Valuation of the Corporation Accounting Balance Sheet - analogous to a “snapshot” Assets=Liabilities + Equity Assets cash, inventory, fixed assets (buildings, equipment), intangibles (patents, goodwill), accounts receivable current assets-assets that are likely to be converted to cash within one year cash, inventory, securities
generally, assets on balance sheet reflect historical costs, not market value, liquidation value, or replacement value.
Liabilities current liabilities - due within the year long-term liabilities - due in greater than one year to the extent that assets depreciate, they represent future expenses, and so are depreciated over their useful life rather than expensed in the year purchased whether company uses straight line or accelerated affects apparent growth - more accelerated means more growth and lower current taxes
intangibles are “amortized” over their useful life (similar to depreciation)
Equity - two sources: direct investment by shareholders “legal capital account” or “capital account” or “capital surplus” is where direct investment by shareholders is tracked
profits/income/earnings “earned surplus” or “retained earnings” are where earnings are tracked
Shareholder’s equity = net assets = book value of corporation.
GAAP - Generally Accepted Accounting Principles Individual journal entries are made Journal entries are summarized into General Ledger General Ledger is “closed out” into balance sheet “matching principle” or “accrual accounting” - match expenses for this year with income from this year (except for depreciated assets - see above)
Income Statement - analogous to a “motion picture” Operating Income or Earnings Before Interest & Taxes (EBIT) equals: Net Sales; minus Operating Expenses
Net Income (profit, earnings) equals EBIT; minus Interest Expenses; minus Income Taxes
Income statement is an entry in the balance sheet in the retained earnings account (see above)
Comparison Ratios: Profit Margin - equals Net Income over Net Sales (is it increasing or decreasing) Operating Margin - equals Operating Expenses over Net Income (is it costing more or less to make money from year to year) Current Ratio - “Quick Test” equals current assets over current liabilities (ability to cover current debts as they become due) Working Capital - equals current assets MINUS current liabilities (how much extra cash is available for new things)
Debt Ratio - equals total debt over total assets (how much does the company have to show for its debts) Debt to Equity Ratio - equals total debt over total equity (how much is the company leveraged) Price to Earnings Ratio - equals market price over net income (earnings) per share Inventory Turnover Ratio - equals net sales over Inventory (how many times per year care you able to turn over you entire inventory - more is better - is the company holding too much inventory) Total Assets Turnover Ratio - equals net sales over total assets (is the company holding too many assets?) Return on Assets (ROA) - equals net income (earnings) over total assets (how efficiently is the company using its assets) Return on Equity (ROE) - equals net income from current year over shareholder’s equity of prior year (is the company investing its assets wisely or could it do better in other investments)
Methods of Valuation Book Value - Net Asset Value - Shareholder’s Equity Merely add up the Equity from the balance sheet. only reflects historical data and ignores appreciation or depreciation
Adjusted Book Value Add up Equity from balance sheet and correct for depreciation, or appreciation (current valuation)
Liquidation Value add up what the Net Assets would sell for if they were sold in pieces today only reflects the break-up value of the individual assets, ignoring the going concern value of the company
Capitalized Earnings discount the anticipated future earnings to the present day Divide 100 by the discount rate to get an capitalization rate - higher discount rate means that the company is more risky (less likely to show a profit) discount rate also includes the time value of money
Multiply the capitalization rate times the expected earnings ex: If Company A anticipates to make a profit of $50K per year, but it is fairly risky, then the earnings multiple might be 100/15% = 6.6. So it would be fair to pay 6.6 times $50K or $330K for Company A for the chance to make a 15% return per year on your investment.
Capitalized Cash Flow discount cash flow to present value
Capitalized Dividends discount future dividends to present value
Stock Market Price what is the “market” willing to pay for this company? What are Earnings Per Share (EPS)? What is the Price to Earnings (P-E) ratio?
Choice of Organizational Form Key Considerations Liability of Owners Management and Control of Owners Transferability of Ownership Continuity of Life Entity Status Taxation Formation and Organization
Tax Considerations Corporation is treated as a separate entity for tax purposes when there are losses or gains, corporation retains the reporting requirements on its own tax return.
Partnership (P), Limited Partnership (LP), Limited Liability Partnership (LLP), Limited Liability Company (LLC) - all make an election as to whether they wish to be taxed as a “corporation” or as a “partnership” for the next 5 year period. default for failure to elect is partnership a partnership passes on losses and gains to the individual partners for recognition on their individual tax returns. partnerships may therefore act as tax shelters to offset personal income if the partnership is expecting losses
S-Corporation (S-Corp.) - treated like a partnership as far as passing on losses to shareholders. must be less than 30 shareholders who are individuals, trusts, or estates (not other corporations) must only have one economic class of stock, but can have many voting classes.
“Double-Taxing” - if a corporation makes money, it is taxed on its income. If the corporation then declares a dividend, the dividends are taxable to the individual shareholders as income. Corporations try to hide dividends as excessive salaries because salaries are deductible to the corporation as a current expense. Corporations try to avoid distributions by selling debt instead of selling equity because the interest on the debt is deductible as a current expense.
Key
Consideration |
Partnership |
Limited
Partnership |
Corporation |
Limited
Liability
Partnership |
Limited Liability Company |
Owner’s Liability |
Personally liable |
General partner personally liable |
No personal liability |
No personal liability |
Members have limited liability |
Mgm’t & Control |
partners control |
general partner controls |
board of directors control |
General partner controls |
members/ manager controls |
Continuity |
dissolves if partner leaves |
dissolves if partner leaves |
Yes. Buyout agreements. |
Dissolves if partner leaves |
member may withdraw |
Entity or Aggregation |
Aggregation |
Aggregation |
Entity |
Aggregation |
Entity |
Taxation |
Passed on to partners |
Passed on to Partners |
Taxed to Corporation |
Passed on to partners |
Taxed to LLC |
Formation |
Informal |
File certificate |
File Art. of Incorp. & Bylaws |
File Application |
File Articles. |
Conflicts of Interest Lawyer representing the constituent promotors of a corporation may have a conflict of interest that prevents him from representing all of them Each individual may have pre-existing conflict however, their interests are generally aligned so you may represent them as a lawyer for the “situation.”
Must advise clients that: nothing they say is confidential with respect to the others present may not be able to represent ANY of them as individuals if a conflict arises in the future will become “lawyer for the corporation” after the formation. Danforth “entity rule” applies retroactively if: the persons only contact with the firm was for forming a corporation; and a corporation was thereby formed.
Lawyer should not sit on the board of a corporation for which he is the attorney. Board of directors determines the lawyer’s fee Possible future conflict if the shareholders sue the board of directors might be liable to a greater extent than the other directors for legal violations other directors may ask for free or personal legal advice or representation
If lawyer accepts stock as payment of fees, a conflict would arise if shareholders decided to sue the corporation.
Incorporation Process Internal Affairs Doctrine - the state of incorporation determines the laws that will apply to the internal affairs of the corporation, not the state(s) of place of business. For small corporations: tax considerations might weigh in favor of local incorporation (foreign corporations are taxed at a higher state tax rate). personal jurisdiction might weigh in favor of local incorporation (can’ t be sued easily elsewhere).
For large corporations directors liability considerations might weigh in favor of incorporation in Delaware more limited shareholders rights might weigh in favor of incorporation in Delaware
Formalities File the Articles of Incorporation with the state authority RMBCA §2.02 - Articles must set forth names, addresses, number of shares. Articles optionally may also set forth: purpose of corporation - RMBCA §3.01 - any lawful purpose ultra-vires RMBCA §3.04 - court can provide damages if the corporation or directors enter into obligations outside of corporate purpose
powers of corporation - RMBCA §3.02 - non-exclusive (illustrative) list of 14 general powers - same powers as a natural person.
Corporate existence begins when the articles of incorporation are filed - RMBCA §2.03
Rendering of Legal Opinions on Corporate Status “Duly Incorporated” must file articles of incorporation; AND be in compliance with the corporation law of the state as to the form and contents of the filed documents. Many states provide “duly incorporated” certifications, but a prudent lawyer does not take the state clerk’s evaluation as conclusive.
“Duly Organized” RMBCA §2.05 Need to have bylaws adopted Need to verify that there are shareholders Need to verify that there is a board of directors Need minutes of the corporate meetings Need a corporate seal
“Validly Existing” Make sure that company still has a charter Make sure that company has not been dissolved Make sure that attorney general has not revoked charter
“In Good Standing” corporation has paid all of its taxes corporation has paid all of its franchise fees
“Qualified to Do Business” in a foreign state Proper documents and fees filed
Consequences of Failing to File Articles of Incorporation Constituents are personally liable for the debts of the corporation unless: “corporation by estoppel” - creditor thought he was dealing with a corporation, so he can’t claim now that the promotor is personally liable “de facto incorporation” - a good faith effort to file the articles plus proper following of corporate procedures having board meetings keeping minutes treating corporation as a separate entity with its own accounts, etc. ex: in Cranson, IBM could not sue the promotor of the corporation for personal liability because he had a good faith effort to incorporate, and had observed corporate formalities. Furthermore, IBM contracted with what it believed to be a corporation and is therefore estopped from claiming now that it was not a corporation.
RMBCA §2.04 - promotors are liable for knowing failure to comply with filing of documents, but are not liable if they are unaware of an agent’s (lawyer’s) failure to file the documents ex: if you are responsible for filing the articles, but forget to do so, and then enter into a contract on behalf of the corporation, then you are personally liable for knowing failure to file. trend is toward stricter liability for non-filing - promotor can always bring an action against the person who failed to file (lawyer) for indemnification.
Pre-Incorporation Contracts Two types of contracts: “Novation” type promotor is expressly personally liable in the contract until the corporation is “duly incorporated” at which time the corporation’s liability is substituted for the promotor’s
Other type if there is no express term on promotor liability, then it is a question of fact whether the intent of the parties was for the corporation to substitute its liability in place of that of the individual. corporation may not unilaterally “adopt” the contract without the consent of the creditor because it changes the creditor’s security.
Financial Structure of the Corporation Debt Securities Notes - a short term unsecured debt Debenture - long term unsecured debt “sinking fund” debenture - company saves up earnings in a sinking fund to buy back debentures at a periodic rate so that all do not come due at the same time. - decreases the company’s risk and therefore decreases the interest rate they pay on the debenture
Bond - long-term secured debt with a consequent interest rate that is lower than a note or debenture debt instruments may be “redeemable” by the company before their full term allowing the company to refinance. Convertible Debt - a debt that becomes convertible to an equity Right of return - debt holder is entitled to return the debt instrument for face value on maturity there may also be a market value for the debt security which changes according to increases/decreases in interest rates
Indenture Contract a public offering of debt that sets for the terms of the offering managed by a trustee may provide for restrictive covenants to prevent the corporation from issuing more debt in order to protect the security of the existing debt holders (helps prevent hostile takeover by raider which is highly leveraged with junk bonds)
Tax Consequences Interest on debt is deductible as a current expense - avoids double taxation (see above) Company must pay debt, even if it is doing poorly, whereas in regard to equities, the company could decide not to pay dividends.
Procedure for issuing debt - board of directors authorizes an officer to negotiate a debt issuance
Equity Securities Preferred Stock Right to return - preferred stock is entitled to be paid dividends before common stock (but not entitled to anything unless the board declares a dividend) ex: $8 preferred shares - pay an annual dividend of $8 to the holder as long as the board declares a dividend at all.
May be cumulative or non-cumulative cumulative - if the dividend is not paid in one year, it cumulates for the next year and pays double (or triple if three years, etc.) non-cumulative - does not cumulate from year to year if the board does not declare a dividend, then you are out of luck
“liquidation preference” - If the corporation is liquidated, preferred shareholders are paid from the proceeds before common shareholders May have different voting or control rights than common stock ex: a preferred shareholder may have the right to vote out the board of directors if they fail to declare a dividend for X years running.
Common Stock Right to residual - a proportionate interest in whatever is left after creditors and preferred shareholders are paid. voting rights - generally one share is one vote unless articles provide otherwise (see below).
Procedure for Issuing More Stock - since the Article of Incorporation are required to state the number of shares authorized (see RMBCA §2.02), the only way to authorize more shares is to amend the articles under RMBCA §10.03. majority of directors propose the amendment to the stockholders majority of stockholders approve the proposed amendment
DGCL §152 - consideration to be paid for stock in the absence of fraud, the directors have the power to determine, conclusively, the value of consideration paid for stock (the stock price) future consideration is NOT valid for stock in Delaware.
RMBCA §6.21 - consideration to be paid for stock director’s valuation of shares is conclusive shares MAY be issued for may types of consideration, including future consideration
DGCL §153 - Shares can not be issued for less than their par value - but par value is almost meaningless because it is set artificially low. DGCL §162 - shareholder must pay for the full value of shares, but is not liable beyond that amount RMBCA §6.22 - shareholders are only liable to the extent of the consideration paid for their shares
Procedure for Issuing More Preferred Stock still need to amend the articles to increase the number of shares;
however, articles may provide that the board of directors determines the precise terms of the preferred shares - “blank check preferred shares”
Legal Capital Account the par value of the shares times the number of shares issued board of directors can reduce the par value such that the lion’s share of the consideration paid for the shares goes to the “additional paid-in capital surplus” account.
Payment of Dividends In Delaware DGCL §170 can distribute dividends out of “surplus” or net profits of the current or preceding year DGCL §154 “surplus” is the net assets in excess of “capital” and “capital” is the price of the shares issue over par value.
DGCL §172 - a director who acts in good faith in reliance on prepared data is exculpated for voting for a dividend that later turns out to be illegal. DGCL §174 - director who willfully directs the payment of an unlawful dividend is personally liable for the full amount
In California CGCL §500 - can distribute dividends out of retained earnings or surplus and the sum of the assets remaining must be 125% of the liabilities; AND the current assets must be at least equal to the current liabilities. this allows the corporation to meet their liabilities as they mature
A board of directors is protected by the business judgment rule in its decision whether to declare a dividend, but a dividend may be compelled if the failure to declare a dividend by the board is an abuse of their discretion in bad faith. ex: Dodge Bros. v. Ford Motor Co. - corporation had excessive surplus, and the failure to declare a dividend was to prevent the Dodge Bros. from having the money to build a competing business. counter-ex: Kamin v. American Express - board may properly decide to declare a stock dividend rather than a cash dividend to make their income look better, even though it had adverse tax consequences.
Limited Liability of Shareholders “piercing the corporate veil” - passing on the obligations of the corporation to the shareholders themselves corporate veil will be pierced for equitable reasons if the owners are conducting business to further their personal pecuniary interests rather than that of the corporation ex: in Walkovsky v. Carlton, the claim did not allege that the owners were doing business in their personal capacity, and so the claim was defective, even though the owner set up many small corporations with limited assets as a shield to liability.
Instrumentality Rule: domination and control over the corporation which is so complete that the corporation has no separate mind or existence of its own counter-ex: claimants may not pierce the corporate veil to get at the parent of a wholly-owned subsidiary that has a valid separate existence respected by the parent. - American Trading.
use of this domination and control to commit fraud or wrong or any other dishonest or unjust act counter-ex: in Brunswick v. Waxman, the court declined to allow a sophisticated corporation to recover from a failed no-asset corporation under the instrumentality rule because there was no fraud - Brunswick knew they were contracting with a no-asset corporation.
injury proximately caused by the unjust act.
Corporate veil may also be pierced if the corporation is grossly undercapitalized and an obvious front or shield for personal business to avoid liability ex: in Kinney Shoes, the court allowed the corporate veil to be pierced to avoid the an inequitable result.
Agency Power in a Corporation Actual Authority - authority granted by the corporation for a person to bind the corporation express authority - expressed by the corporation in words ex: board of directors passes a resolution authorizing the president to contract for the construction of a new building also can arise if the board (or someone else with sufficient authority) later “ratifies” a previously unauthorized contract.
implied authority - implied by the nature of the office and the surrounding circumstances implied authority to perform all things necessary or incidental to the assignment ex: a Vice President purchases $1,000 of equipment without specific authorization from the board, but as a normal part of carrying out his duties.
Apparent Authority - person is “clothed” in indicia of authority sufficient to induce the reasonable reliance of a third party ex: President of a company, representing himself as such, contracts with a vendor for the purchase of equipment in the normal course of business, and the vendor relies on such representation. ex: President contracts with valuable employee for a life pension, and the employee relies on that pension as a reason to remain at the company. - Lee v. Jenkins Bros. ex: in First Interstate Bank of Texas v. First National Bank of Jefferson, the court held that there was sufficient evidence to present a jury question as to apparent authority for a bank vice-president to negotiate a financial deal. not valid for “extraordinary” transactions that are out of the normal course of business
Inherent Agency power - miscellaneous - mostly used for tort liability under respondeat superior. How to render an opinion that a contract will be binding on a corporation: get a confirmation that the person has actual authority to bind the corporation. ex: get corporate secretary to certify that the board of directors meeting minutes grant such authority
determine the scope of the express authority granted in the meeting minutes is it express or implied are any of the terms “extraordinary” in the contract
verify that the corporation was duly incorporated and is in good standing verify the signature as authentic
Authority of the Board of Directors Formalities Quorum - RMBCA §8.24 - by default it is a majority of the directors, but it may be reduced by the articles or bylaws to no less than 1/3 of the directors. Notice - RMBCA §8.22 by default, notice is not required for regular meetings by default, 2 days notice is required for special meetings RMBCA §8.23 - director may waive notice, thereby curing any defect in the notice given, by merely showing up.
Directors may not vote by proxy - it must be in person (or conference call RMBCA §8.20) RMBCA §8.21 - if all directors are unanimous, the board may proceed informally without conducting a formal meeting. RMBCA §3.03 - also may act informally in an emergency unless there is a pre-emptive statute.
RMBCA §8.25 / DGCL §141 - committees of the board must comprise two or more persons must be elected and created by majority of the entire board can exercise many of the lesser functions of the board, except as specified.
RMBCA §10.20 - Board may unilaterally amend the bylaws unless that power is specifically reserved to the shareholders by the Articles.
Mergers and Acquisitions Statutory Merger RMBCA §11.01/DGCL §251(a) all assets and liabilities of target company become those of the parent. all of target’s shareholders get consideration - Parent’s shares Both parent and target shareholders get to vote under RMBCA §11.03/DGCL §251(b) unless: “small scale merger” - the merger would not increase (dilute) the parent’s outstanding shares by 20%, in which case it may merge without the approval of the parent’s shareholders - RMBCA §11.03(g)/DGCL §251(f); OR “short form merger” - the parent already owned 90% of the stock of the target in which case neither the parent’s nor the target’s shareholders have voting rights. RMBCA §11.04/DGCL §253
Both parent and subsidiary shareholders may seek appraisal rights. RMBCA §13.02/DGCL §262 unless in Delaware, no appraisal rights for a public corporation if the merger consideration is stock DGCL §262(b)(1)
Triangular Merger parent sets up a subsidiary which then executes a statutory merger - into the target (reverse) or target into subsidiary (forward). target’s shareholders get to vote under RMBCA §11.03 target’s shareholders get appraisal rights under RMBCA §13.02 however PARENT’S shareholders do NOT get voting or dissenter’s rights because the parent’s board of directors, not the shareholders, have control of the stock of the subsidiary. parent can then, if it desires, merge with its subsidiary under a short form merger.
Exchange of Shares RMBCA §11.02 - shares of the target are purchased using shares of the parent. shareholders of the TARGET, but NOT shareholders of the parent, have voting rights under RMBCA §11.03. shareholders of the target also have dissenter’s rights. after the exchange, target becomes a subsidiary of parent, and the parent can merge with it under a short form merger.
Tender Offer Parent offers to buy Target’s shares directly from Target’s shareholders. If parent is successful, parent gains control of a majority of target’s stock and controls the board No appraisal rights by either company’s shareholders Target’s shareholders vote with their pocketbook Parent’s shareholders have no right to control the transaction because it is not a merger
If parent gets sufficient shares of Target, it may execute a merger. then voting rights would be determined by the form of the merger.
Exchange of Stock for Assets Parent uses its stock to buy target’s assets The shareholders of the TARGET, but NOT the parent, have voting rights - RMBCA §12.02/DGCL §271 (sale of all or substantially all of the assets) Shareholders of the TARGET, but NOT the parent, have dissenter’s rights - RMBCA §13.02(a)(3), EXCEPT: in Delaware, there are no dissenter’s rights for Exchange of Stock for Assets - DGCL §262
Target then becomes a subsidiary of the parent, and may thereafter be merged by short form.
De Facto Merger Doctrine A shareholder who does not have voting or appraisal rights because the parent structured the merger in a different way may try to sue for voting or appraisal rights under the doctrine of de facto merger counter-ex: in Delaware, an exchange of stock for assets (not dissenter’s rights for target) followed by a short form merger is not a de-facto merger because of the doctrine of “independent significance”. There is a stock for assets statute that is independent from the statutory merger statute. Hariton
Counter-ex: same is true for triangular mergers - Terry v. Penn. Central
|
Parent |
Target |
Parent |
Target |
|
Vote |
Dissent |
Vote |
Dissent |
Vote |
Dissent |
Vote |
Dissent |
Statutory Merger |
Yes §11.03 |
Yes §13.02 |
Yes §11.03 |
Yes §13.02 |
Yes
§251 |
Yes
§262 |
Yes §251 |
Yes*
§262 |
Triangular Merger |
No |
No |
Yes §11.03 |
Yes §13.02 |
No |
No |
Yes §251 |
Yes*
§262 |
Statutory Share Exchange |
No
§11.03 |
No
§13.02 |
Yes §11.03 |
Yes §13.02 |
N/A |
N/A |
N/A |
N/A |
Stock for Assets |
No |
No |
Yes §12.02 |
Yes §13.02 |
No |
No |
Yes
§271 |
No
§262(c) |
Small Scale Merger |
No
§11.03 |
No
§11.03 |
Yes §11.03 |
Yes §13.02 |
No
§251(f) |
No
§251(f) |
Yes §251 |
Yes* §262 |
|
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