Business Organizations 2010-2011 Lectures

1. Business Organizations2010-2011 Lectures Partnerships, Corporations And the variants PROF. BRUCE MCCANN (707) 874-9204 Lecture 7 capitalization pp. 255-299

2. Incorporation Process Review Lec. 7, pp 255-299 Corps Prof. McCann

3. California Corporations Code §204 • (a) Any or all of the following provisions, which shall not be effective unless expressly provided in the articles: • (1) Granting, with or without limitations, the power to levy assessments upon the shares or any class of shares. • (2) Granting to shareholders preemptive rights to subscribe to any or all issues of shares or securities. • (3) Special qualifications of persons who may be shareholders. • (4) A provision limiting the duration of the corporation's existence to a specified date. • (5) A provision requiring, for any or all corporate actions … the vote of a larger proportion or of all of the shares of any class or series, or the vote or quorum for taking action of a larger proportion or of all of the directors, than is otherwise required by this division. • (6) A provision limiting or restricting the business in which the corporation may engage or the powers which the corporation may exercise or both. Lec. 7, pp 255-299 Corps Prof. McCann

4. Cal. Corp. Code §204(a) continued • (7) A provision conferring upon the holders of any evidences of indebtedness, issued or to be issued by the corporation, the right to vote in the election of directors and on any other matters on which shareholders may vote. • (8) A provision conferring upon shareholders the right to determine the consideration for which shares shall be issued. • (9) A provision requiring the approval of the shareholders (Section 153) or the approval of the outstanding shares (Section 152) for any corporate action, even though not otherwise required by this division. Lec. 7, pp 255-299 Corps Prof. McCann

5. Cal. Corp. Code §204(a) continued • (10) Provisions eliminating or limiting the personal liability of a director for monetary damages in an action brought by or in the right of the corporation for breach of a director's duties to the corporation and its shareholders, as set forth in Section 309, provided, however, that • (A) such a provision may not eliminate or limit the liability of directors (i) for acts or omissions that involve intentional misconduct or a knowing and culpable violation of law, (ii) for acts or omissions that a director believes to be contrary to the best interests of the corporation or its shareholders or that involve the absence of good faith on the part of the director, (iii) for any transaction from which a director derived an improper personal benefit, (iv) for acts or omissions that show a reckless disregard for the director's duty to the corporation or its shareholders in circumstances in which the director was aware, or should have been aware, in the ordinary course of performing a director's duties, of a risk of serious injury to the corporation or its shareholders, (v) for acts or omissions that constitute an unexcused pattern of inattention that amounts to an abdication of the director's duty to the corporation or its shareholders, (vi) under Section 310, or (vii) under Section 316, • (B) no such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when the provision becomes effective, and (C) no such provision shall eliminate or limit the liability of an officer for any act or omission as an officer, notwithstanding that the officer is also a director or that his or her actions, if negligent or improper, have been ratified by the directors. Lec. 7, pp 255-299 Corps Prof. McCann

6. Cal. Corp. Code §204(a) continued • 11) A provision authorizing, whether by bylaw, agreement, or otherwise, the indemnification of agents (as defined in Section 317) in excess of that expressly permitted by Section 317 for those agents of the corporation for breach of duty to the corporation and its stockholders, provided, however, that the provision may not provide for indemnification of any agent for any acts or omissions or transactions from which a director may not be relieved of liability as set forth in the exception to paragraph (10) or as to circumstances in which indemnity is expressly prohibited by Section 317. • Notwithstanding this subdivision, in the case of a close corporation any of the provisions referred to above may be validly included in a shareholders' agreement. Notwithstanding this subdivision, bylaws may require for all or any actions by the board the affirmative vote of a majority of the authorized number of directors. Nothing contained in this subdivision shall affect the enforceability, as between the parties thereto, of any lawful agreement not otherwise contrary to public policy. Lec. 7, pp 255-299 Corps Prof. McCann

7. Incorporation Process Review • Articles filed • By laws prepared • First meeting held of shareholders • Elect Directors • Make subchapter S election • Directors meeting • Adopt pre-existing agreements • Appoint officers • Authorize issuance of stock • Authorize banking relationships Lec. 7, pp 255-299 Corps Prof. McCann

8. Cal Corp Code 25608(c) • (c) The fee for filing a notice pursuant to paragraph (5) of subdivision (h) of Section 25102 and the fee for filing a notice pursuant to paragraph (4) of subdivision (f) of Section 25102, in addition to the fee prescribed in those paragraphs, if applicable, shall be determined based on the value of the securities proposed to be sold in the transaction for which the notice is filed and in accordance with subdivision (g), and shall be as follows: Value of Securities Proposed to be Sold Filing Fee • $25,000 or less $ 25 • $25,001 to $100,000 $ 35 • $100,001 to $500,000 $ 50 • 500,001 to $1,000,000 $150 • Over $1,000,000 $300 Lec. 7, pp 255-299 Corps Prof. McCann

9. Where Does a Corporation Get the Money to Get Started? They borrow it (debt) They sell stock (equity)

10. The Debt-Equity Relationship Lec. 7, pp 255-299 Corps Prof. McCann

11. Why Capitalize with Debt? • You can keep (i.e., leverage) the cash you have. • You retain ownership (control) of the business • Interest payments are tax-deductible • Generally easier to sell debt because you don’t have to convince someone that the company will grow, only have to convince them that they’ll get paid back (and they get paid first). • Lender is first in line to get paid if must liquidate assets • Have a good return on investment (ROI) Lec. 7, pp 255-299 Corps Prof. McCann

12. Other People’s Money • The Beauty of Leverage: • Step One: Put $25,000 into your business • Step Two: Use that money to put 10% down on a building (or any depreciable asset) costing $250,000. • Step Three: If the building increases 3% per year in value: • Ka-ching… your net worth increases $7,500 each year • Step Four: The building is depreciated for tax purposes over 20 years (depending on asset) • Ka- ching…you write off 1/20 X $250,000 each year, or $12,500. • (At a 30% tax rate, you saved $3,750 on taxes alone, meaning you made 15% on your $25,000 investment on tax savings alone) Lec. 7, pp 255-299 Corps Prof. McCann

13. The Owner’s Dilemma: Use Debt or Equity • Say Owner (O) borrows $50,000 from the bank and puts in $50,000 of her own money to fund the business. • Assume the business earns (after expenses) $12,000 a year. • Assume the bank charges 10% for the loan, or $5,000 per year in interest. • She is better off with the loan because she has a $7,000 profit personally ($12,000-$5,000) on an investment of $50,000 (of her money), or 14%. That is 2% better than the 12% the business earned. That is what is referred to as LEVERAGE.

14. Voilá • Interest at 10% on $75,000 = $7,500 • Revenue minus interest = $12,000-$7,500=$4,500 • Owner’s Investment= $25,000 • Owner’s ROI (Return On Investment) = $4,500/$25,000 = 18% • Note: Same relationships are true if she sells the business and pays off the loan.

15. But What Happened With the Risk? • It seems the more risk she put on the bank, the more reward she got. • In the real world, how does the bank protect itself? • Recourse debt (personal guarantees) • Security (sometimes in excess of 100% of the debt) • Increased interest rates on riskier loans • Controls on debt/equity ratio of a business (“skin in the game”)

16. Typical Types of Debt Contracts • BONDS • Long term obligation secured by the assets of the corporation • DEBENTURE • Long term unsecured obligation • NOTE • Short term obligation Lec. 7, pp 255-299 Corps Prof. McCann

17. The Indenture • A contract underlying the bond/note/debenture • Governs actions corporation may take while debt remains unpaid such as: • Limit other borrowings • Limit payment of dividends • Limit use or disposition of security • May give corporation right to “call” the bond/note Lec. 7, pp 255-299 Corps Prof. McCann

18. Typical Terms • COVENANTS • (a) Use of Proceeds. Proceeds received from the Payee pursuant to this Note will be used by the Borrower for working capital and general company purposes. • (b) Affirmative Covenants. Until the conversion or repayment (or prepayment) of this Note in accordance with the terms and conditions set forth herein, each Borrower shall perform all covenants in this Section 4(b). Lec. 7, pp 255-299 Corps Prof. McCann

19. Typical Terms • (vii) Compliance with Laws. The Borrower will comply with the requirements of all applicable laws, rules, regulations and orders of any governmental authority, noncompliance with which could reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect. As used herein, “Material Adverse Effect” means a material adverse effect on and/or material adverse developments with respect to (i) the business, operations, properties, assets, condition (financial or otherwise) or prospects of the Borrower (taken as a whole); (ii) the ability of the Borrower to fully and timely perform its obligations hereunder; (iii) the legality, validity, binding effect or enforceability against the Borrower of a Loan Document; or (iv) the rights, remedies and benefits available to, or conferred upon, Payee under any Loan Document. Lec. 7, pp 255-299 Corps Prof. McCann

20. Typical Terms • (c) Negative Covenants. Until the conversion, repayment (or prepayment) of this Note in accordance with the terms and conditions set forth herein, the Borrower will not, without the prior written consent of the Payee, undertake to do any of the following: (i) create, issue, sell or transfer any debt securities of the Borrower or enter into or incur other indebtedness other than indebtedness which, together with this Note, does not exceed $200,000 in principal amount (for purposes hereof, “Indebtedness” shall mean any indebtedness of the Borrower for borrowed money from banks, other financial institutions, (except indebtedness consisting of drawing down on existing lines of credit) and any Person (defined as natural persons, corporations, limited liability companies, limited partnerships, general partnerships, limited liability partnerships, joint ventures, trusts, land trusts, business trusts, or other organizations, irrespective of whether they are legal entities)); Lec. 7, pp 255-299 Corps Prof. McCann

21. Negative Covenants Continued • (ii) (A) redeem, repurchase or otherwise acquire for consideration any outstanding equity securities of the Borrower (or securities convertible or exercisable into or exchangeable for equity securities of such entity) or permit any Borrower to take such action; or (B) declare or pay any cash or property dividend or distribution of any kind on any class of stock or membership interest (except with respect to ordinary course inter-company transfers and accounts of the Borrower); (iii) make any material change in its ownership or organization or the manner in which its business is conducted outside of the ordinary course of its business; (iv) transfer, sell, lease, or in any other manner convey any equitable, beneficial or legal interest in any assets of the Borrower except inventory sold in the normal course of business, or allow to exist on its assets any mortgage interest, pledge or security interest , title retention device, or other encumbrance, junior or senior to Payee, other than as set forth herein. Lec. 7, pp 255-299 Corps Prof. McCann

22. Advantages of Selling Equity • Motivate buyer to pull for the success of the company • Doesn’t use precious cash • No obligation to re-pay • Can “print” more when needed Lec. 7, pp 255-299 Corps Prof. McCann

23. Disadvantages of Selling Equity • Usually requires giving up at least some control • Allows “camel’s nose under the tent” • Dividends are not deductible from corporate tax Lec. 7, pp 255-299 Corps Prof. McCann

24. Types of Equity • Common Stock • Preferred Stock • Convertible preferred stock • Warrants Lec. 7, pp 255-299 Corps Prof. McCann

25. Common Stock • Required to be issued • Usually carries voting power • May or may not have “par” value • First in line in terms of control, last in line in terms of getting paid on liquidation Lec. 7, pp 255-299 Corps Prof. McCann

26. Preferred Stock • Preference given as to • Dividends • Liquidation of the company’s assets • May also allow certain rights if the dividends are not paid (such as electing a number of directors) Lec. 7, pp 255-299 Corps Prof. McCann

27. Convertible Preferred Stock • Preferred stock that carries with it right to convert to common stock Lec. 7, pp 255-299 Corps Prof. McCann

28. Warrants • Are issued by the corporation • Give the owner the right to acquire common stock in the future for a specified price • Usually added as an enticement to lenders but may be sold independently Lec. 7, pp 255-299 Corps Prof. McCann