pgs_241-264

Chapter 7: Accounting and Valuation

Disparities in Reporting Income and Cash Flow

• Firms often report different amounts of income vs. cash flow for a given year.

• This disparity can arise from GAAP (Generally Accepted Accounting Principles) requirements related to fixed assets.

Fixed Asset Accounting

• When a firm acquires a fixed asset:

  • Asset recorded on the balance sheet at cost.

  • Over its useful life, a portion of its cost is recorded as depreciation expense on the income statement.

  • Importantly, this depreciation does not represent a current cash outflow; cash was spent upon acquisition.

Cash Flow vs. Reported Income

• Cash flow lower than reported income occurs in years with significant fixed asset purchases.

• Conversely, cash flow is higher than reported income in years when depreciation exceeds new fixed asset acquisitions.

Insights from Income and Cash Flow Statements

• Comparing income and cash flow statements can reveal:

  • Potential business trends or needs for further inquiries.

  • Shortfalls in cash flow may indicate rapid growth requiring additional financing or could suggest poor management of inventories/accounts receivable.

F. Basics of Business Valuation

Valuing a Business

• Simplest valuation of a business method: Value of assets minus liabilities

  • If values on the values on the balance sheet are accurate

• Often it is not that simple & might have to use different method

Common Valuation Approaches

1. Asset Approach:

   • Calculates value based purely on assets.

   • May not reflect true market value due to historical cost accounting limitations and exclusion of intangibles.

2. Discounted Cash Flow (DCF) Analysis:

   • Estimate how much cash the business is likely to produce each year for its owners, and then determine how much that cash should be worth in today's dollars

     • Estimates future cash flows and determines their present value.

   • Regarded as one of the most reliable valuation methods.

   • Varies for each business; adjustments made based on company's current and projected financial performance.

3. Comparables Approach:

   • look at comparable businesses → particularly ones that have been valued recently or traded in the market

     • Evaluates comparable businesses to derive valuation metrics

   • EX) you might find some companies you believe are comparable to Widget, Inc. and base your valuation of Widget, Inc. on information about these companies

   • Involves negotiating appropriate comparisons; P/E (price-earnings) ratios often used.

1. The “Asset” Approach

• The first method of valuing a business - assets and liabilities

• Ex) Adjusted Book Value: Adjust valuable assets in exchange for how they might be liquidated

  • Book value of Widget’s assets minus liabilities was $1,510,000 in most recent year

    • if look at balance sheet now → this number equals assets of $5,260,000 minus liabilities of $3,750.000 (or tort liability)

      • This value represents what Widget would be worth if balance sheet ACTUALLY reflected all of its assets & liabilities

      • BUT these assumptions are often false ie book of value does NOT reflect actual value

        • BC Many assets are recorded at historical cost, not market value

          • Accounting depreciation and other markdowns might not reflect market realities

          • often excludes intangible assets, such as intellectual property and economic goodwill, which are important to the value of many businesses.

  • The asset approach also does not take into account the potential for a business to generate more cash flow or income in the future

• Sometimes a business would be worth more being liquidated (its assets sold for cash) than continuing as a going concern

  • To make this determination, the market value of the assets and liabilities, including those not on the balance sheet, can be determined, by making appropriate adjustments to the balance sheet.

  • Ex) given some of Widget apparent trouble in moving inventory & collecting from customers— that a liquidation of the company might be a viable option and thus a useful way to value the business

• Asset approach might be used for simple assets, such as office equipment

• Although the asset approach has limitations, many company valuations nevertheless are based on assets

  • Ex) stock analysis often refers to the book value of assets of financial institutions, such as banks and insurance companies, in determining and assessing their valuations

  • Regulators also use calculations based on asset values in examining such institutions.

• For many small businesses, owners and prospective purchasers base their valuations on the book value of assets on the balance sheet, and then make common sense adjustments based on how accurate they think those numbers really are

  • Ex) you might start a negotiation by saying Widget office equipment is worth just $25,000, even though you understand there are good reasons it should be worth more

2. Discounted Cash Flow Method

• Routinely accepted by courts & regulators as a reliable method for experts to use in valuing a business, & it is widely used in practice

• You calculate the value of a business in two steps

• Step 1: Estimate Future Cash Flows

  • Starts with the income statement or the cash flow statement and then adjusts the numbers up or down based on estimates of likely future changes (Utilize income or cash flow statements)

    • Ex) look @ Widget Inc's financial state-ments → will see that it reported $390,000 of net income last year, and $285,000 of operating cash flow

      • How much annual cash flow should we expect from Widget in the future? Involves art & science

        • Ex) recall that Widget reported that it paid $120,000 of bonuses to the owners

          • These payments were not part of net income or operating cash flow, meaning that, if Widget hadn't paid bonuses, its net income and operating cash flow would have been much higher

          • Shouldn't you take these bonuses into account in valuing the company?

            • If you bought Widget you would not have to pay the former owners that $120,000

            • Instead, you could pay it to yourself (as salary or dividends), or reinvest it in the business

        • Other judgments for future prospects of Widget

          • will next year be better or worse?

          • what about the year after that?

          • when will the old equipment need replaced?

            • these will prob involve educated guesses

  • Discount each of these future cash flows to determine their present value (Normalize numbers based on expected future changes)

    • Present value & future value

      • basic idea is called the "time value of money”

        • Example:

          • suppose you have $100 today

          • keep that money in cash or a checking account that doesn't pay interest → then you'd still have $100 in the future

          • BUT could put the money in a bank account that pays a return

            • earn 10% annually on $100 → about $200 after 7 yrs

            • only earn 7% on that $100, it would take you longer → about 10 years-until you doubled your money

          • Rough approximation → "Rule of 72" is the # 72 divided by your % return is how long it will take for your money to double

            • It will take longer for your money to double if the rate is lower, shorter if the rate is higher

              • 72 divided by 10 is about 7 → will take 7 yrs for $100 to become $200 at rate of 10%

              • 72 divided by 7 is about 10 → will take 10 yrs for $100 to become $200 at rate of 7%

      • $100 today is not worth the same as $100 tomorrow

        • Instead, a present value of $100 today can grow to be worth a future value of $200

        • The higher the assumed % rate then the higher the future value relative to the present value

      • MAIN LESSON: do NOT compare $100 today to $100 tomorrow.

        • We should not add or subtract present vs. future values; they are like apples and oranges

        • Instead, we should try to convert future values into present values by using a technique known as "discounting."

• Step 2: Discount Future Cash Flows

  • each future value cash flow is discounted to present value by using a "discount factor" based on a "discount rate," a rate of interest that corresponds to the cash flow

    • The higher the discount rate, the more the future cash flow is discounted in order to calculate its present value

      • Ex) suppose we will receive a cash flow in 7 yrs w/ a future value of $200, & we want to figure out its present value

        • If we use a discount rate of 7%, then we will calculate the present value as being about $100 (remember the rule of 72).

        • But if we instead assume a discount rate of 25%, the present value of that future cash flow would be a lot less than $100.

        • The lingo is that the future cash flow is "discounted" more, so that its present value is less

    • How should we figure out what discount rate to use when valuing a business?

      • Complicated question = based on numerous factors, including the risk associated w/ the future cash flows

      • Each of the future value cash flows in the middle column are then discounted to obtain the present value numbers in the far-right column

        • (Ex) the FV of $550,000 we estimate as a cash flow in year 5 is discounted to a PV of $180,224

          today)

    • "terminal value" discounted cash analysis often involves this kind of estimate of the value of all of the future cash flows as of some final date, so we don't have to keep calculating these numbers for every year, forever.

Example Cash Flow Projection

• Projected cash flows calculated and discounted to find present value estimates. Terminal value can also be calculated for the future cash flows beyond a specific year.

Importance of Due Diligence

• However one values a business, the company's financial statements will be a source of important information

  • But the financial statements should not be accepted at face value

  • Prospective purchasers will want to perform their "due diligence" and look behind the financial statement numbers

  • Ex) a purchaser should inquire what is behind the cost of goods sold, investigate overhead charges, understand the selling and marketing expenses, determine whether receivables really are collectible, and ascertain whether inventory is obsolete

    • In addition, an important part of "due diligence" is to inquire into contingent liabilities, such as possibly costly environmental claims or potential liability to customers

• Despite valuable data from financial statements, purchasers should ask deeper questions & conduct thorough due diligence before transactions

3. The “Comparables” Approach (pg 249)

• uses comparable assets or businesses as a guide

  • Ex) thinking of buying a house & figuring out what a house should be worth

    • might find some comparable houses that have sold recently, & then assume that this house's value is similar

    • If houses in a neighborhood have been selling for around $500 per square foot - you might assume that a 2,000-square-foot house you are looking at is worth $1 million

    • Also involves some art

      • the seller of a house & their broker might assert that there have been just a few recent sales of houses that they claim are most like their house, and then claim that true comps have been selling for $600 per square foot

      • That is why they have listed this house at a price of $1.2 million.

      • You might respond by arguing that these houses are nicer than their house, or in a better location, so that they are not accurate comps

      • Instead, you might find recent house sales at closer to $400 per square foot, and claim that the house is worth much less

  • To value Widget using the comparables method

    • have to make some assumptions about how similar businesses have been valued

    • A frequent valuation method is to use a price-earnings ratio (or P/E ratio)

    • Suppose that a basket of companies similar to Widget have recently been purchased on average at 6 times "trailing earnings”

      • That is, the P/E ratio in these transactions has been 6—meaning that the purchase price paid for these companies has been 6.3 times recent annual net earnings as stated in the companies' financial statements

        • (This information → collected & carefully guarded by business valuators

    • If Widget were to be valued on this basis, a prospective purchaser might be willing to pay $2,340,000 based on the company's most recent earnings of $390,000

      • where 6 times $390,000 is equal to $2,340,000

    • Or, the purchaser might look at an average of Widget earnings over the past several years and apply the P/E ratio to this average

      • Given that Widget’s net earnings averaged $290,000 for the 3 most recent years, the purchaser might be willing to pay instead only $1,740,000

        • where $290,000 times 6 equals $1,740,000

  • Another indication of value using comparables might be the price at which shares of comparable companies have been trading

    • For publicly traded companies, this is one of the most frequent methods for company valuation

    • Pick some companies we think resemble Widget, & then calculate Widget's value based on their publicly available financial information, perhaps also using a P/E ratio or similar info

• Buyers are typically willing to purchase control of publicly traded companies for more than the total market price of their issued shares (their "market capitalization," or "market cap")

  • This "control premium" is often in the range of 30-35%

  • Would need to adjust our valuation based on publicly traded comparables to include this control premium

  • As the sole shareholder of Widget, we obviously would have control

• Using these various approaches, we could come up with a range of valuations based on comparables

  • As with the valuation of a house, we would need to justify our choice of comparables, and all of that would become part of our negotiations

    • Suppose that we come up with a range and claim that the average is $1,875,000. We might even include a detailed spreadsheet, with calculations that appear to be very scientific

4. A Final Thought on Valuing Businesses

• So how much should Widget sell for?

  • Notice that our three valuation methods-based on assets, DCF, and comparables came to similar results, ranging between $1,8 million and $2.0 million

  • Might conclude that the value must be in that range

  • But you might also be suspicious

    • Our tight range of valuations reflected — some convenient assumptions that we made about asset market values, earnings, market comparables, and discount rates

• It can be even more difficult to value startup companies, or companies that depend a lot on unpredictable events or technologies

  • Assets can be difficult to value

  • Future cash flows can be difficult to predict

  • And some companies are unique, and don't really have comparables

  • Ultimately, valuation is similar to financial analysis and accounting more generally

    • We are studying art, not science

Chapter 8: Capital Structure

Understanding Capital Structure

• Focus on the right side of the balance sheet = Capital Structure

• Capital structure refers to how a company finances its operations through various means:

  • Debt (loans, bonds, etc.)

  • Equity (shares of stock)

• how the corporation has been financed and whether money has been (and can be) paid to those who hold the corporation's debt and equity

Theoretical Framework vs. Practical Challenges

• Modigliani-Miller Theorem: In an ideal world, the structure shouldn’t affect a company's value.

• Real-World Complexity: Actual capital structures often involve unpredictable elements, differing greatly by company

Life Cycle of Capital Structure

• Companies typically start with a simple capital structure—just common stock owned by the founders and early employees. Over time, as they grow and need more funding, they add new layers to this structure

  • 1. Early Stage: A company might begin with a small group of founders who divide common stock among themselves

  • 2. Raising Funds: Startups often bring in outside investors by issuing “seed” funding and then multiple rounds of preferred stock

  • 3. Growth & Exit: As the business expands, it may either sell to a larger company or go public through an initial public offering (IPO)

  • 4. Tracking Ownership: With each new investment, ownership stakes shift. Lawyers and investors track these changes using a “cap table,” which lists all securities the company has issued, such as stock, convertible notes, warrants, and stock options

  • 5. Founder Control: Many founders try to keep control, even after going public. Some companies use “dual-class” structures, where founders hold shares with extra voting power compared to public investors

  • 6. Complex Structures: Some businesses, especially financial institutions, develop even more intricate capital structures over time

• Corporations with different capital structures — ie different ratios of debt and equity-face different challenges

  • central question of this course: for whose benefit should the corporation be run?

    • Should corporate managers run the corporation for the exclusive benefit of equity?

    • Or for some combination or equity and debt?

    • And, if so, how should managers take debt into account in making decisions?

A. Slicing up the Corporation: Some Details on Capital Structure

• Corporations can raise money by issuing securities to investors

  • The investors are willing to give money to the corporation, in exchange for securities, bc they expect a return on their investment

  • Corporations have considerable flexibility in tailoring the terms of their securities to allocate control, profit, and risk among the various investors

• Corporate securities can be divided into two broad categories: equity and debt.

  • In general, equity securities represent permanent commitments of capital to a corporation, while debt securities represent capital invested for a limited period of time

  • Returns on equity securities generally depend on the corporation earning a profit

  • Although equity securities might share in the corporation's assets in the event of liquidation, the rights of equity securities are subordinated to the claims of creditors, including those who hold the corporation's debt securities

  • On the other hand, holders of equity securities typically elect the corporation's board of directors & thus exert more control over the conduct of the corporation's business and the risks it incurs

• In contrast, debt securities typically represent temporary contributions of capital (for example, until the maturity date of a loan)

  • Debt securities are more likely to have priority in terms of payment if the firm becomes insolvent or liquidates voluntarily

    • Because debt securities are less risky, they typically are entitled only to a fixed return

  • Holders of debt securities can secure their rights by placing liens on some or all of a corporation's assets

    • or by negotiating contractual covenants restricting the corporation's operations

  • Apart from such covenants, however, debt holders ordinarily play no role in the management of the firm

• Although the distinction between equity and debt is not always sharp or well defined, it is a standard distinction, and most people use it

1. Equity Securities

• terms “common shares” & “preferred shares” describe the two basic kinds of equity securities

• Corporate statutes require that at least one class of equity security have voting rights and the right to receive the net assets of the corporation in dissolution or liquidation

  • These rights usually are assigned to common shares

• Basic terms of equity securities

  • When a corporation is formed, its articles of incorporation create authorized shares

    • Until shares are first sold to shareholders, they are authorized but unissued

      • When sold, they are authorized and issued or authorized and outstanding

      • If repurchased by the corporation, they become authorized and issued, but not outstanding— commonly referred to as “treasury shares”

    • Corporation statutes do not dictate how many or what kind of shares must be authorized

      • But the statutes do require that the articles specify the number of shares that a corporation is authorized to issue and, unless they are common shares, describe the characteristics of those shares

        • If a corporation has issued all the shares authorized in its articles, it cannot issue more shares unless the articles are amended to authorize additional shares

          • For this to happen, the board of directors must recommend the amendment, which must then be approved by holders of at least a majority of its outstanding voting shares

        • However, if a corporation has not issued all the shares authorized in its articles, then the board can decide on what terms to issue these authorized but unissued shares

        • Consequently, if a corporation's shareholders authorize more shares than the corporation currently plans to issue, they also delegate authority to the board to decide if, when, and on what terms additional shares should be issued

  • Should the organizers of a corporation authorize more shares than they initially plan to issue?

    • They might want to issue additional shares at a later date to raise new money, to use for employee benefit plans, or to acquire other companies.

    • As a practical matter, it may seem tempting to authorize a large number of shares at first so the corporation has the flexibility to issue additional shares in the future without the bother of amending the articles

      • However, convenience might not be the only issue, especially in a close cor-poration

      • Shareholders might wish to keep control over the issuance of new shares by authorizing only the number of shares the company will issue immediately

        • Ex) the articles might authorize 100 shares.

          • For the company to issue more shares in the future, there would have to be another shareholder vote to amend the articles (to increase the number of authorized shares above 100)

          • The need for an aditional vote can protect minority shareholders and preserve existing control relationships

          • However, such a limitation might enable one or more shareholders to prevent the company from raising additional capital by blocking the vote to authorize

            additional shares

  • In large corporations

    • Shareholders usually exert relatively little influence over day-to-day management

      • Allowing the board to issue additional common shares may not constitute the surrender of much real power

    • Convenience usually decides the question in favor of an initial (and subsequent) authorization of many more shares than the corporation has current plans to issue

    • Under MBCA, shareholders retain some power over the issuance of additional shares of authorized stock

      • Shareholder approval is required if the corporation issues, for consideration other than cash or a cash equivalent, shares with voting power equal to more than 20% of the voting power outstanding immediately before the issuance

    • The precise number of shares that a shareholder owns in a corporation at a particular time determines her position relative to other shareholders

      • What is important, however, is not the absolute number of shares owned, but the percentage of the corporation's outstanding stock those shares represent (or more specifically, the voting power)

        • Ex) Assume that 2 corporations are identical except Corp A has two shares of common shares outstanding & Corp B has 1,000 shares outstanding

          • One share of Corp A, representing 50% of its outstanding shares, clearly would have more value and greater proportionate voting power than 100 shares of Corp B, representing 10% of its outstanding shares

      • When additional shares are sold to other investors, the voting power of existing shareholders is diminished in relative terms- or "diluted"

        • This is a problem for shareholders who want to maintain their proportionate voting interest to exercise a degree of control

      • The common law doctrine of "preemptive rights" addressed concerns about dilution

        • Courts held a shareholder had an inherent right to maintain her proportionate interest in a corporation by purchasing a proportionate number of any new shares issued for cash

          • Ex) a shareholder who owned 100 shares in a corporation with 1,000 shares issued and outstanding would be entitled to purchase 10% of any new issue

        • Although the preemption rights worked in closely held corporations with simple capital structures, it became problematic in corporations with several classes of shares or those that issued shares in exchange for property to be used in the business

        • Preemptive rights also were of questionable value in publicly held corporations: a typical public shareholder, owning far less than 1% of the outstanding shares, presumably would care little about being diluted, so long as the overall value of her shares were not affected

          • Moreover, if she believed the firm was selling new shares at too low a price, she could protect herself simply by purchasing additional shares on the open market

        • Courts and legislatures addressed the problems posed by preemptive rights

          • First courts developed several exceptions to the rule that shareholders always had preemptive rights

          • Legislatures have modified state corporate laws to allow corporations to avoid preemptive rights

            • Almost all public corporations exercised this option

      • Today, many states have adopted an "opt-in" approach to preemptive rights

        • MBCA $ 6.30(a) provides that "The shareholders of a corporation do not have a preemptive right to acquire the corporation's unissued shares except to the extent the articles of incorporation so provide."

          • To provide shareholders w/ such rights the articles must include an appropriate provision

            • A simple declaration, such as "The corporation elects to have preemptive rights"

            • Absent such a declaration in the articles, no preemptive rights exist

      • Delaware's corporate statute no longer explicitly addresses preemptive rights

        • But - DGCL $ 157 authorizes a corporation to issue rights to purchase its shares, which can include preemptive rights

          • In addition, a Delaware corporation can include a provision in its articles creating preemptive rights

• Common Shares

  • Most basic of all corporate securities

    • All corporations have common shares

    • Many small corporations issue no other kind of equity security

    • Holders of common shares usually have the exclusive power to elect a corporation's board of directors

      • Although in some corporations one or more classes of common shares are non-voting

      • In many corporations preferred shares have limited voting shares

  • Common shares represent a "residual claim" on both the current income & the assets of a corporation

    • Income that remains after a corporation has satisfied the claims of creditors and holders of its more senior securities -preferred shares and debt - "belongs" in a conceptual sense to the holders of common shares

      • (ie Left over income after debts are paid belong to common share holders)

    • If no income remains, shareholders receive nothing

    • If some income remains, the board of directors can distribute it to shareholders in the form of a "dividend" or can choose to have it reinvested in the business

      • At least in theory, the board should choose to reinvest income only if it believes that the future returns from that investment will be greater than those that shareholders could generate by investing that income on their own elsewhere

  • If the corporation is liquidated:

    • Common shares also represent a residual claim on the corporation's assets

      • This means that in liquidation the corporation must first pay the claims of creditors and holders of preferred shares

    • Common shareholders receive whatever "residual" remains

      • As a consequence, common shareholders are the first to lose their investment if the corporation experiences economic difficulties

      • & they have the greatest potential for gain if the corporation is successful

  • Common shares generally represent a permanent commitment of capital to a corporation

    • Holders of common shares, if they wish to get out of their investment, generally do so by "exit"

      • “exit” — selling their shares to other investors, who buy at a price that reflects the firm's current value

    • Generally, common shares are not redeemable & the corporation has no obligation to repurchase them from shareholders

    • If a corporation is paying large current dividends or is reinvesting its income successfully, shareholders often will be able to realize substantial gains by selling their common shares to other investors

      • However, shareholders of close corporations might not be able to find a ready market for their shares

  • Although common shareholders are last in line when it comes to distributions of income and in liquidation → they generally are first in line with respect to control

    • They often have the exclusive right to elect the board of directors & to vote on other matters that require shareholders' approval

    • This combination of voting rights and a residual claim on profits and assets gives shareholders a strong incentive to ensure that the corporation is operated efficiently

      • If shareholders elect competent directors and monitor their performance effectively, they will realize the benefits of those directors' sound business decisions

      • If shareholders elect incompetent directors or fail to monitor their performance effectively, they will bear the loss if the directors mismanage the corporation's business or misappropriate its assets

  • Common shareholders also are seen as the primary beneficiaries of the fiduciary duties that corporate law imposes on the board of directors

    • Courts defer to a considerable degree to directors' business judgments

      • but they do so on the assumption that directors have exercised reasonable diligence & acted in the corporation's and thus the shareholders' best interests

    • These obligations extend to decisions concerning whether a corporation should reinvest its profits or distribute them as dividends

    • In addition, directors have a duty to refrain from engaging in transactions that will provide them with unfair profits at the corporation's expense

    • (ie directors have broad discretion to manage, but must bear in mind that they are managing other people's money and that they have obligations to do so with care, loyalty, and good faith)

• Preferred Shares

  • Preferred Shares have economic rights senior to those customarily assigned to common shares

    • They vary widely, depending on the attributes assigned to them in the articles of incorporation

    • If no attribute is assigned to a class of shares with respect to its voting rights, right to dividends, or rights to redemption or in liquidation, courts generally will presume that "stock is stock"

      • “Stock is stock” is stock with certain preferences otherwise have the same rights as does common stock

    • Thus, although the rights attached to preferred shares are set forth in articles authorizing such shares

      • The rights of preferred shares are viewed as part of a contract b/n the preferred shareholders and the corporation

  • Preferred shares almost always have dividend rights senior to those of common shares - meaning that payment of dividends on common shares cannot happen until dividends due on preferred shares have been paid

    • A preferred share's dividend preference usually will be stated as a fixed amount that must be paid annually or quarterly

      • The preference may expire if a dividend due for a given period is not paid

      • or it may be "cumulative" —meaning that if a dividend is not paid when due, the right to receive that dividend accumulates and all accrued dividend arrearages must be paid before any dividends can be paid on common shares

  • Preferred shares also may be "participating."

    • Meaning preferred shares will receive dividends whenever they are paid on common shares

      • either in the same amount as or as a multiple of the amount paid on common shares

  • In addition to a dividend preference → preferred shares often have a preference in liquidation, generally stated as a right to receive a specified amount before any amounts are distributed with respect to common shares

    • The amount of this preference most often is the amount that the corporation received when it sold the preferred shares plus, in the case of cumulative preferred, any accumulated unpaid dividends

    • In some instances, there may also be a specified "liquidation premium" that must be paid

      • However, as with common shares, the liquidation rights of preferred shares are subordinate to the claims of creditors

      • Consequently, when a corporation does not have assets sufficient to pay its debts, the preferred shareholders receive nothing in the event of liquidation

  • Preferred shares sometimes represent a permanent commitment of capital to a corporation and sometimes do not

    • In the latter event, the shares are "redeemable" for some specified amount-that is, the corporation will repurchase the shares from the preferred shareholders

    • The right to require redemption may be held by the shareholder, by the corporation, or by both

    • The amount for which shares are to be redeemed generally is equal to the preference to which they are entitled in the event of liquidation, although it is not unusual to provide that, when shares are redeemable by the corporation, some premium above that amount must be paid by the corporation

  • Preferred shares can have voting rights and will be deemed to have voting rights equal to those of common shares, unless the articles of incorporation provide other-wise

    • Sometimes the preferred have voting rights on an "as-converted" basis with the common shares, but often the voting rights of preferred shares are limited to specified issues and circumstances

    • They usually have a statutory right to vote on changes in the corporate structure that affect adversely their rights and preferences

      • In addition, preferred shares are often given the right to elect some or all of a corporation's directors if dividends due on the preferred shares are not paid for some designated period

      • Such provisions reflect the nature of the contract between holders of preferred shares and the corporation

    • (In short, the preferred shareholders may relinquish their right to participate in control in exchange for a priority claim to periodic dividends, but if the corporation fails to pay those dividends, preferred shareholders then become entitled to exert control)

  • The standard features of preferred shares may be supplemented by a variety of other features, including the right to convert preferred shares into common shares at some specified ratio, the right to vote on certain transactions, or the right to require the corporation to redeem preferred shares if and when specified events should occur

    • As noted, these rights are essentially contractual in nature and must be spelled out in the articles

    • Moreover, most courts have taken the position that the preferred shareholders are owed fiduciary duties only when they rely on a right shared equally with the common stock and not when they invoke their special contractual rights

  • Preferred shares are a favorite way for "venture capital" (VC) firms to finance "start-up" or "early-stage" businesses, particularly in areas of new technology

    • After such companies have raised their initial capital and need more money to expand or survive, they often will raise money from VC firms, which manage investment pools comprised of wealthy individuals and large institutional investors, like pension plans and university endowments

    • Why do VC firms prefer convertible preferred stock?

      • A number of explanations exist, ranging from tax motivations to governance

      • Ex) convertible preferred stock has long been attractive to VCs because of its hybrid nature, which gives VC firms some protection on the downside and the ability to convert their equity to common stock on the upside

      • VC firms can negotiate specific protections in their preferred, including a liquidation preference, the right to elect a certain number of directors to the board, and the ability to convert their preferred shares into common shares if the company goes public

  • Corporations often raise money by selling preferred shares in lieu of taking on debt

    • The two have obvious similarities

      • The price at which a company can sell preferred shares is influenced by factors similar to those that determine the price at which it can borrow-the dividend rate, the redemption features, whether the preferred can be converted into common shares and, if so, at what price

      • Consequently, the requirement that the terms of preferred shares be spelled out in the articles can pose real timing problems, especially in the case of a publicly held company

      • It usually takes a minimum of 30 days to obtain shareholder approval of an amendment to the articles of incorporation authorizing new preferred shares

        • By the end of that period, market conditions are likely to have changed enough so that whatever terms were specified at the beginning of the period must again be modified

  • Most corporation statutes address this timing problem by permitting the articles to authorize "blank check preferred shares," the essential characteristics of which —rights to dividends, liquidation preferences, redemption rights, voting rights, and conversion rights— can be set by the board of directors at the time the shares are sold

    • Such an authorization may facilitate the sale of preferred shares, but it also enhances substantially the power of a corporation's board of directors by allowing it to issue preferred shares with rights that may materially impinge on those of common shares without first obtaining explicit shareholder approval

      • Ex) many corporate boards use blank check preferred shares as part of "poison pill" rights plans, because the issuance does not require shareholder approval

2. Debt Securities

• Debt securities represent a corporation's liabilities to lenders

  • They can be labeled notes, debentures, or bonds—and sometimes these terms are used interchangeably

    • Typically, notes and debentures have shorter maturities than bonds, and debentures are usually not secured by corporate assets

    • Some short-term debt securities resemble accounts payable or the debts of trade creditors

    • But typically, debt securities are part of a company’s long-term interests in a corporation’s financial fortunes

  • The terms of a bond typically are fixed by a complex contract known as an indenture that specifies the rights and obligations of the bondholders and the corporation

    • Whether or not an indenture is used, certain fundamental terms are set forth in every debt contract

      • For example, the corporate borrower is obliged to repay a fixed amount of principal on a particular date

    • Typically, interest must be paid at periodic intervals, whether the interest is a floating rate that varies over time or is fixed throughout the term of the contract

      • Importantly, the interest obligation does not depend on whether the corporation earns a profit

      • If the corporation fails to pay interest on a bond when interest is due, it will be deemed in default

        • Typically, an event of default will cause the entire principal amount of the bond to become due immediately, and this "acceleration" entitles the bondholders to pursue all legal remedies for which they have bargained, including the right to initiate bankruptcy proceedings

  • The indenture can require that the corporation repay the entire principal amount all at once at maturity, or it can specify that the corporation make periodic principal payments, so that the principal amount is "amortized" over time

    • Some indentures require that borrowers make payments into a "sinking fund" that will be used to repay part of the principal prior to the bond's maturity date

  • If a bond is secured, the debt contract also must specify the terms of the security arrangement and the collateral that secures the bond

    • The debt contract also may include provisions, known as covenants or negative covenants, requiring the borrower to refrain from taking certain actions that might jeopardize the position of the bondholders

      • A corporation may agree, for example, not to pay any dividends or repurchase any of its own shares unless it meets certain financial conditions

  • Bonds may be made redeemable or "callable" at a fixed price at the option of the corporation

    • This right can be valuable to a corporation; if interest rates decline, it can redeem outstanding high-interest bonds by issuing lower-interest bonds or otherwise borrowing at a lower interest rate

      • To compensate bondholders for their loss of income, a bond's redemption price usually is set at something above the principal that the bondholders would be entitled to receive when the bonds mature

  • Because the terms and conditions of debt securities are fixed entirely by contract and often are the result of extensive negotiations, many other provisions may be included in a debt contract

    • For example, the corporation might give the bondholder the right to convert bonds into common shares

    • So-called convertible debentures are hybrid securities that closely resemble convertible preferred shares-indeed, two such instruments might have all of the same substantive terms so that the only real difference is the label

  • Unless the articles of incorporation provide to the contrary, a corporation's board of directors has the authority to issue debt securities w/out shareholder approval

    • The board decides whether the corporation should incur new debt, in what amount, and on what terms and conditions

    • The board must involve shareholders only if it decides to issue bonds that will be convertible into shares and the corporation does not have enough authorized shares to satisfy the bonds' conversion rights

      • In such a case, the board must seek shareholder approval of an amendment to the articles increasing the number of authorized shares

      • However, shareholders need not approve the issuance of the convertible debt securities

  • The use of long-term debt as part of a corporation's capital structure creates a tension between debt and equity investors

    • Both have stakes in the long-term health of the corporation, and both benefit if the corporation accumulates funds in excess of the amount it needs for current operations

    • But holders of debt and equity have agreed to different trade-offs between risk and reward, and each thus has a different perspective on how much risk that a corporation should assume

  • Unless she has bargained for a right to convert her debt into equity, a bondholder has accepted rights to fixed payments of interest and repayment of her capital in lieu of the possibly higher, but uncertain, returns available to holders of equity securities, especially common shares

    • Common shareholders have assumed more risk, but also can exercise more control over the conduct of the corporation's business

    • A debt holder is viewed as an outsider entitled only to the protection specified in her contract

      • In contrast, common shareholders are protected by directors' fiduciary duties, including the duty to advance the interests of the common shareholders even if at the expense of the interests of non-shareholders

3. Options

• In addition to debt and equity, companies often issue options, which are the right to buy securities, typically common shares, at a specified time and price

  • Stock options are important pieces of the financial accounting and valuation puzzle

  • Corporate lawyers frequently deal with options, in part because most publicly traded companies and many private companies award stock options to managers and employees

• The definition of an option is simple: it is the right to buy or sell something in the future

  • Options are everywhere

  • A tenant with the right to renew a lease at a particular monthly rate owns an option

  • A car rental company that permits a client to purchase the car's tank of gasoline in advance is selling an option

  • Any corporation that gives its employees the right to buy its shares at a set time and price also has issued an option

• Options generally are known as contingent claims, because they are assets whose value and future payoff depend on the outcome of some uncertain contingent event, such as fluctuations in rental markets, gasoline use on a trip, or changes in the corporation's stock price

  • Remember: a party who owns an option has a contractual right (to buy or sell), but not a contractual obligation to do so

    • A tenant with a right to renew the lease need not renew; a car renter who pre-purchases a tank of gas need not use all of it; and an employee with stock options is not obligated to buy corporate stock

    • (Simply stated, option holders have rights, not obligations)

• The most familiar type of option is the stock option

  • Corporations frequently grant stock options to their employees, particularly senior managers, as compensation

    • Again, the option holder has the right-but not the obligation-to buy shares of the company

  • Options have a special terminology:

    • The right to buy shares is known as a call option, whereas the right to sell is known as a put option

    • The price specified in an option contract is known as the strike price or exercise price

    • The date specified in an option contract is known as the maturity date or expiration date

  • Corporations typically issue only call options

    • When issued to the public, call options are sometimes known as warrants

    • Stock options awarded to managers typically are call options with a ten-year maturity date and an exercise price equal to the market price when the options were awarded

      • As incentive compensation, the options may be subject to a vesting period over which time the rights become exercisable

Elements of Capital Structure

• Debt Securities:

  • Represent money borrowed by the company, reflecting a firm's liabilities. They come in various forms (bonds, debentures).

  • Key terms typically defined in an indenture, outlining borrower’s obligations, interest rates, and payment schedules.

• Equity Securities:

  • Common shares typically represent residual claims on company income and assets.

  • Holders have exclusive rights to elect directors and influence corporate governance.

  • Preferred shares may have fixed dividends and senior rights over common shares.

B. Capital Structure in the Real World: Taxes Bankruptcy, and Conflicts

• Capital structure can evolve over time, exemplifying initial offerings to complex arrangements including multiple classes of shares.

• Corporations must strive to maintain an attractive investment opportunity amidst fluctuating market conditions.

Conclusion

• Understanding valuation and capital structure is essential for corporate management, investors, and those engaged in corporate law.

• Each approach to asset valuation and management's fiduciary duties is crucial in decision-making processes.