Financing Your Small Business

Corporation Equity

The equity of a corporation is called stock. Typically, you will hear the stock in a corporation referred to as shares of stock. A corporation may sell its stock to investors to raise capital for expansion and operations, and once an investor has purchased stock in a corporation, he or she becomes an owner of part of that corporation. The ownership of stock is perpetual, meaning
that there is no maturity date for the stock, and the investor may own the stock until the corporation decides to buy them back or until the investor decides to sell them. Shares of stock of a corporation have a number of terms associated with them.

Authorized stock is the total amount of stock that a corporation possesses. When a corporation is formed, it must state the amount of its authorized stock in its articles of incorporation. That language will read something like the following.

The number of shares that the corporation is authorized to issue is 15,000,000, 10,000,000 of which are common shares at a par value of $0.001 and 5,000,000 of which are preferred shares at a par value of $0.001. Authority shall be vested in the board of directors to change the class, the number of each class of stock and the voting powers, des­ignations, preferences, limitations, restrictions, and relative rights of each class of stock.

By stating its authorized stock, the corporation determines the size of its universe, and it lets investors know where their investment fits into the company. For example, they want to know if the 10,000 shares they are buying represent 1% or 10% of the company. Par value is a nominal value arbitrarily assigned to the shares and bears no relationship to the market value that changes over time.

The next term you need to know is issued stock. Issued stock is the amount of authorized stock that currently is or has been in the hands of the founders, or sold to investors since the beginning of the corporation. Once stock has been issued, it will always be regarded as issued, regardless of its current status (i. e., whether someone currently owns it or if it has been repurchased by the corporation). Closely related to issued stock is the term outstanding stock. Outstanding stock is stock that has been sold or issued that is currently in the hands of the founders and investors.

Treasury stock are those shares that had been issued but have subse­quently been returned to the corporation through a redemption, purchase, or other liquidity event. These shares are back in the treasury of the corpo­ration. The corporation may elect to reissue the shares at a later date or it may retire the shares.

To determine the amount of treasury stock, use the following formula:

Issued stock - Outstanding stock = Treasury stock

/ Figure 3.1: THE LIFE OF A SHARE OF STOCK

To gain an understanding of the terms just described, an example is helpful. Anderson Industries, Inc. is founded with 10,000,000 authorized shares with a par value of $0.001. The founders want to maintain majority control of the corporation, so they issue 5,000,000 shares amongst them­selves, for which they pay the par value, or $5,000 (5,000,000 x $0.001 = $5,000). At this point, there are 5,000,000 issued and out­standing shares, which is 50% of the authorized shares. The ownership structure looks like this:

Next, the board of directors of Anderson Industries, Inc. decides that the corporation needs to raise $1,000,000 for operations, and they deter­mine that a fair market value for the shares to be sold will be $1.00 per share. (Do not get too bogged down with how they are going about rais­ing capital or what the value of the shares is here—the finer points of val­uation and raising capital are discussed in later chapters). The ownership structure now includes the investors and looks like this:

Once the 1,000,000 shares are sold to investors, there are 6,000,000 issued and outstanding shares, or 60% of the authorized shares. Investors will be concerned with two ratios here: the amount of issued and out­standing shares they own in relation to the number of authorized shares, and the amount of shares they own in relation to the total number of issued and outstanding shares in the corporation.

In this example, the investors own 1 0% of the authorized shares (1,000,000 of the 10,000,000 authorized shares) and they own 16.6% of the issued and outstanding shares (1,000,000 of the 6,000,000 issued and outstanding shares). These values can be expressed like this:

Over the years, the corporation becomes successful and the board of directors decides to redeem the shares it has sold to investors for $5.00 per share, so it creates a plan of redemption and offers it to all of the investors. A number of the investors decide to redeem their shares and the corporation buys back 750,000 of the shares it had sold. At this point, there are still 1,000,000 issued shares, 250,000 of which are outstanding shares and 750,000 are treasury shares. Now the ownership structure looks like this:

With a good grasp of the terms associated with the status of shares of stock, a description of the types of shares that you will typically see in a corporation, their function, and their attributes, is discussed in the following pages.

Common Stock

C corporations can sell equity in two basic forms—common stock and pre­ferred stock. Common stock is voting stock. Typically, it is issued to the founders of a corporation shortly after formation in exchange for the founder's time and expertise, or perhaps the assignment of intellectual property or other assets. Some common stock may be sold to initial investors and issued to officers, directors, and consultants as incentives. Common stock may also be given as stock options that may be exercised at a higher price at some future date.

Dividend Rights. Dividends are declared by the board of directors from available after tax earnings and profits. In most states, the company cannot pay a dividend if it would impair the capital of the corporation, which means, in layman's terms, you cannot pay a dividend unless you have earnings and profits. Directors can be held personally liable under some laws if they impair the capital of a corporation. A board of direc­tors is not under any obligation to declare a dividend at any time. They merely have the right to declare one. The practical reality is that most beginning corporations do not pay dividends and may never pay divi­dends until they are fully mature. In 2002, Microsoft Corporation paid the first dividend in its history.

Common stock can receive dividends, but if there is any outstanding preferred

Stock that has a dividend preference, it will be entitled to receive dividends first.

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Voting Rights. Holders of common stock are typically entitled to one vote per share on all matters to be voted on by the shareholders. When holders of common stock vote for directors, the directors with the greatest plurality win. Most states allow common stockholders to cumulate (combine) their votes, if such voting is allowed by the articles of incor­poration. The use of cumulative voting should be discouraged, because it concentrates unequal voting power in a few shareholders and can be a negative to new investors.

Liquidation Rights. In the event of a liquidation or dissolution of the corporation, holders of common stock are entitled to share in all assets remaining after creditors and any preferred stockholders are fully repaid. Unfortunately, if liquidation or dissolution of the corporation occurs, it means that things are not going well and probably have not been going well for quite some time. So, there may not be much left in the way of assets to distribute to common stockholders.

Redemption Rights. Redemption is the purchase of issued and outstand­ing stock by the corporation. There is no inherent right of shareholders to redeem their shares unless it is part of a contract with the corporation. The company can attach a right of redemption to a particular class of common shares, and this could create an attractive exit strategy for certain common shareholders. However, a company can voluntarily offer redemption to some or all of its common shareholders. If a right of redemption is part of a stock offering, the company may wish to create a sinking or reserve fund to have the after-tax money available to fund the redemption in the future.

Redemption can be at the option of the company, the stockholder, or both. There are a variety of methods to set the redemption price—a fixed price per share, a multiple of the purchase price, market value deter­mined by an appraisal, and other methods. In setting the time for the redemption event, the longer the hold period of the stock, the greater the redemption price.

Preemptive or other Preferential Subscription Rights. Preemptive rights entitle a current shareholder to purchase additional shares in the event of an ownership percentage dilution due to subse­quent rounds of stock offerings. The use of preemptive rights or other preferential subscription rights is not recommended because they can discourage additional investors. By granting a shareholder the right to purchase additional shares of stock when the corporation offers stock to outside investors, funding is often delayed because the stock has to be offered to existing shareholders first.

Nonvoting Common Stock. Nonvoting common stock can also be used in a stock incentive plan. Such a plan may reward employees with shares in the company as part of their compensation package. In this man­ner, the company can share ownership with its employees and still maintain voting control.

You may use nonvoting common in both an S corporation and a C corpo­ration when the voting shareholders do not want to grant voting rights to other shareholders. Family-controlled corporations are another instance where the family members maintain control by issuing nonvoting common stock.

QUICK Tip

The S Corporation: One of the limitations of an S corporation is that it is allowed only one class of stock. However, S corporations do allow the issuance of non­voting common stock in addition to issuing voting common stock.

Preferred Stock

Preferred stock is the second kind of equity available for sale by a corpora­tion. It entitles its holders to certain preferences that differ from common stock. Investors like preferred stock because dividends are paid before com­mon stock, and if the company is liquidated or dissolved the preferred stockholders have a preference to the liquidation proceeds ahead of com­mon stock.

The board of directors of a corporation is typically authorized in the arti­cles of incorporation to create multiple series of preferred stock. It is allowed to determine the rights, preferences, and privileges of any series of preferred stock, and the number of shares constituting any such series. Pursuant to this authority, the board of directors will adopt a resolution at a board meeting designating a series of preferred stock. The board will then file the preferences with the state through an amendment to the articles of incorporation or a designation of preferences, depending upon the laws of the state of incorporation.

The language would read something like this.

RESOLVED, that the number of shares that the corporation is author­ized to issue is 15,000,000 shares, 10,000,000 of which are common shares and 5,000,000 of which are preferred shares, and

RESOLVED FURTHER, that 750,000 of the 5,000,000 authorized preferred shares are hereby designated as Series A Preferred Shares, and RESOLVED FURTHER, that the voting powers, designations, prefer­ences, limitations, restrictions of Series A Preferred Shares are as fol­lows: [Details of the preferences would appear here].

When amending the articles of incorporation, the board of directors sets forth the proposed amendments in a resolution (like described) and submits it to the shareholders for approval. In most cases, the chairman or president calls a special meeting of the shareholders and the shareholders vote to rat­ify the amendment to the articles. If there are few shareholders, all share­holders sign a unanimous written consent and no meeting is necessary.

Preferences for preferred stock can include the following.

Dividend Rights. Shares of preferred stock will either have a cumu­lative or noncumulative right to dividends. A cumulative dividend accu­mulates from year to year if it is not paid. For example, if a corporation promises to pay a cumulative dividend of ten cents per share every year to each holder of preferred stock, and the corporation was unable to pay one year because it had no available earnings and profits, the dividend would cumulate the next year, so that the corporation would owe twenty cents per share. A noncumulative dividend does not accrue when unpaid, and it does not roll over to the next year. If dividends are not declared during the year, no dividend is due. Investors realize this, too, and often will want cumulative dividends. It is all about bargaining power.

Dividends are calculated by applying a rate percentage to the face value or the purchase price of a share of stock at the time a dividend is declared. In a privately held company, the face value is what the investor paid for the preferred stock. If there was an 8% dividend rate and the face value was $1.00 per share, the dividend would be $0.08 per share multiplied by the

Number of preferred shares owned. Whether or not the company declares dividends to shareholders will depend upon a number of factors, including the capital requirements and the financial condition of the company.

Voting Rights. In exchange for their preferential treatment for divi­dends, preferred stockholders will usually give up their right to vote on cor­porate matters, except when it pertains to changes to the preferences of the stock they are holding. They will most likely want to be part of the decision­making process if their preferences are going to change. They may also want a voice if the corporation wants to create a series of preferred stock that is senior in preference to their series of preferred stock.

If an institutional buyer, an angel, or a venture capitalist is funding the company, they want a designation of an entire series of preferred stock. The stock structure of venture deals usually involves preferred stock that votes and converts to common stock in a variety of circumstances. In addition, the venture funder may demand representation on the board, which is gener­ally helpful because of their experience and contacts.

Liquidation Rights. Holders of preferred stock will normally be entitled to receive a certain dollar amount per share (plus declared but unpaid dividends) before any distribution or payment is made to holders of common stock in the event of a dissolution, liquidation, or wind-up of the corporation.

If the corporation liquidates, dissolves, or winds up, and the assets of the corporation are insufficient to permit full payment of the amount promised to the preferred stockholders, the holders would then be entitled to a rat­able distribution of the available assets and the common stockholders would get nothing.

A consolidation, merger, or sale of all or substantially all of the assets of a cor­poration is generally not considered a liquidation, dissolution, or winding up for these purposes.

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Conversion and Redemption Rights. Preferred stockholders are sometimes granted the right to convert their shares into shares of common stock of the corporation. Conversion rights can be voluntary or compulsory. The preferred shareholder can exercise voluntary conversion anytime. Compulsory conversion usually occurs on the happening of an event, such as a public offering or merger.

When the time comes to convert, the conversion ratio is the paramount concern. The conversion ratio is the formula by which you calculate the number of shares of common received by surrendering a certain number of preferred shares. The most straightforward conversion formula is one share of preferred stock for one share of common stock. Other formulas call for a third party appraisal at the time of conversion, which can be expensive. The conversion rate should be subject to adjustment from time to time if any of the following events occur:

• the company splits or combines its common stock or issues dividends to common stock;

• the corporation issues other convertible securities at a lower price or with a conversion rate less than the then-current conversion rate for the issued and outstanding preferred stock; or,

• the corporation sells its common stock at a price less than the then-cur­rent conversion rate of the issued and outstanding preferred stock.

There are a number of different formulas used to safeguard the interests of an investor when calculating how to convert convertible securities. These are called antidilution provisions and the corporation needs to pay particular attention to these provisions when negotiating with an institutional investor.

As a starting point, look at this typical conversion scenario:

Original share price number of shares of common stock

Conversion price X preferred stock = to be received

To be converted on conversion

Under this scenario, the original share price and the conversion price would be equal and essentially the investor would be converting at a ratio of one to one. But what happens if the corporation sold a bunch of convertible preferred stock at $2.00 per share and subsequently had to lower their valuation based upon changes in the economic landscape? The corporation would probably have a tough time selling additional shares at $2.00 per share and would probably have to enter into what is called a down round of financing, in which the price per share is lower than had previously been offered.

Existing investors do not like down rounds because their ownership in the corporation is diluted. Essentially, their investment is worth less. That is when antidilution provisions come into play.

The first and most harsh antidilution provision is called a full-ratchet con­version. A full-ratchet looks at the price per share paid by the investor and compares it to the price paid later on by other investors and compares the two. If the first investor paid $2.00 per share and later investors paid $1.00 per share, the first investor with full-ratchet protection could convert at a 2 to 1 ratio. This is harsh because it applies even if the corporation went out and sold just a few shares at $1.00 per share.

The second and more preferable antidilution provision is called a weighted-average conversion. A weighted-average takes into account sales prices just like the full-ratchet, but it also takes into account how many shares were sold at the lower price in proportion to the total outstanding shares of the corporation.

What the investor is trying to accomplish through these antidilution formulas is to safeguard their position in the corporation. If the investor bought their securities at $2.00 per share and the corporation needs to sell securities in a future round at $1.00 per share because the corpora­tion's valuation will not support a $2.00 per share price, the investor wants some assurance that they will not be left holding the bag. They want some assurance that when it comes time to convert, they will get more shares for their money because of the subsequent lower valuation of the corporation.

The corporation will also want to maintain automatic conversion rights if the corporation merges with or into any other corporation, if it sells or transfers substantially all its assets, or in the event of an underwritten pub­lic offering. Essentially, the corporation wants to have the option to convert everybody over to common stock if a big deal is coming down the pike and it makes a whole lot more sense to be selling apples as opposed to apples, oranges, pears, and mangos.

Redemption can go hand in hand with conversion. A series of stock may be redeemable, in whole or in part, at the option of the corporation upon the happening of a specified event such as a public offering or the sale of the corporation's assets. So, the investor can either convert to common stock or have their shares redeemed by the corporation.

Preemptive or other Subscription Rights. Just as with common stock, preemptive or other preferential subscription rights are discouraged. If an investor already has some antidilution protection, it is unnecessary to add preemptive rights to the package.

Other Types of Stock

In addition to common and preferred stock, there are endless variations and hybrids a creative business attorney can design to reflect ownership in your company. For example, some companies have nonvoting common stock, others have convertible preferred stock that converts into common stock at the option of the holder or when certain events occur (i. e., a pub­lic offering) or both.