How create?

– Once mandatory, then default, now opt-in

– MBCA: No preemptive rights unless in articles

• Needed? – Issuance at fair price– Voting agreements



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Assure equity cushion

Hypothetical #3

Remember that Justin paid $100,000 cash and gave a $100,000 personal note for his JKL shares. Kathy and Lorenzo paid cash for theirs.

– Was Justin’s note lawful consideration?

– What protection do creditors have if JKL Corporation becomes insolvent?

Del. GCL § 152 (old)… cash, services rendered, personal property, real property, leases of real property or a combination thereof ....

* * *

Del. GCL § 152 (as of 2004)… cash, any tangible or intangible property or any benefit to the corporation …



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“Validly issued, fully paid and non-assessable”

Hypothetical #4

Justin, Kathy and Lorenzo want some assurance that once they’ve paid for their shares, there will be no further payment obligations.

– What legal opinion can you give them?

– What documents will you use in giving your opinion?

MBCA § 6.21

Before the corporation issues shares, the board of directors must determine that the consideration received or to be received for shares to be issued is adequate.

The determination by the board of directors as to the adequacy of consideration is conclusive as to whether the shares are validly issued, fully paid, and nonassessable.



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Payment of dividends

(money out)

Hypothetical #5

Since the acquisition 3 years ago, JKL Corporation has had some success. This year there were $90,000 in net profits. Justin, Kathy and Lorenzo would like to take some cash out.

– Can they declare a dividend of $200,000?

– Answer in Delaware?– Same for MBCA?



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Legal distribution

Assets

Cash $ 200Accts receivable $1,400Inventories $1,300Prepaid expenses$ 600Total current assets $3,500 Fixed assets Land $ 600 Buildings $1,700 Machinery $1,000 Total PP&E $3,300 Notes receivable $ 100Goodwill $ 100

Total Assets $7,000

Liabilities & Equity

Current liabilities $2,650

Long-term liabilities

Note (old one) $2,000

Note (sellers) $ 750

Note (bank) $ 500

Debentures (Bernie) $ 500

Total liabilities $6,400

Common stock (5000 shs) $ 500

Retained earnings $ 100

Total equity $ 600

Liabilities & Equity $7,000



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Del GCL § 170 (a) The directors of every corporation ... may declare and pay dividends ... either (1) out of its surplus ..., or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year.

Del GCL § 154 ... The excess, if any, at any given time of the net asset of the corporation over the amount so determined to be capital shall be surplus. Net assets means the amount by which total assets exceed total liabilities.

Del GCL § 154 [paraphrased]Capital is – (1) "the aggregate of par value of shares issued having par value" (2) "that part of consideration [in dollars] specified by the board to be capital, for shares issued without par value"If the board does not specify, "the capital ... shall be ... the amount of the consideration for such shares without par value.“



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Legal distribution (Delaware)

Assets

Cash $ 200Accts receivable $1,400Inventories $1,300Prepaid expenses $ 600Total current assets $3,500 Fixed assets Land $ 600 Buildings $1,700 Machinery $1,000 Total PP&E $3,300 Notes receivable $ 100Goodwill $ 100

Total Assets $7,000

Liabilities & Equity Current liabilities $2,650Long-term liabilities Note (old one) $2,000 Note (sellers) $ 750 Note (bank) $ 500 Debentures (Bernie) $ 500Total liabilities $6,400

Common (5000 shs)$ 500Retained earnings $ 100Total equity $ 600


Common stock Stated capital (5000 shs @100/sh) $ 500 Capital surplus $ --Retained earnings $ 100



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Assets


Total Assets $7,000




Common stock Stated capital (5000 shs @1/sh) $ 5 Capital surplus $ 495Retained earnings $ 100



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Assets


Total Assets $7,000




Common stock Stated capital (5000 shs no par) $ -- Capital surplus $ 500Retained earnings $ 100



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MBCA § 55-6-40 Distributions to shareholders. (a) A board of directors may authorize and the corporation

may make distributions to its shareholders subject to restriction by the articles of incorporation and the limitation in subsection (c).

(c) No distribution may be made if, after giving it effect:

(1) The corporation would not be able to pay its debts as they become due in the usual course of business; or (2) The corporation's total assets would be less than the sum of its total liabilities …

Legal distribution (MBCA)



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Legal distribution (MBCA)

Assets


Total Assets $7,000






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Repurchase shares …



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Repurchase of shares

(money out)

Hypothetical #6

Since the acquisition 3 years ago, JKL Corporation has had some success. Lorenzo wants out, and Justin and Kathy agree. A bank will lend $300,000 to finance the buyout.

–Can the corporation buy Lorenzo’s shares for $500,000?–Answer in Delaware?–Same for MBCA?



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Del GCL § 160. Corporation's powers respecting ... redemption.

(a) Every corporation may purchase, redeem, ... or otherwise acquire its ... own shares; provided, however, that no corporation shall:

(1) Purchase or redeem its own shares of capital stock for cash or other property when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment of the capital of the corporation,

MBCA § 1.40. ACT DEFINITIONS

In this Act: …(6) "Distribution" means a direct or indirect transfer of money or other property (except its own shares) or incurrence of indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its shares. A distribution may be in the form of a declaration or payment of a dividend; a purchase, redemption, or other acquisition of shares; a distribution of indebtedness; or otherwise.



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Repurchase shares

Assets Cash $ 200Accts receivable $1,400Inventories $1,300Prepaid expenses$ 600Total current assets $3,500 Fixed assets Land $ 600 Buildings $1,700 Machinery $1,000 Total PP&E $3,300 Notes receivable $ 100Goodwill $ 100 Total Assets $7,000






Note (bank) $ 500





Total equity $ 600


Borrow $300 from Bank



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Repurchase shares

Assets Cash $ 500Accts receivable $1,400Inventories $1,300Prepaid expenses$ 600Total current assets $3,500 Fixed assets Land $ 600 Buildings $1,700 Machinery $1,000 Total PP&E $3,300 Notes receivable $ 100Goodwill $ 100 Total Assets $7,300






Note (bank) $ 800





Total equity $ 600




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Revaluation of assets …



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Revaluation of assetsAssets

Cash $ 500Accts receivable $1,400Inventories $1,300Prepaid expenses$ 600Total current assets $3,500 Fixed assets Land $ 600 Buildings $1,700 Machinery $1,000 Total PP&E $3,300 Notes receivable $ 100Goodwill $ 100 Total Assets $7,300


Common stock (5000 shs) $ 500Retained earnings $ 100Total equity $ 600 Liabilities & Equity $7,300



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Revaluation of assetsAssets

Cash $ 500Accts receivable $1,400Inventories $1,300Prepaid expenses$ 600Total current assets $3,500 Fixed assets Land $1,200 Buildings $1,700 Machinery $1,000 Total PP&E $3,300 Notes receivable $ 100Goodwill $ 100 Total Assets $7,300


Common stock (5000 shs) $ 500Retained earnings $ 100Revaluation surplus $ 600Total equity $ 600 Liabilities & Equity $7,300



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Plaintiff (an SFD public shareholder) claims SFD does not have enough “surplus” for repurchase– SFD would have a

“negative net worth” after repurchase

– Pro forma balance sheet in proxy statement (filed with the SEC) shows negative “capital surplus” of more than $121.6 million

What is issue?

Yucaipa Companies

Smitty’s

Smith’s Food& Drug Centers

Cactus Acquisition

Merger

3.0mm shares

Public shareholders

repurchase 50% stock(6.3mm shares)

Klang v. Smith’s Food & Drug Centers, Inc.



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PRO FORMA (DOLLARS IN MILLIONS)

Current portion of long-term debt: New Term Loans..........………………………………........................ $ 12.3 Other indebtedness...............…………………………………................ 1.4 ---------------------------------------------------------------------------------------------------------------- Total current portion of long-term debt...…………………………..... $ 13.7

=============================================================

Long-term debt: New Term Loans (a)...............……………………………................ $ 792.7 New Revolving Facility (a)(b).........…………………………….............. – New Senior Notes.............................………………………………..... 150.0 New Senior Subordinated Notes...............………………………....... 350.0 Other indebtedness.....................…………………………………......... 50.4 -------------------------------------------------------------------------------------------------- Total long-term debt...............………………………………............. 1,343.1

=============================================================

Redeemable preferred stock, $.01 par value..……………………………...... 3.3 New Preferred Stock, $.01 par value.............……………………………..... 71.2 Common stockholders' equity: Common Stock, $.01 par value (c)...…........ 0.2 Additional paid-in capital.................……………………………………….... 164.9 Retained earnings (deficit)...................……………………………….…..... (286.7) --------------------------------------------------------------------------------------------------------- Total common stockholders' equity (deficit).……………………………….. (121.6) --------------------------------------------------------------------------------------------------------- Total capitalization.................…………………………………………...... $1,296.0 ================================================

=============



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DGCL § 160(a): No corporation shall purchase … its own shares … when such purchase … would cause any impairment of the capital of the corporation

DGCL § 154: [The board may] determine that consideration … received by the corporation for … its capital stock … shall be capital... The excess … of the net assets of the corporation over the amount so determined to be capital shall be surplus. Net assets means the amount by which total assets exceed total liabilities.



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Revaluation of assetsSFD hires investment firm – Houlihan - to render solvency opinion

–compares SFD's "Total Invested Capital" of $1.8 billion -- valued under the "market multiple" approach -- with SFD's long-term debt of $1.46 billion.

–SFD's "concluded equity value" equals $346 million, more than outstanding par value of SFD's stock

Houlihan gives opinion to SFD Board that transactions would not impair SFD's capital

“Figures never lie”

“Market” Balance Sheet

Assets $1.8 B

Equity $346 M

Liabilities $1.4 B



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Delaware Supreme Court:

“We understand that the books of a corporation do not necessarily reflect the current values of its assets and liabilities.”

* * *

“Market multiple” approach (FMV of assets minus liabilities) is OK to value company’s solvency.

Holding: Recapitalization does not violate DGCL §160!

Chief JusticeNorman Veasey

(1992-2004)



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Legal context: Distributions to shareholders are subject to legal capital rules (in Delaware and under MBCA)

• Delaware: Dividends or repurchases may not “impair capital” -- must be paid out of “surplus” = assets minus liabilities minus capital

• MBCA: Distributions are permissible only if (1) assets exceed liabilities plus liquidation preferences of preferred stock (treated as debt) AND (2) corporation able to pay debts as come due

Valuation of “surplus” / “net assets”: Determination of “assets” and “liabilities” (corporate value) is within discretion of board of directors.

• Delaware Supreme Court: “We understand that the books of a corporation do not necessarily reflect the current values of its assets and liabilities.”

• Corporations may revalue assets to reflect corporation’s “long term health” (appreciation, goodwill, intangibles) – protect creditors according to “current realities”



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Dividend policy

Who sets dividend policy?

Can shareholders challenge dividends?

Close vs public corporation



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CHC (modern approach)

What is effect of no-dividend policy on each?

What is judicial standard of review of dividends in CHC?

Modern cases: “Oppression” doctrine requires that board not frustrate “reasonable expectations” of minority.

Can’t use dividend policy to coerce minority to sell cheap.

Close Corporation

2/3 1/3

Year Reported earnings 1987 $739,000 1988 $909,000 1989 $3.8 million 1990 $3.6 million

Waters(majority)Waters

(majority)Litle

(minority)Litle

(minority)



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Waters served his own personal financial interests in having DMGT not declare dividends.

– receive a greater share of the cash available for corporate distributions via loan repayments

– put pressure on Litle to sell his shares to him at a discount

– while Litle has to find sources of cash to pay his tax liability.

Therefore, I must consider Waters to be an interested director with respect to the Board’s decision to not declare dividends.

Lytle v. Waters (Del Ch 1992)

Chancellor WilliamChandler



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B: Sell stock at Corp level(AmEx takes tax loss)

Corporation

Shareholders

stock

stock

Kamin v. American Express Co. (NY Sup Ct 1976)

A: Distribute DLJ stock to SHs (no tax effect on AmEx)

Corporation

Shareholders

PHC (modern approach)



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Same Operating incomeSame

Less (by $17.9)Net incomeSame

Less (by $8.0)TaxesSame

Less (by $25.9)Taxable incomeSame

$25.9Capital lossesNone

SameRevenuesSame

Sell DLJ stockIncome Statement Distribute DLJ stock

“Stated earnings” are $17.9 million higher (no effect on cash flow)

$8 million in real tax savings (increases cash flow to the company)



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Dividend policy in PHC

The directors’ room rather than the courtroom is the appropriate forum for thrashing out purely business questions …

[The board concluded] a reduction in net income would have a serious effect on the market value of the publicly traded AmEx stock.

Kamin v. American Express Co. (NY Sup Ct 1976)

New YorkSupreme Court



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Dividend policy in PHC?

Why doesn't corporate law compel the board to declare all free cash flow as a dividend?

If management has good investment projects, it can ask shareholders to re-invest?

If it doesn't, management should not keep the money?

Warren Buffett



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Group hypo

The majority shareholders in a very successful family bakery refuse to share the dough with the minority.

The majority refuses to pay dividends; instead they eat their cake by paying themselves nice salaries.

When the minority asks for their piece of the pie and tries to sell their shares, the majority only offers them crumbs.

The minority complains the board’s dividend policy is meant to slice them out.

You are lawyer for the corporation. Draft the minutes of the board meeting (as you would want them to read) at which the minority demands payment of large dividends. See Wikipedia



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“First, order of business …who is eating all the cupcakes?”



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Minutes - Board meeting (24 Sep 2014)

Attendance: Directors A, B, C, D, E; Pres X, Treas Y, Secy S (absent: F)

Chair C called regular meeting to order at 11:40a. A questioned company’s no-dividend policy, asks for money. Discussion ensued.

B stated salaries to all concerned were fair, comparable to what paid at similar companies – citing ExecPayConsult report (attached).

Pres X described need for keeping cash surplus: problems with acquisition of Gooey Farms; higher flour storage costs than anticipated; need for new baking equipment, warehouse, etc. Treas Y agreed.

Treas Y says cash position not that strong and Banker advises company value falling, not to be “profligate.” Concerned discussion ensued.

Board approved motion (4-1 vote) to keep no-dividend policy intact.

Meeting adjourned at 12:40p. Respectfully submitted, Secy S



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The end

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Chapter 10 Corporate Financial Structure

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