Overview and Risk
Debt is simply a loan, typically comprised of the principal (initial loan amount), interest rates, and installments (how much of the loan needs to be paid back in each payment). Loans are typically made by creating a promissory note and may also be secured by collateral (in this case, probably the corporation).
The interest rate of debt is likely going to be dependent on the riskiness of the investment. The more risk, the higher the interest rate, and vice versa. So, creditors need a reliable way of evaluating risk, usually by checking a credit score. Businesses also have a “credit score” by obtaining a PAYDEX Score. The three major credit agencies for businesses is S&P, Moody’s, and Fitch, each rating the business as AAA, AA, A, BBB, BBB-, BBB+, BB, B, CCC, CC, C, or D. AAA being the best and D being the worst (typically in default).
The more money involved, the higher the likelihood that the creditor will require a loan agreement. These loan agreements include:
- Representations and Warranties – Statements of fact by the contracting parties. False information being a reason of breach.
- Covenants – Promises either to do something (affirmative) or not do something without consent of the lender (negative).
Either in the form of a mortgage for real property or a security interest in personal property, liens are used to secure the transaction by associating it with collateral that can be collected in the case of a default.
Most lenders ask shareholders to waive their liability status by personally guaranteeing that the loan will be paid back. If the corporation fails, the guarantor will be liable for the obligation.
Types of Debt
- Term loan – payments made periodically for a term
- Line of credit – pulling from a set amount (not given all at once, but could be if requested). The debtor can payback then reborrow at later times.
- Equipment loan – Loan specifically designed so the corporation can purchase product producing equipment. Loan equals 50% – 80% of equipment value.
- Equipment lease – Lender purchases the required equipment then leases it to the business.
- Inventory loan – Loan secured by inventory. Loan equals 50% of inventory value.
- Mortgage loan – loan for real estate
- Subordinated debt – junior creditor. See priority issues with secured transactions for more details.
- Accounts receivable loan – secured by the businesses accounts receivable.
- Syndicated loan – One loan funded by a group of lenders.
- Corporate bond financing
- Debenture financing – Selling unsecured bonds, called debentures.
- Junk bond financing – Selling bonds with a grade of BB+ or lower.
- Commercial paper – Short-term debt used to fund “current transactions.”
- Trade debt – See PMSIs in secured transactions.
Typically, the role of the lawyers is to create term sheets (what the business wants out of the loan), draft agreements, review them, make revisions, and then recirculate the changes for approval. Once all the changes are made, the business can close on the deal and the loan may be issued.
Equity = Business ownership. For corporations, this is denoted as “shares” of stock, either common or preferred.
DGCL § 212(a); MMBCA § 7.21(a).
Common stock has two benefits for owners: (1) full voting rights and (2) a residual claim on net assets after dissolution. As for voting rights, by default, one share equals one vote of common shareholders. As such, many charters will authorize multiple classes of common stock, with different voting power depending on the class. So, if Party A has 10 shares of Class A with one vote each, and Party B has 10 shares of Class B with 10 votes each, Party B will have more say in the business because they have more votes (despite having the same number of shares).
Preferred stock means that the owners have a preference over common stock owners in either dividends and/or asset distributions upon dissolution. Corporations typically have several “Series” or rounds of preferred stock.
A per share amount of the dividend the holders will receive before common stock holders. These can be cumulative or non-cumulative from year to year. If the charger is silent, the default rule is that the dividends are cumulative.
Additionally, this preference can also “participate” in receiving the dividends of common stock (must opt into it in the charter).
A per share amount of the liquidated assets the holders will receive before common stock holders. Again, this preference can be participating or non-participating. Cumulative does not apply because liquidation is a one-time event.
Conversion refers to when a preferred stock can be converted to a common stock and how much value the converted stock has. Holders of preferred stock are not likely to convert unless if the corporation is being bought out and common is worth more or if the common stock can be sold but not the preferred stock (the holder wishing to sell their shares). Automatic conversion could also occur if the business receives an initial pubic offering (IPO) of a certain price (the purpose is to simplify the capital structure of the corporation).
Dilution is when the percentage interests of existing shareholders and their power decrease. Typically, this is going to occur when a new investor joins in and pays less than the book value of the share. As such, Anti-Dilution clauses are put in place to adjust the weight of the shares given changes in the number of shares outstanding.
These are clauses that prevent the corporation from harming preferred stock holders without their approval.
The default voting rights of preferred shares is one share equals one vote. Many clauses will alter this to say that the preferred holders would have the same number of votes as they would if their shares were converted to common stock.
Preferred stock holders typically have the right to elect a certain number of directors.
Preferred stock holders may require the corporation to buy the stock back (essentially, preferred stock is debt).
Necessity for Careful Drafting
Lack of careful drafting (typically done by the investor’s lawyers) of any of the provisions listed above will lead to holes that the corporation may exploit.
Benchmark Capital Partners IV, L.P. v. Vague
2002 WL 1732423 (Del. Ch. 2002).
Benchmark and CIBC both invested in a corporation called Juniper. Benchmark invested first and obtained Series A preferred Stock. Later, they invested again and received Series B preferred stock. Once again, Juniper needed financing and found it in the form of CIBC, who was issued Series C preferred stock, but bought a ton of it, giving them the majority of the voting power within the company. Finally, Juniper needed more financing, but CIBC was the only party who had the money. So, they created a Series D, which would substantially impact the Series A and B. The mechanism for this impact would be through a merger. The protective provisions of Series A and B protected against a substantial impact, but not if that was caused by a merger. So, using this hole, CIBC intended to purchase Series D.
There was nothing in the protective provisions guarding against changes made by a merger. As such, there was no need to request the approval of Series A and B for the creation of Series D. In other words, the lack of one word “mergers” allowed Benchmark to suffer significant losses to voting power and ownership rights.
Public Company Preferred Stock
Public companies can sell preferred stock too, except they typically lack the provisions above.
Corporate Law Requirements
Preferred stock terms are established in the corporation charter (articles of incorporation), which means each new series would subject the charter to amendment with shareholder approval. However, this can be done by creating a provision at the charter’s drafting called a “blank check preferred” which allows the corporation to create new series without approval. See DGCL § 151(a); MBCA § 6.02(a).
Warrants and Options
Warrants and options are not equity, but instead the right to purchase equity at a specified price on or before a specified date.
Warrants are often offered in addition to debt financing. In other words, lenders will likely lessen the interest rate in exchange for the right to exercise a warrant.
Options on the other hand are often offered to employees as an incentive plan (work here and we’ll give you an option to purchase stock). Typically, an option will “vest” when the employee has worked there for a certain period of time (you can’t exercise the option until it has vested, meaning no access to the money until then).
Corporate Law Requirements
Issuing warrants and options requires board approval. DGCL § 157; MBCA § 6.24.
Internally Generated Funds
Businesses can also fund themselves by making sales and applying the proceeds to business expenses. Additionally, businesses could sell some of their assets to finance the business.
Capital structure references the balance between financing through both debt and equity. Below are some ways this structure varies depending on the type of funding provided.
Ownership dilution only occurs through equity changes. Changes to the debt will not affect ownership.
Leverage can only be utilized in debt scenarios. It is the principal that when you make an investment with debt funds, you retain any gains or losses of that investment. Thus, if you increase your leverage by accepting more debt (and thus your risk), you are much more likely to make more money in a quick turn-around time (assuming everything goes right).
Debt needs to be repaid, even if the business is struggling.
In the event of bankruptcy, debt will beat out equity.
Debt interest is deductible while dividends from equity dispersement is not.
Businesses prefer debt over equity. If the business relies primarily on equity first, it is generally because they have to.
Federal Securities Regulation
Any security sale is regulated and either needs to be registered or exempt. Because stock is a security, the federal securities regulations need to be satisfied for each transaction.
Registering an Offering
The company must file a registration statement that involves several pieces of documentation describing the financial position of the business. Then, the filing is reviewed, comments made, and revisions provided until the registration is “effective.” At that point, the sale could occur. The whole purpose of the registration is to ensure that investors are well informed before making an investment decision.
Section 4(a)(2)/Rule 506
Public offerings must be registered but private offerings do not. Rule 506 serves as a safe harbor to determine whether the requirements of 4(a)(2) are satisfied.
SEC v. Ralston Purina Co.
346 U.S. 119 (1953).
Ralston Purina provided several offers to their “key employees” to purchase stock in the corporation. The SEC said that this was a public offering not subject to the exception.
A public offering does not require that the offering be made to everyone. The offering can be made to few or to many and still be considered public. What turns the offering to private depends on the knowledge of the individual who is made the offer. If the individual would have access to the same kinds of documentation required by the registration, then the filing can be considered private. However, if the individual does not have that access, even if they are an employee, then the offering is considered public.
This rule allows a business to make an offering to as many individuals as it wants, as long as the offering does not exceed $5 million in a 12-month period. No information requirements are necessary. However, these are still subject to state security laws.
The process of gathering small amounts of money from large numbers of people. Typically, selling securities through crowdfunding is not a viable option.
Private Placement Memorandum
Basically, this is a letter to the investor providing them with the information that would otherwise be required in an investment.
Definition of Security
Securities include: notes, stock, bonds, debentures, evidence of indebtedness, transferable shares, investment contracts, voting-trust certificates, put, call, straddle, option, warrant, etc.
The biggest question with this definition is how an investment contract is defined.
Securities and Exchange Commission v. W.J. Howey Co.
328 U.S. 293 (1946).
Howey was in the business of land development. At one point, the corporation engaged in several contracts where the land was sold to the investors, not for development, but simply as an investment. To sit there and watch it grow.
An investment contract means “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”
In other words, invest in my business to return a profit, and that is an investment contract.
The content contained in this article may contain inaccuracies and is not intended to reflect the opinions, views, beliefs, or practices of any academic professor or publication. Instead, this content is a reflection on the author’s understanding of the law and legal practices.