CORPORATE FINANCE – FALL 2010 PROFESSOR GERALD BROWN 1. Publicly traded companies: a.
These companies have shares of their equity securities (ie. Common stock) listed and traded on an organized stock exchange. i. They are required to fill out periodic reports under the exchange act. ii. The reports are available to the public. iii. The first time a company offers and sells stock to the public is called an initial public offering or IPO. iv. A company’s sales of common stock to the public effected after its IPO are referred to as secondary or follow up offerings. v. The Securities Act requires each prospective issuer to file with the SEC. the registration requirements are two parts 1. Prospectus: is the disclosure document that the issuer and those underwriting the offering use as a selling brochure. 2. Information not required in the prospectus: sets for additional information that an issuer must file with the SEC but need not send to the prospective purchaser. vi. To help with the sale of the stock the issuer typically hires one or more underwriters. Underwriters are normally investment banks with expertise necessary to place the issuer’s stock into the hands of public investors. In other words underwriters are outsourced sales force that the issuer hires to get the offering sold. In return they receive a commission. 7% a share. vii. The Exchange Act comes into play after the IPO. Once the company goes public those shares will be bought and sold by investors over the organized stock exchange. 1. Exchange act requires that the company make and keep books and records accurately reflecting the transactions and maintain an internal system of accounting using GAAP. 2. Exchange act requires reporting companies to file periodic reports with the SEC viii. Pros of going public: 1. Lower cost of capital. When equity markets are strong the cost of capital raised through a public offering is typically lower than the cost of capital raised in the private market. 2. Liquidity: by going public and listing its securities on an organized stock exchange a company creates a liquid secondary trading market for its stock. 3. Exit strategy: by going public a company gives its existing stock holders (its founders usually) an avenue to cash out, ie turn their illiquid stock into cold hard cash. 4. Acquisition currency: by going public a company can facilitate acquisitions of other companies by using its stock (either in a stock for stock deal or stock for assets deal). 5. Control: the placement of shares in the hands of a large number of public stockholders each of whom owns a relatively small part is likely to permit current management to continue to control the company. In a private financing by contrast a company very often has to transfer a certain degree of control to private investors. 6. Prestige: a company increases its exposure and prestige by going public. ix. Cons: 1. Commitment of management’s time: preparing the registration statements and all the disclosure stuff is time consuming. 2. Going public is expensive. Typical costs range from $300000 to 800000
3. Living in a glass house. By going public they become a reporting company and this means the company must satisfy continuous and formal reporting requirements. 4. Hostile takeovers: going public could open the company up to a hostile takeover attempt. If a hostile party acquires enough shares of the company through a hostile tender offer it can oust management completely. 5. Focus on short term results: because communication with management and the stockholders is minimum at best the stockholders judge management’s performance based on its returns. There is a lot of pressure on management to focus on short term results often to the detriment of long term shareholder value. 2. Privately held companies: a. These are companies that are not reporting under the exchange act. They don’t issue securities to the public through an IPO. They don’t have a liquid secondary trading market for their shares. Thus, there is no readily available market price exists for their shares. b. Four attributes i. Limited number of shareholders ii. Generally run by managers who are stockholders, receiving compensation through salaries. iii. No secondary trading market exists for shares of closely held companies. iv. Formal (contractual) restriction typically influence their corporate governance and their stockholders’ ability to transfer shares to third parties. c. Shareholder agreements: i. Usually in privately held corps the shareholders enter into a buy-sell or shareholder’s agreement at the time they make their investment. Contingencies covered by this agreement include stockholder voting, the alienation of stock and the valuation of stock. ii. A given shareholders agreement usually contains provisions affecting the ability of the stockholders to vote their shares freely. Sometimes require unanimous stockholder consent to certain fundamental transactions. iii. These agreements can also be voting agreements. iv. They prevent shares from falling into the hands of strangers. These provisions include forced resale and transferability restrictions. 1. forced resale prevents shares from falling into the wrong hands. Upon the occurrence of one or more specified events the stockholder in question is forced to sell her shares back to the company. a. Usually happens with termination of employment, death of stockholder. 2. Restrictions on transferability: in order to control the identity of those who own shares most shareholders agreements severely restrict the ability of a stockholder to transfer her shares to a third party. a. First type: right of first refusal: if a stockholder receives an offer from a third party to buy her shares she must first offer her shares for sale to the company, the other existing shareholders, or both on substantially the same terms as the third party offering. b. Second, right of first offer: if a stockholder desires to sell her shares, she must first offer them for sale to the company, the other existing stockholders, or both on terms previously agreed upon and set forth in the shareholder’s agreement. 3. Capital Formation a. When someone provides funds to a corporation that person wants something in return, either an equity or interest b. The giver of capital will be either an owner (equity interest) or a creditor (debt interest). c. BALANCE SHEET: main financial statement that is relevant. i. THREE BASIC ACCOUNTING STATEMENTS:
1. Statements of Income showing gain or loss for the period: income statement measures the financial performance of a company over a given period of time. It includes the company’s total revenue and expenses and then presents the difference as net income or loss. 2. Balance sheet showing assets, liabilities at the end 3. Statement of cash flow showing the actual flow of cash: the balance sheet and income statement are prepared using the accrual basis of accounting. Statement of cash flows presents a company’s financial information under the cash basis of accounting. This statement is useful because it provides answer that the other accrual based financial statements cannot. These include from 1. What sources did the company generate cash during the period, 2. how did the company use the cash during the period and 3 what was the change in the company’s cash balance during the period. ii. Balance Sheet Three parts: 1. Basic equation: OE = A – L. Owner’s equity (what the owners own individually) = Assets (what the corporation owns, their capital) - Liabilities (what it owes creditors). 2. The Balance Sheet: a. It reflects the assets and the liabilities and the owner’s equity NOT at market value, but according to GAAP (assets historical costs or original costs). b. Balance sheets can be misleading. iii. Balance Sheet in Depth: 1. The balance sheet provides a snapshot of a company’s financial position. Snapshot is used because the balance sheet provides information on a given date as opposed to a period of time. 2. It summarizes what a company owns (assets), what it owes (liabilities) and the difference between the two (shareholder’s equity) on a given date. d. ASSETS i. Assets are the first category listed on a company’s balance sheet. Assets are anything that a company owns that has economic value. A company purchases assets to increase its value or benefit its operations. It can develop assets like intellectual property. ii. Assets are listed in decreasing order of liquidity. From current assets to long lived assets. iii. Liquidity refers to a company’s ability to convert an asset into cash, with assets more quickly convertible into cash being viewed as more liquid than others. Thus, current assets are more liquid than long lived assets. iv. Accounts receivable: money owed to a company by a customer for products or services provided on credit. v. A current asset has a useful life of less than one year. This means that the assets is fairly liquid and can be converted into cash within 12 months. Examples of current assets include accounts receivable, inventory, marketable securities, prepaid expenses, and cash balances. vi. A long lived asset is one that has a relatively longer useful life and is not as easily converted into cash. These are fixed assets like property, plant equipment, and intangible assets such as goodwill and patents. vii. Under GAAP all assets on the balance sheet are valued at their historical costs. This leads to more conservative figures. e. Liabilities: i. Liabilities are debts that a company owes to creditors. A company’s liabilities are broken down on its balance sheet in a manner similar to assets. Thus current obligations that a company must pay in one year or less are listed first as current liabilities. These may include accounts payable, accrued expenses, and the portion of a long term debt due
v. vi. f. Shareholder’s equity: i. Reflects the claim of a company’s owners—its stockholders—to the company’s assets remaining after all the company’s creditors have been paid in full. It is the difference between the total value of a company’s assets and its liabilities. ii. SE = Total Assets minus Total Liabilities. iii. Shareholder’s equity reflects the fact that if the company were to sell all its assets and use the cash to pay off its debts, the residual money that remains would belong to the stockholders. iv. The stockholder’s equity section is generally broken down into three accounts: 1. Capital stock at par value; 2. Additional paid-in capital referred to as capital surplus and 3 retained earnings. v. The first two categories constitute the capital contributed by the investors who bought shares of stock directly from the company. vi. When the initial investors in a company resell their shares to other investors either privately or over a stock exchange in the secondary market, the company’s capital stock at par value account and APIC account are not affected. Only initial issues of stock by the company itself - so called primary offerings - affect these accounts. Moreover if shares trade in the secondary market, changes in their market value do not affect these accounts. Therefore the value listed in the capital stock at par value and APIC accounts (ie the accounting value of a company’s stock) and the aggregate value of the stock trading in the secondary market are usually not related. For financial analysts and corporate executives the accounting value of the stock is not important; it is the market value that matters. vii. The third category of shareholders equity is retained earnings. Retained earnings represent the earned capital of the company that has not been distributed to the stockholders. The main source of retained earnings is income from a company’s operations. g. Owner’s Equity i. Equity is an ownership interest in a corporation in the form of common stock or preferred stock. It also refers to total assets minus total liabilities in which case it is referred to as shareholder’s equity or net worth or book value. ii. The balance sheet will show for owner’s equity stock and retained earnings: earnings that have not been distributed iii. But it will NOT show if employee’s have an option to buy stock or an investment banker has a warrant to buy stock. h. i. Historical costs = original costs. ii. Limitations of the balance sheet. 1. Balance sheet does not tell you how you got the assets. 2. It does not tell you the fair market value of the assets. (Depreciation) 3. It does not show good will or what a business is worth as a going concern.
within the current year. Obligations that are not due within the next 12 months are listed as long-term liabilities. Liability side: Balance Sheet These are booked according to GAAP 2, meaning that a liability is not booked until it matures. So it won’t show contingent liabilities (a liability that is hard to quantify or which may or may not come to pass such as a outstanding lawsuit.) It is probable that you have a liability but it has not fully matured and you don’t know how much it is. So your liabilities will likely be more than the books show. Accounts receivable is money owed to a corp by a customer for products or services provided on credit. Your receivables may be less, and your liabilities may be more.
i. EX: there could be a business that has only 100000 of hard assets shown on the books, but it makes 200000 in profits, that business has good will because if you went to sell it and you bought it and in the first year it creates 200000 in profits you will get something for it. FOUR LIMITATIONS The historical approach to valuing assets and liabilities requires the omission of the current fair values of most assets and liabilities. Depreciation of tangible long lived assets such as plant and equipment also contributes to the understatement of asset values on the balance sheet. Depreciation is an accounting process that allocates the cost of long lived assets to expenses. Depreciation only applies to tangible long lived assets. The cost of intangible long lived assets like goodwill and patents is allocated in a similar manner but is known as amortization. Amortization: The gradual elimination of a liability, such as a mortgage, in regular payments over a specified period of time. Such payments must be sufficient to cover both principal and interest. Writing off an intangible asset investment over the projected life of the assets. Intangible assets with definite useful lives are amortized systematically. For example, the price paid to obtain a patent can only benefit a company for up to 20 years. Therefore, the price of obtaining the patent is allocated to expense systematically over a 20 year period. By contrast intangible assets with indefinite useful lives such as good will are allocated to expense only as their value becomes impaired. Working with the balance sheet: A company’s balance sheet provides a basis for computing its rates of return, measuring its exposure to debt, evaluating its capital structure and assessing its liquidity and financial flexibility. RATE OF RETURN o Two primary measures of return are return on assets and return on equity. ROA indicates how much income is generated from each dollar of assets. ROE indicates how much income was generated from each dollar of shareholder’s equity. 4. EX. If Ed contributes 10000 to the corp and the corp buys land for 10000. And oil then found and the land is now worth as 10000000, the land is still worth 10000 on the books. 5. Ex. The converse is true, if you buy the land for 10000000 and they open a garbage dump and now only worth 10000 that is not on the balance sheet. 6. Ex. If the corp develops intellectual property, doesn’t buy it, that will be on the books for very little or for nothing. The value of the patent will not be on the books. 4. What is CAPITAL: the funds you need. a. You cant start a business without capital. b. All businesses need capital to operate, except the most simple service business thinkable (babysitting). c. Providers of capital can give you assets in kind. d. 99% of the time the corp raises cash and buys the assets or capital it needs to run the corp. e. Working capital: rent, inventory. f. Selling products on credit: accounts receivable. g. When capital is raised you can use it to buy assets like land and equipment or keep the cash and use it as working capital. h. When a corp receives cash (capital) from a provider of capital that provider wants something back. i. The government can give capital in the form of tax subsidies and grants. i. When the government does this it is usually to entice a corp to locate in its town so that the corp will produce jobs, attract other businesses, and stimulate the economy. So the government gets indirect benefits. ii. The local governments do this by either providing land at lesser than market value or tax incentives. They usually don’t take equity interests.
iii. However, they do make these corps sign agreements that they wont leave. Basically saying that you agree to provide x jobs for z years and bring w to the economy. If you don’t then you have to pay back some retrieval or recapture. 5. Providers of capital want either an equity interest, debt interest or, hybrid interest a. Debt interest: they become a creditor and they are expecting the debt to be repaid with interest. If you buy a debt interest, you will also get a security representing that interest and a loan agreement. Someone with a debt interest is called a creditor b. Equity interest: an ownership of the corp. usually in the form of stock, they would get paid periodically with the income of the corp in the form of dividends. If there is a liquidation or the company sells they will get something. Someone with an equity interest is called an owner. i. When there is an equity interest you may also have a vote in the corporation. However, corps can issue nonvoting stock. ii. You get a dividend and if no dividend it increases your interest or stake in the company and if liquidated you would get paid, you also will have a voice as a shareholder if there is voting stock. c. DIVIDEND: A taxable payment declared by a company’s board of directors and given to its shareholders out of the company’s current or retained earnings (usually quarterly). Dividends are usually given as cash (cash dividend) but they can take the form of stock (stock dividend) or other property. Dividends provide an incentive to own stock in stable companies even if they are not experiencing much growth. o Hybrid Interest: if I want a piece of equipment and I don’t have the money, I as an owner can buy the equipment from a vendor and borrow the money and finance it from taking a loan from the bank or I can get a hybrid interest. Vendor, lender, lessor. You can go to a lessor, someone who leases. The equipment is sold to the lessor and the lessor takes title and then leases to me the whole life of the equipment and then over the life of the equipment I pay them the cost of the equipment and interest. In a way you could call it a hybrid transaction. Something more close to a hybrid: in a typical debt/creditor relationship everything is fixed to the market, without regard to the profits of the corp. If the issuer corporation borrowed money from a creditor but bc of market conditions and the nature of the creditor they might have to say (hybrid) we’ll pay you five percent interest, plus something more each year based on my earnings the profit. And more likely than not a weak debtor would do it. SO it is like you are paying them interest on the debt and dividends. Use hybrid where there is a shaky corp when they will get two part interest, one is fixed and is tied into prime rate and the second part is based upon the corp’s profits (dividend). o Most hybrids have a debt on its face, but two parts: fixed interest and some additional interest based on the profit or the income of the corporation. o Same example, if a creditor is loaning money to a shaky corp, I will loan you money, instead of additional interest I want a KICKER, a right to buy your stock at whatever value when I want, therefore if you make it I will buy it. I will take equity or warrants as part of a package. This is called a debt equity package. o ISSUES WITH HYBRIDS: When you talk about equity and debt together you have a different situation that you could run into a closely held corporation. If you provide both the debt and equity or multiple shareholders provide the debt and equity proportionally. The tax issue is: the IRS may come and say that 60000 is not really debt it is equity and therefore you need to pay taxes on it. If it is held to be equity rather than debt then the so-called interest is a dividend and not deductable to the corp. If a corp pays off the creditor there is no tax consequences to the creditor only tax consequences on payments of interest. If the shareholders of a closely held corp put in the debt proportionally. There is an issue of whether this is really debt for tax purposes.
o Resolve whether it is debt or equity when representing a closely held corp. o A promissory note can have a base interest with an interest on earnings-this is hybrid o The package is rather than that you get a note with interest and a warrant to buy stock later. CAPITAL FORMATION Two more things for capital formation: o Internally generated capital. If a corporation does not give dividends from their earnings it will get generated capital. If it retains it, it is internally generated capital and should increase the value of the stock. o Another means of raising capital indirectly other than not paying dividends: it is using a joint venture or a strategic alliance to raise capital. o Strategic alliance: A Strategic Alliance is a partnership between businesses in which you combine efforts in a business effort. The joint effort can involve anything from getting a better price for goods by buying in bulk together to seeking business together with each of you providing part of the product. The basic idea behind strategic alliances is to minimize risk while maximizing your leverage in the marketplace. o Joint venture; A contractual agreement joining together two or more parties for the purpose of executing a particular business undertaking. All parties agree to share in the profits and losses of the enterprise. If A and B entered into a strategic alliance that will indirectly help A. Difference between a joint venture and a strategic alliance is if the two form a third corp to do the deal that is a joint venture, if they don’t and they sign an agreement to do a deal it is a strategic alliance. in a big construction deal, they got together for a strategic alliance or a joint venture because either neither one could do it alone financially or they did not have the bonding power (no one would give them a bond). When they are building new roads more than one company is involved (one does paving, one does bridges). Very limited joint ventures and strategic alliances historically However now: in the new economy: looking at wireless telephone, tv, biotech, computer, there are a lot of joint ventures today and a lot of strategic alliances where more than one company gets together to provide financing. Usually it is in high tech and pharmaceudicals. The biotech comes up with the drug it does not have the capacity to manufacture and distribute so it hooks up with Merck and they manufacture, distribute, and market. Now we see a lot of this and this indirectly generates capital. o The easiest example are biotech. Little company develops a drug, does not have the money to create manufacturing facilities or market. Rather than to go out and raise money to do it they go out and do a joint venture with Pfizer or Merck. PROCESS: how do investors or contributors contribute or invest the capital: o Public offering is when a corp goes on the market and sells either stock or bonds to the public in an offering. o Private placement or private transaction i. Debt Instruments: three main types of corporate debt securities exist: bonds, debentures, and notes. All three represent contractual claims against the corporate borrower. Each is evidenced by a promissory note which incorporates the terms of a lengthy contract, typically called an indenture. Each security represents a promise by the borrower to pay the amount borrowed on a specified maturity date, together with interest at specified times until that date. a. An INDENTURE is a contract between the issuer of debt securities and the indenture trustee. The trustee typically is a commercial bank that acts as the agent for the actual holders of the debt securities and serves to protect their rights. b. In practice there is no clear cut definition of bonds, debentures, or notes. The term bond is in fact sometimes used to describe a debenture or a note as well as a bond. i. BONDS:
1. Bonds are long-term promissory notes with maturities of 30 years or longer that are secured by collateral of the corporate issuer. Corporate bonds are normally issued in denominations of 1000 dollars. The denomination is also known as the bond’s face value or par value. 2. An investor pays the face value when she purchases a bond at its issuance. The issuer must repay this amount to the investor on the bond’s maturity date. 3. The rate of interest on a bond is referred to as its coupon rate. This refers back to the time when each bond was represented by a certificate which said that they have a right to interest and principal. 4. Terms of a particular issuance of bonds are set forth in a contract called the bond indenture. 5. The corporate issuer and the indenture trustee are signatories to the bond indenture and thus stand in privity of contract. The bond holders themselves are technically third party beneficiaries of the contract. ii. DEBENTURE: 1. A debenture is a long term unsecured promissory note. 2. Thus the main difference between a debenture and a bond is that the former is an unsecured obligation of the corporate issuer while the latter is a secured obligation. 3. Debentures usually have shorter maturities than bonds, such as ten to 20 years as opposed to 30 but this is not always true. 4. Terms of a particular issuance of the debenture are set forth in a contract called a debenture indenture entered into between the corporate issuer and the debenture trustee. 5. Other than this name a debenture indenture is substantially similar to a bond indenture. iii. NOTES: 1. Notes are short-term promissory notes with maturities ranging from five to ten years. Notes may be either secured or unsecured obligations on the corporate issuer. 2. Terms of the notes are set forth in a contract called a note agreement. Other than the name, a note agreement is substantially similar to a bond indenture except in one respect. Because notes are often issued to only a handful of investors, each note holder is often a direct signatory to the note agreement. Thus the corporate issuer may stand in privity of contract with the note holder’s directly rather than with a trustee. 3. More flexibility with maturity date (5 to 10 years). ii. DEBT INSTRUMENT: least to most formal. You want to have an instrument because it memorializes the deal and provides proof that the deal went down. i. OPEN ACCOUNTS PAYABLE: Simplest which is really not an interest: if a vendor provides a corp with a product or service on credit. I give you a service or product and you pay me at end of month. No instrument. But if no interest then there is no promissory note, what do you do if you have to sue. THE OPEN BOOK ACCOUNT WHICH SHOWS ACCOUNTS PAYABLE. The accounts payable will probably be the only written evidence. But maybe other underlying evidence but not an actual debt instrument. Ex) phone service, cable, etc. ii. Promissory Note: The creditor who gives the money makes the corp sign a note saying I agree to pay $W to creditor X on date Y at interest rate Z. This promissory note can be negotiable or not. The negotiable promissory note can be transferred, or assigned. A nonnegotiable and negotiable promissory note is revealed by the language of the promissory note. If it is negotiable you can assign it to someone and they will be liable for the debt and you pay him. iii. Commercial Paper: rarely see. This is issued by corporations that need varying amounts of money to operate on a short term basis. Need diff amounts at different times. They are short term notes that usually have a 60-90 day maturity. Usually purchased by institutions or very wealthy individuals. It is a short term bond. iv. Debentures/Bonds: 1. The corp can go into a public offering and offer the bond or debenture. 2. Private transaction between a corp and a bank. 3. A bond usually has a maturity of around 5 years. Bond and debenture are used interchangeably.
4. Usually have a life of 5 years, but nothing legally says that you cant have it longer. A lot of authors will use one term for secured and one term for unsecured. No one will buy a bond unless the creditor or the buyer is going to receive interest or money for the use of its money. It is consideration. 5. A corporate bond normally has a face value of 1000 and pays interest semi-annually at its stated rate of interest (its coupon rate). During its life, it is an interest only bond. This means that its corporate issuer pays interest over the bond’s life, but only repays principal (the bond’s 1000 value) in one lump sum when the bond matures. a. If the bond’s original purchaser holds the bond until its maturity she will receive the full 1000 face value plus of course interest along the way. However, that purchaser need not hold onto the bond until its maturity. Instead if the bond is listed on a stock exchange for trading purposes she can resell it in the secondary market to another investor. The important question is at what price. b. Although the corporate issuer is obligated to pay interest at the bond’s coupon rate to any secondary market purchaser of the bond, investors seeking to buy bonds in the secondary market demand an interest rate (a yield to maturity) YTM competitive with the current market rate on similar newly issued bonds. That rate however, may be higher or lower than the existing bond’s coupon rate. Because the existing bond’s coupon rate cannot be changed, the only way to raise or lower its YTM in response to current market conditions is for the bond to sell above (ie at a premium) or below (ie at a discount) its 1000 face value. c. I think in a secondary sale when the coupon rate (interest rate of the bond) is below the market rate you sell the bond at a discount. If the coupon rate is above the market rate then you sell it at a premium. b. Equity Instruments: Two kinds, preferred and common stock. i. Preferred Stock: 1. this stock has a preference as to dividends and liquidation. 2. So holders of preferred stock get their dividends before the common stock holders. 3. Preferred stock dividends are usually limited to 6% a year. $100 of preferred stock you get $6 a year 4. This is regardless of how profitable the entity is 5. Most of the time it is nonvoting but it could be voting. ii. Common Stock: 1. If only one class of stock in a corp then it is common stock. 2. It gets whatever dividend is declared after the preferred gets their money. The preferred gets money first and then the common gets the residual. 3. Usually common stock is voting but there could be nonvoting common stock. 4. If a liquidation the order to who gets paid first: debt, stock (preferred, common). iii. Warrants/Options: 1. In theory they are the same in that they give the holder the right for a fixed period of time to buy or sell shares of stock at a fixed price. 2. E.g. If I have an option to buy stock at $10 a share for 10 years and in the 9th year the stock goes up to $100, then I can buy shares of the $100 stock for $10. 3. Employees get stock options. More prevalent in the late 1990s. 4. The advantage of giving employee’s stock is that they did not take out cash or take a hit on earnings for accounting purposes. 5. Warrants are the right to buy stock at a stated price for a stated timeframe. Usually given to an investor or investment banker. c. Convertible Instruments: i. Debentures/Bonds: When the corp issues a bond it is a debtor and the person receiving it is a creditor. You can get this bond or debenture to be convertible into common stock. ii. E.g. You buy a hundred dollar bond that is convertible into stock at $120. When the stock goes above $120 you are in the money and will want to convert.
iii. When you buy a convertible bond you are protecting yourself as a creditor, so if they default you can buy equity in their company. But if the company does well and the stock goes up you can convert it into shares of stock. iv. Also, a corp can issue preferred stock that is convertible into common stock. v. Debenture is convertible into common stock in unstated terms. If you convert you pay for the stock with the bonds, and you give them the bonds and you get the stock. You don’t get both**** d. Use of Separate Agreement in connection with debt instruments: i. When a corp goes to a bank and takes out a loan it signs a promissory note. ii. They will usually always put extra conditions and restrictions on the corp to protect the bank. This is called the loan agreement and will be very long. iii. They will tell the corp 1. Every year you must give me a financial statement 2. You cant pay dividends until you pay the loan off 3. We can restrict salaries iv. So basically there is always a promissory note with a huge loan agreement. e. In a public offering of bonds, an offering to the public, since they are sold on the market you cant sign a loan agreement, however these bond holders need protection just like the banks in a private transactions but no way to negotiate because there is no way to know who they will be. i. Under the trust indenture act of 1939, the debtor corp enters into a trust indenture with a bank, a trustee, the bonds are issued and the trustee has the responsibility to enforce the terms of the indenture. Not required in private transactions because of privity. ii. Publicly traded securities (trust indenture): iii. Use of a separate agreement in connection with stock of a closely held corporation: A public offering of stock is sold with an indenture or protection. But if five people buy stock in a closely held corp the five people in the corp will generally enter into a separate agreement saying they wont sell the stock, it adds conditions and requirements. a. RETURN ON EQUITY INVESTMENT AND EQUITY/DEBT LEVERAGE i. In its most basic terms, leverage is the financial impact on a company when it borrows money (ie takes on debt). In fact those operating in finance use the term leverage and debt interchangeably. The greater a company’s debt load in relation to its shareholders’ equity the greater its leverage. ii. Like a lever resting on a fulcrum, debt financing increases the potential for greater gains or losses on a company’s common stock. This potential is often referred to as the leverage effect, and it occurs for two reasons. 1. First, a lender of capital e.g. a commercial bank or bond holder has a fixed contractual claim on a corporate borrower. That claim is limited to the payment of interest and the repayment of principal in accordance with the contract evidencing the debt. Thus, the return to the lender is capped at the rate of interest associated with the debt. 2. Second, the return that a company earns on its use of borrowed funds is not limited. It may be more than, less than, or equal to the rate of interest associated with the debt. Because stockholders of a company have a residual claim to whatever monies are left after the lender’s claim is satisfied, any return on borrowed funds that exceeds the cost of those funds accrues solely to the stockholders. iii. Example of the leverage effect: assume that DBR Corp. has the chance to pursue a new project that requires a 100000 dollar investment. Dbr expects the new project to earn 14K per year, return of 14% on its 100K investment. DBR invests 50K in the new project using the proceeds from the sale of common stock. It finances the other 50K by borrowing those funds from a commercial bank at an interest rate of 12% per annum. Thus, dbr will be required to make an annual interest payment of 6K on the loan. For purposes of the following, assume that dbr faces no transaction costs or allowances and that the tax effects of the incurring debt are ignored. If dbr’s expectation is realized, leveraging the investment will increase DBR’s pretax cash flow more than if it had financed the investment solely from the equity. As seen below dbr will receive a 16% annual return on its 50K equity
investment by borrowing the other 50K at a 12% interest rate and reinvesting it into a prject that returns 14%. 1. Return on equity (%) = (investment return –interest payment)/equity = (14K-6K)/50K = 8K/50K =16 or 16%. 2. This result compares favorably to the 14% return on equity achieved when DBR uses 100% equity to finance the same project. 14K-0/100K=14K/100K=14 or 14%. 3. Importantly DBR must receive an annual investment return from the new project of at least 12% for the leverage to benefit the company. if the project were to earn less than that the leveraging would work against DBR. If the project only earned 10% then DBR’s return on equity would fall to 8% because the project is earning less than the cost of borrowed funds. At the 12% breakeven point there will be no gain or loss from the use of the leverage assuming no transaction costs. iv. PURE LEVERAGE EFFECT: consider multiple investment projects. See pages 210-212. EXAMPLE 2 of LEVERAGE EFFECT: b. Million put in and get 100000 back you get 10%. Instead of a million of your own, you put 500000 of your own in and 500000 of the banker and you can pay the banker less than ten percent interest. Your return would increase. You scalped 5% if you need to pay the back 5%.* c. If you borrow at the same rate as your earnings on the investment it has no effect***** d. If you borrow at less than the return you get your ten percent plus what you borrowed you are making more than you did in interest. e. If you have to pay more than earning on banking interest it hurts you. This is called leverage. f. You are leveraging your money and increasing your return: this is called playing OPM (other people’s money). If I can get other people’s money and I can put it to work and make more than I have to pay them in interest I am going to make money. I can leverage the business. g. Leverage is use of debt to finance an activity. Basically, the use of fixed costs in order to increase the rate of return from an investment. For example, one usually borrows money in the form of a mortgage to buy a house. h. Leverage represents the portion of a company’s assets financed with debt (e.g. bank loan or bonds) and therefore involves contractual obligations to pay interest and principal. The more debt that is added to the company’s capital structure the more uncertain the return on common stock. i. The total debt ratio provides creditors with some idea of a company’s ability to withstand losses without impairing its interest of creditors, primarily the timely payment of interest and principal payments on loans. The lower the ratio the better for creditors as there are fewer contractual claims on the assets of the company. j. Total debt ratio: total liabilites/total assets. k. Debt to equity ratio: total debt/shareholder’s equity. l. A company with much more debt than equity is generally called "highly leveraged." Too much leverage is thought to be unhealthy, but many firms use leverage in order to expand operations. 1. If you are getting involved in the issue of return on investment the moral of the story is what they mean by return or investment. m. I put in one million and the corp makes 100000 then my return is 10%. n. Assuming this company needs 1 million capital and will make 100000 dollars am I better or worse or same in my return when rather than putting 1 million I put in 500000 and get 500000 from the bank. Cant tell until you see how much the borrowed money is. o. To be better: you have to borrow the 500000 at less than 10% interest or what I am making I am better leveraging it. p. If I can borrow at less than the business is returning I can maximize or improve or increase my return by borrowing part of the money. q. If I borrow at 10% it is a wash. If I have to borrow at more than 10% I am losing on the deal. r. If you have preferred and common stock you have the issue of how much of the earnings should be allocated to the preferred stock before you come up with the residual to the common stock. s. Define your terms when you do an agreement because it will obviate litigation. t. RETURN:
i. What does it mean: the dividends paid out, the after tax book income. ii. If the corp buys its outstanding shares, it has two choices with what to do with the shares: 1. Hold them as treasury shares and use them again, or 2. Cancel them and cant use them again. Valuation concepts. Ways to evaluate a company’s worth i. Market capitalization: the number of shares outstanding times the price. This is used by publicly traded companies. If company A is trying to acquire company b they will have to pay a premium on the market cap. If corp a wants to make a tender offer to corp b they will make a premium above market cap to entice the shareholders of the target corp to tender the deal. 1. Market capital: the total value of all of a firm’s outstanding shares, calculated by multiplying the market price per share times the total number of shares outstanding. For example, a current price of fifty dollars for each of its 20 million outstanding shares a firm has a market capitalization of 1 billion dollars. Also called market value. 2. You don’t have market cap in closely held corporations. 3. Thus the best way to value it is Assets/liabilities: hard assets minus liabilities =net hard assets. Good will might be an addition. 4. Used in hostile takeovers. ii. Book Value: is the net worth of the company or owner’s equity shown on the balance sheet. 1. The book value is the simplest valuation method because it is derived from the books of the company (the company’s balance sheet). The book value of a company on any given date is simply the value of its total assets (TA) less the value of its liabilities TL on that date. In other words, book value is the amount of the company’s assets that would be left after the company’s creditors are paid off in full. 2. BV= Total assets-total liabilities 3. net worth does not represent the market value. Book value is lower than market value generally because book value does not account for the fact that earnings can increase in the future or other potentialities, or goodwill or what the company can easily grow into. 4. Book value is a conservative estimate of what the company is worth. iii. Adjusted book value: 1. The adjusted book value approach attempts to keep the simplicity of the book value method while eliminating the conservative asset valuation. Under the adjusted book value approach asset values listed on the balance sheet are restated to reflect their current market value. Once this is done the adjusted assets values are plugged into the basic book value formula. a. Adjusted BV= (current market value of Total assets)-Total liabilities. iv. Liquidation value: 1. Pure liquidation value: you stop doing business and sell all your assets. In such a situation you are not going to get what you want for your assets. 2. Example: inventory. If you sold it in the ordinary case you would get X but if you liquidate you would get less than X. I may be willing to pay 100 for shoes at retail but if they are liquidating and they are trying to get rid of their merchandise they will have to sell for lower. Similarly if someone is going to buy all of their merchandise they will get it at a discounted rate. 3. Once you liquidate and sell your assets and pay off your debts and liabilities the residual goes to the shareholders. 4. Possibly the liquidation value is more than the market cap because when they are operating the business they are losing value but they own property new york and if they sell it they could make money or the company has some IP that is not recognized in the market cap. Goals of a publicly traded company i. They want the earnings up so the executives can get bonuses and they can give out dividends and attract investment. But then for tax purposes you want earnings to be lower. RAISING CAPITAL: Various phases/stages of financing (rounds) i. Examples of various phases/stages
ii. Effect of the underfunding of a phase/stage on a later phase/stage y. Private placements and public offerings: come from the Securities Act of 1933. This act involves the issue of securities. And the 1934 act regulates the markets after the company goes public. i. A public offering is subject to registration ii. A private offering is an issue of securities, bt the private placement is an exempt transaction and exempt from registration. iii. A public offering: a corp issues its debt or bonds, or its stock its equity to the public iv. A private placement: where one two three a small group of individuals without a public offering makes a deal to buy the debt or stock from the corp and is not subject to registration. v. Transactions are either private or public. 1. Public offerings require registration, private offerings don’t. A public offering is when an investment banker offers the bonds or stock to the public in an offering where after the securities will be listed on an exchange and are tradable. 2. A private placement can be a simple two party transaction. It is a privately negotiated transaction. These transactions are exempt transactions and are exempt from securities under the 1933 act: any issuance of a security is subject to the 1933 act unless it is an exempt transaction or security (private placement transaction, deemed that registration is not necessary.) 3. If a corp sells a security to X and qualifies as an exempt transaction so registration is not required. That does not give X the right in a subsequent transaction to sell it and claim that it is exempt. A second transaction would have to qualify in and of itself. z. Typical investors in a private placement. aa. This is the hierarchy of persons who would invest in private placements, debt or equity. i. Founders-owners: if a and b form a corporation and buy all the stock they are the founders and owners. Closest knit deal. They are subject to the 1933 act because there was an issuance of a security. They don’t have to register it but you are subject to it. These are the guys who start the company up and put their money in. ii. Angels: mother and father, family. Because they may not ask whether or not it is a good deal. They are looking at it to help you not whether it is a good investment or not. iii. Other individual investors: social contacts, past business partners. Repeated business owners have groups of people that have invested in the past. iv. Commercial banks: other lending types of entities, GE capital. v. Venture capital funds: real desperate. Venture capital funds are a form of private equity that look for companies that need retooling or getting off the ground, specialize in start up companies, big time venture capital proliferation was before the bubble burst before 1999. Problem with these funds is that they are not like a bank where you sign a loan agreement, but in order to ensure their agreement they through various devices have total control. You don’t go to them unless you really need them, in addition to control they want to provide an intermediate out: venture capital funds want to invest its money and stay in for five years sell it and get out and then make another investment. If they invest in a start up that becomes successful, the biggest appreciation is before it flat lines. They want to put in the agreements someone for them to get out. Or after a certain period of time you have to buy them out. They also protect themselves in the type of instruments they take: convertible subordinated debt. iv. either specializes by industry or specializes in different phases like initial start up, expansion, or product development. Around the bust of 2000, there were many venture capital funds. The one practical problem with this is that once it gives the corp money it wants to get a choke hold and control what is going to happen. They will take board seats, get the corp to agree to certain things like how does the venture capital fund get out in some period of time. In order to protect itself many of these venture capital funds will take a good part of their interest in Subordinated convertible debentures: it is downsize protection. So if it goes belly up they are ahead of the stockholders, they get their money first if there is any money. (explains why they want debentures). They want convertible so they can make it to common stock if it becomes successful. They can sell it and then convert right before the sale. They convert before the public offering. Why do they subordinate it: because if they don’t subordinate it to every day creditors no one will give them
credit. Corporations go through various rounds of financing v. FIRST PHASE START UP. Hopefully you get all your start up funds after the start up. a. What happens if your projections are wrong and you underfund the start up. that is in round one you don’t get enough money to get it going: so it devalues it. If you are talking about debt you have to give them a bigger interest, same with equity, given them a bigger interest. DON’T MISCALCULATE ON YOUR FIRST ROUND OF FINANCING. b. Example, So lets assume that X bought the first round: she put in 1 million. I miss calculated and I need another million. Trying to get the other million, the person who will give it to you will want more than just half. They will want 60 percent interest because you are desperate to get that extra million because the first million was insufficient.******* because if you cant get the other million then the rest is worthless. THUS IF YOU UNDERFUND A PHASE, AND HAVE TO GO AND GET MORE MONEY, THE COROPORATION WILL PAY DEARLY. BECAUSE YOU ARE IN A DISADVANTAGED POSITION. BECAUSE OF THE DESPERATION. D. Parties to a typical public capital formation transaction 1. Corporation (issuer): c. issues the stock or bonds and receive the money. d. And the public who will buy the stock or debentures. e. In the middle you have an investment bank who is called an underwriter. They will bring it to market. They are the selling agent. vi. 2. Investment bank (underwriter) the selling agent. They form an underwriting syndicate. If you go to goldman sachs and hire them to do the transaction. Goldman would be the lead underwriter. They will write the prospectus. They bring everyone else in. Goldman will bring in six others, when they are lead underwriters they bring in goldman. You scratch my back I will yours. Why do they bring in more underwriters: for marketing purposes. Each has their base, or people to sell it to. The issue is that you want to sell it and market it so you bring others in so they can market it to their clients. Goldman would be the lead underwriter and the others would be the syndicate. a. Investment banks: from 1939-1999, you had Glastegal federal law: enacted post depression after 33 and 34 acts in order to protect the public. It separated the investment banking and commercial banking selling of stock. b. A commercial bank could not be an investment bank and vice versa. c. Watered down this law and then repealed by 1999. d. This resulted in operations like CitiCorp. They own a commercial banking company, investment banking, and insurance. e. Comparison with commercial bank and merchant bank vii. C Lead underwriter/underwriting syndicate : see above. Also, there is an underwriting agreement. If you go public, there is a registration statement filed with the SEC, there is a disclosure document given to the people buying it. Then there is an underwriter agreement between the corp and underwriter. viii. In the agreement between the issuer and the underwriter the underwriter can either agree to a firm commitment or to a best efforts deal. 1. Firm commitment: the underwriter will agree to buy a certain number of securities and if they cant sell all of them they are stuck with them. 2. Best efforts: the underwriter just performs its best efforts to sell them. They are not stuck with the securities if they can’t sell them. ix. 3. Investor E. Public offerings: step by step. Order could differ. x. 1. Primary/secondary offerings: two kinds of public offerings. There is a primary and secondary. a. Primary offering: merely means that the corp is issuing stock for the first time. b. Secondary offering: when one of the inside shareholders is selling his or her stock. c. You can have a combination.
d. Sometimes the secondary offering people have agreements with the corp that the next time it does a primary offering, they will also register (piggy back) their shares that they want to sell. Thus in order to dump them they have to register. e. Example: a b and c own a corp. they have initial public offering and sell half the shares to the public and abc still own half. Although they registered the fifty they sold to the public the fifty abc own are not registered and cannot be sold. If a or b or c want to sell shares they must be registered. And they may have piggy back rights. f. Example 2: a publicly held company acquires another company in a merger or stock or asset acquisition and they pay for it with stock, those shares are typically unregistered. Usually those who receive these shares will have piggy back rights so they can sell them. g. EXAMPLE 3: corp xyz, publicly held company. You are the sole shareholder of Corp T. XYZ gets your company through paying you with stock. You now have 200000 shares of xyz you can’t go and sell them. You need to put in there a provision that the next time xyz has a public offering they will piggy back your shares so you can sell them and you pay a little of the registration costs. For those shares to be equivalent to cash they must be tradable and for this they have to be registered. h. To make this transaction exempt you must show that you are acquiring them not for trying to sell them the next day and that you are acquiring them for investment. i. Only diff from public offering and initial public offering is that ipo means it is the first time it goes to market. 2. Firm commitment/best efforts agreements: In the agreement between the issuer and the underwriter the underwriter can either agree to a firm commitment or to a best efforts deal. j. In the best efforts deal: the underwriter says that we will use our best efforts to sell 1 million shares but if we don’t, we do not have any obligations to the issuer. k. In a firm commitment underwriting agreement: the underwriter agrees to eat the unsold shares. Thus it has to buy them if they can’t sell them and then slowly feed them out to make their money back. Thus you need to be a solid company before you get this deal. THE PUBLIC OFFERING PROCESS l. 1. The decision to have a public offering m. 2. Put together the team. From day one until you close the deal you get to know these people well. This becomes a 24/7 job. i. The team consists of reps of the issuer, reps of the lead underwriter, law firm for the underwriter, lawyers for the issuer, the accounting firm for the issuer (must put in x number of years for financial statements). They are at the table from the beginning until the end. n. 3. Now you commence preparation and put together the registration statement and underwriting documents. Go until you finalize it will all financial statements and exhibits necessary to go public. The registration statement is really a disclosure statement, the SEC is there to just verify if all is disclosed. Usually a tug of war between the lawyers and the business people because the more you disclose the more the corp is protected from a lawsuit from a buyer if the stock goes down (if you don’t disclose then violation). The lawyer says disclose disclose disclose. Business people say don’t because I am disclosing info that my competitors will want. o. Keep working on the registration statement. while you are doing this, if the corp is a start up and you need corp cleanup. p. 4. Complete corporate cleanup and commence due diligence: you don’t have all the financial stuff in place. It is a catch up. you commence due diligence. q. Under the 33 act, people who buy the stock have a right of action against the corp for i. a material misstatement of fact or ii. an omission of fact. r. So if I buy and the stock does not perform well and there is a misstatement of fact or omission of fact then I have a claim. i. The due diligence. The young lawyers do this. You will check every fact stated in there to make sure that they are right. If it says that this company has 12% of the market, the young lawyer will go find the documents that show that. s. 5. Distribute directors’ and officers’ questionnaire: their relationship between shareholders, their
t. u. v. w.
x. y. z. aa. bb. cc.
compensation, ect. This is part of due diligence. 6. Circulate and discuss drafts of the registration statement: to officer and directors and they must approve it. 7. Board of directors approves the registration statement 8. File the registration statement draft with SEC and other agencies 9. Receive SEC comments and file amendments in response thereto: this will tell you to make changes or put things in that you didn’t and you go back and forth until you finish. Eventually you reach agreement with the staff on what should be in there. 10. Due diligence meeting: 11. Set price and file the pricing amendment with the SEC: 12. Execute the underwriting documents 13. Registration statement becomes effective with SEC ORDER 14. Press release and public offering 15 Closing : week later there is a closing with the underwriter and issuer and lawyers and underwriter turns over the money and the issuer issues the stock. xi. While this is going one the underwriting syndicate and the issuer holds road shows in big cities and in each city they invite potential buyers of the stock, hold off the record meetings. The issuer and underwriters try to sell the stock. xii. engages in appropriate selling activities including a road show. xiii. They never take the lawyers on these road shows. Reason is, is that they go beyond what they have in the registration statement. paint a little rosier picture for the company’s projections. As long as the stock goes up, people don’t look for misstatements or omissions. Only when the stock goes down because then there will be damages. xiv. There are requirements of each exchange. So if you will list on the New York stock exchange you must meet their listing requirements. xv. Once a company goes public and starts trading: this is what is called the aftermarket. This is governed by the 34 act. This is what governs the quarterly reports.
DEBT TRANSACTIONS: First Issue: when a corp issues debt. o Legal authority to issue debt and opinions of counsel: Since a corp is a creature of the state it only has the authority or powers that the state has given to it. The first basic issue: does the corp have the legal authority to borrow money and issue debt instruments> Today corps follow the modern law and there is not really an issue that it can issue stock, bonds, warrants, or options. o But the corp nonetheless needs the authority from the state to borrow money, issue debt instruments. Second Issue: the buyer of debt wants to be assured that the corp had authority and did everything right in borrow that money and issuing that instrument. In other words, if they have to sue to collect, they don’t want the issuer to ever raise a defense that the borrowing instrument was not properly authorized or exercised. The best way to protect the creditor or lender is for them to receive an insurance policy guaranteeing that if something goes wrong they are protected. Other way going short of insurance is to get an opinion of counsel from the issuer’s lawyer. If you get such an opinion and something goes wrong you can sue the lawyer for malpractice. So there is a deep pocket plus insurance. This incentivizes the lawyer to do all the work and do it thoroughly. o The opinion usually states that the corp has authority to issue the debt or stock, and there are no prior restrictions, the transaction was properly authorized, the board adopted the right resolutions, all the documents were properly executed and delivered, meaning that the resolution was legally binding. o All lawyer’s legal opinions are binding and enforceable against the corporation.
o There will always be exceptions, like for bankruptcy. So the lawyer can have an out. Furthermore, the creditor or lender may protect itself further requiring a note and a security with the loan agreement. LINE OF CREDIT AND LOAN: Line of credit: An arrangement in which a bank or vendor extends a specified amount of unsecured credit to a specified borrower for a specified time period. also called credit line. Loan: An arrangement in which a lender gives money or property to a borrower, and the borrower agrees to return the property or repay the money, usually along with interest, at some future point(s) in time. Usually, there is a predetermined time for repaying a loan, and generally the lender has to bear the risk that the borrower may not repay a loan (though modern capital markets have developed many ways of managing this risk). Difference: With the loan you get the money once, but with a line of credit you can get the money several times. Interest starts on the loan right away. Line of credit in the business world are very common. A line of credit becomes in effect a loan when you draw down on it. o Thus, you have a corp that needs money and the bank that has it. What is the difference between the corp getting a million loan and a million line of credit: a million dollar loan the bank give the corp a million dollars the corp signs the documents and the interest starts running and the corp will pay it back either when its due or over installments. In a line of credit, the bank commits itself to the corporation to allow the corporation to draw down money (borrow) from time to time provided that in no time the amount outstanding over a million dollars. Allowed to pay it back from time to time. A line of credit is like overdraft protection (they allow you to borrow what you go over). What is important is that most corporations to finance their inventory and accounts receivable will use a line of credit and not a loan because the amount varies from time to time. When you do a loan is when you start a business because you need the capital to buy things and when you know the exact amount. o Inventory: lets assume the corp is in the retail business and the big season is Christmas time so they start buying in fall and use a line a credit and draw down as they are buying inventory and start paying it back when it gets close to Christmas when they sell the stuff. Next quarter they wont need it because they are quiet. C. Line of credit: Thus, the million above is called a commitment in a line of credit. The commitment is for a period of time. Million line of credit for 6 months. Two kinds of lines of credit: they have different names o 1. Revolving account: in a revolving account whenever you want money you must notify the bank that I want to borrow 250000 and they would put that amount in your account, then when you accumulate money and don’t need the 250000 you pay them back. Pay interest for the time that its outstanding. (you can have a million dollar line of credit and not draw it down). Almost always in a line of credit regardless what the standing interest, outfront the bank will want a 1 or 2 percent commitment fee for setting up the transaction and keeping that money on hand. Thus, revolving you call for money and pay it back o 2. Sweep account: like an overdraft. You don’t do anything, it is all the computer, you write checks. If you go over the account balance then the bank then loans you the money under the line of credit. If any night the cash balance in your checking account is positive they sweep it out and pay back some or all of the loan. Bottom line: up to a million dollars you are paying interest on the negative balance every night in your account. No money is transferred this is all done by computer. To make the sweep work the loan agreement will provide that the borrower maintain its checking account with the bank and deposit all of its proceeds and revenue in that bank. From the corporate borrower perspective, this type of line of credit is better. Every night they sweep. o The interest does not start until the check clears. This is an adv to the corp borrower. With the resolving door you must call ahead and you don’t know when it will clear. 3. Financial instruments: you sign these at the closing of a line of credit o If the above was a loan at the closing they figuratively give you the million and the corporation
signs a promissory note and a loan agreement and a security document. However, if a line of credit, you go to closing, they don’t give you any money. Wont sign new agreements everytime you draw down the line of credit or pay back. So what happens is that you sign the loan agreement with all the terms for the line of credit, BUT you sign a promissory note at the time of the closing or commitment although you haven’t drawn any money down. The promissory note says the lessor of the one million dollars of the amount outstanding less than one million dollars. It is a promissory note says that only what is enforceable is that which is outstanding. o Most of the time the line of credit is to finance receivables or inventory. Most things that business don’t have enough money to carry all the time. Receivable and inventory as security are floating they are going in and out. If the computer is given as a security and you default he gets the computer. However, if you give me inventory as security that inventory changes every hour. Most business give inventory and accounts receivable as security. 5. Accounting treatment: a million dollar loan, my accounts payable. o The balance sheet shows liability, the amount outstanding. The only way it would show the million dollars if you had a full blown statement with footnotes. ―The amount of the liability on the balance sheet is the amount outstanding‖ o Accounts payable: Money which a company owes to vendors for products and services purchased on credit. This item appears on the company's balance sheet as a current liability, since the expectation is that the liability will be fulfilled in less than a year. When accounts payable are paid off, it represents a negative cash flow for the company.
D. Secured/unsecured debt 1. Particular property as security: the debtor corp can give real estate, machinery as a security. If real estate they follow local real estate laws, if personal property follow UCC. When security is given for a loan it can be with recourse or non-recourse 2. Recourse and non-recourse debt : if it is with recourse that means that if the security is not enough to satisfy the debt when it is foreclosed then the debtor owes and can be sued for the remainder. Non-recourse means that if the creditor takes the security then that is all they get. If it is short then that is it, too bad. Some states are non-recourse for mortgages. 3. Open security (accounts receivable or inventory): inventory and receivables. In other words, I borrow a million dollars to finance my inventory I give the bank a security interest in all the inventory. Buying and selling, they have an interest in all the inventory. Thus, they will always say that I need to have the lesser of a million or the value of my inventory. In other words, if my inventory goes below a million I cant have the amount outstanding. So your security in the inventory must be equal to or more than what is outstanding. o You need to know the business of all the moving parts to know what to take for security. 4. Application of security to debt upon default: If there is a default and the creditor takes the security and sells it and the security does not pay enough to satisfy the outstanding debt it depends on whether there is recourse or not. In a commercial deal there is always recourse. The only way they will do nonrecourse is when you give them security worth 1 million for something worth 500000. 5. Excess security and substitution of security: o Excess security: very rare: excess security: I borrow 1 million and lets assume that the bank wants security of one million and a half (property say). Assume that during the term of the loan for whatever reason that property is now worth five million dollars. Ive got an excess in three and half million pledged. If you are representing the debtor you may want a provision in there that you can use that excess as security for another loan. If you don’t put something in there about this then the documents will say that if I give them security of land then they have all of it. o I railroad borrows money for 99 years and they give as a security a right of way. During the term of the loan people move out west and they have huge excess security because the right away becomes very valuable. The bond holders would not give without them paying, that is they may have a bond issue worth 1 million they have a security worth 100 million. You give land as security with minerals. Oil and gas found then there is huge excess. Simple if you have a provision.
SUBSTITUTION: Another way of solving is caused substitution. The real estate now worth 3 million, I can substitute the 3 million dollar real estate for something that satisfies the million.
Interest Interest bearing: a bond or debenture can be interest bearing that is it will pay x percent interest per atom and the interest can be payable monthly quarterly annually whatever. A bond or debenture is interest bearing at a certain rate. A bond or debenture can either be registered or it can be a coupon-bond. Define coupon bond. The irs wants bonds registered and not couponed so they can trace who they collect income from. If you have an interest bearing bond then you can have an next bullet. The coupon or coupon rate of a bond is the amount of interest paid per year expressed as a percentage of the face value of the bond. It is the interest rate that a bond issuer will pay to a bondholder Original issue discount or premium to adjust stated rate: so assume that a corp authorizes a thousand dollar bond at 6%. Between the time the bond is authorized and the time that the bond is sold privately or publicly, market rates on interest change, six percent is now too low. A comparable bond would bear 8% so they cant sell it. They don’t want to go through the process of destroying all the bonds, so what they do is: depending on how long the bond issue is, all you have to do is that you reduce the issue price (OID). If I want a six percent bond to yield at 8 percent you sell it at 980 and you get six percent on 980 but it comes out as if it was 8% on 1000.******** so you lower the face value if you want a 6% interest to have the same yield as an 8% interest on a 1000 dollar bond. Zero coupon, including mechanics and Federal income tax treatment Trading discount or premium: if I sell a 1000 bond in a public offering at 6% and it is being traded then lets assume the issue remains credit worthy and stable and so the price of the bond on the market does not fluctuate. Lets assume that sometime during the time of this bond interest rates go up. That bond if it trades it will trade at a discount at 8 percent. No one will buy it if they cant get 8%. If the interest rates go down to four percent so that 6% bond will sell for more than 1000. This will sell on what current rates are and the length of time for it to mature. EXAMPLE: With interest rates low today, what they are selling today is lesser than what a comparable company was selling at before. A triple A company that issues a bond today will pay less interest today than 5 years ago, therefore that bond that is out there will sell for a premium that is more. Market has three factors, the rates. The risk. The geopolitical facts. 2. Coupon/registered: zero coupon bond: if I sell you a 100 bond for one year at 10 percent and at end of year I give you 100 plus 10 percent. Zero coupon is that I don’t pay you interest but I sell the bond to you at a discount. So if I sold you the bond at 90 dollars for a year and you collected a 100 you would get 10 percent interest. The problem with these bonds: you are in an unfavorable tax situation. So the only ones who buy these are nonprofits because they will not be paying any taxes due to their except status. Zero coupon bonds are only purchased by tax exempt companies. A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have so-called "coupons," hence the term zero-coupon bond. Investors earn return from the difference between the discounted price of the bond and its par (or redemption) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds, and any type of coupon bond that has been stripped of its coupons. A zero-coupon bond referred to as a zero is a bond that pays no annual interest hence the phrase zero coupon in its name. the bond however, is sold at a significant discount to its face value. Upon maturity its issuer must pay back the full face value and thus its holder’s compensation is the difference between the zerp’s face value and the discounted price at which it was originally issued. Tax Purposes o Although an investor receives no interest payments during the life of a zero she must recognize the imputed income from the zero on her tax return. 3. Acceleration provision: 10 year loan you rep the bank and five years into loan the debtor becomes shaky but he is still paying the interest. He has not defaulted yet but is shaky. You cant sue until he defaults. There is a solution you put in an acceleration clause which is if he commits an act of default, his liabilities exceed his assets, that accelerates the due date, the note becomes due in payable. So you go after him when he still
has some assets. Worst case: you loan your friend money, 10 years principal and interest due. All of a sudden he has two times the liabilities. 2 years in his liabilities are twice his assets. He hasn’t defaulted but this is an act, so you can then accelerate it. So any well-drafted loan documents will have an acceleration clause. C Reasons for use: to cover you. It allows you to call the loan if the debtor cant pay then you can either sue and get to him before his assets are dissipated. And get the security while the security is still there. C Mechanics of typical provision: 4. Redemption provisions: o If the issuer issues a ten year bond it can redeem or call in the bond and pay it off according to the terms in less than 10 years. o Why would someone want to call it in in less than ten years: 1. Its cash position changes and it has enough cash and it does not want to pay the interest any more. 2. Assuming that the bond issue a ten year issue at 6%, 2 years after issuance rates go down 2%. If you are the issuer you are saying call in this bond and pay it off then go borrow the money at two percent. 3. Because of a merger or acquisistion it is desirable for the corp to clean its balance sheet—get the debt off its books. C Reasons for use: C Mechanics of typical provision: you issue a notice that the bonds are redeemed or called as of a certain date. Interest usually stops running on that date. So if the holder is late coming in or does not come in for awhile the interest usually stops. In a public issue there will always be someone who does not turn in their bonds. Generally speaking a redemption provision will have two restrictions. It can’t be redeemed within the first x-years. 2. Cant redeem it with the proceeds with a new bond issue or loan at a lower rate. Why is this in there: this is in there to protect the bond holders to be able to sell it. Without this provision, this is where the holder stands, rates go up and the issuer does not redeem and you are stuck with the bond. If the rates go down they will refinance and you lose. This provision obviously leads to litigation. Generally when they call the bonds they have to pay the face, the accrued interest, and some premium over the face and the best way to describe it is: the longer the period of time between the redemption date and age of maturity the bigger the premium. It is a payment for the lost interest. Stock Redemption/Repurchase: o Common stock repurchases and redemptions are in many ways similar to dividends. Both put cash into the hands of a company’s stockholders. A stock repurchase: primarily refers to a company’s repurchasing of its stock pursuant to its statutory right to do so. A stock redemption; primarily refers to a contractual right a company may have to redeem shares of its stock (usually preferred stock) at specified redemption prices. A stock repurchase generally benefits stockholders by putting cash in the hands of stockholders while reducing the number of shares outstanding. Stock redemptions generally benefit the company as it refinances more expensive (higher yielding) preferred stock with less expensive preferred stock. Stock repurchases: o Private company: A private company primarily repurchases shares of its stock to facilitate a stockholder’s exit from the company o Public company: a public company repurchases its own shares when its board of directors views the company’s shares as undervalued in the market. In other words, the board decides that the best investment for the company’s surplus is in its own stock. Because stock looks to improve the company may want to repurchase. Redemption: a company generally cannot redeem common stock. However, with preferred there may be a redemption provision stating that after a certain period of time, the company will have the right to redeem shares of a given series of
preferred stock at a redemption price per share equal to the par value of that series plus a small premium. o Sinking fund provision: is a device to protect the bondholders and to make sure at the end of the ten years the issuer has the money to pay them off. A simple illustration: if it is a ten year bond issue then each year for the ten years the issuer will put one/tenth the amount of the issue in an escrow fund and then if it did that obviously it would accumulate the money so that at the end of the ten years it would have the money. From the bond holders standpoint the bond holders are interested in knowing that the sinking fund is set up in a way legally that the creditors of the issuer cannot get to. You want a true fund not a book entry. • Convertible debentures: best way to describe this is that it gives the holder or the purchaser downside protection if the company goes south. And upside opportunity. Meaning: you buy a one thousand dollar bond. You are a creditor and you go before the stock holders. By having it convertible into common shares if the company does well and the stock goes up you can share in that increase in the stock price by converting the bond into stock. You don’t convert unless the value of the number of shares you will receive is more than the bond. So you buy 1000 dollar bond and convert to x number of shares, you would not convert the bond into common shares unless the aggregate market value of the shares that you would get is more than the 1000 dollars. Generally speaking you don’t convert until you are ready to sell the shares because the price could go down. Only convert if you are about to sell. One exception: stock keeps going up you think it will keep going up and it is only convertible for a limited time, if no time limit on the conversion you are better off sitting with the debt until you are ready to sell. One more reason to sit with the debt: while you are holding the debt you are getting interest that is probably more than the dividend if you had the stock. Why would a corporation sell convertible debt rather than straight debt: it is more appealing. o It is easier to sell o The convertible debenture will pay lower interest than the regular debenture. If I offer you two debentures: one a straight one and two a convertible debenture if I am the convertible. I will take less interest in the convertible because the convertible feature is worth something to you Mechanics of conversion o Convertible debt securities: Economics A convertible bond, as well as other convertible debt securities, is a hybrid security that allows its holder to exchange it for a given number of shares in the company’s common stock anytime up to and including the maturity date of the bond. A convertible bond is the combination of two financial instruments: 1 straight debt (a nonconvertible bond) with the same coupon rate and maturity as the convertible bond; and 2 a conversion right similar in many respects to a warrant to purchase shares of the issuer’s common stock. The conversion right is not a stand alone instrument that can be separated from the straight bond, but rather it is embedded within it. The conversition right is similar to a warrant in that the conversion right allows its holder to convert the convertible bond into shares of the company’s common stock at a preset conversion price. Thus like a warrant it provides the bond holder with the upside potential of owning common stock in the company. Moreover the conversion right when exercised increases the number of outstanding shares of the company’s common stock thus diluting existing common shareholders. While the exercise of a warrant has a similar dilutive effect, a warrant holder normally pays the exercise price of the warrant in cash. To exercise the conversion right, by contrast, the convertible bond holder does not pay cash but rather turns in his convertible bond. The initial conversion price is typically set somewhere between 20 and 30 percent above the issuer’s per share trading price of its common stock at the time the convertible bond is issued. Example, assume that a given convertible bond has a face value of 1000 dollars and a conversion price of 36 dollars per share. If a bond holder turns in one bond for conversion she will receive 27 shares of the issuers common stock 1000/36=27.77 shares. The .77 is a fractional share and will be cashed out.
Transactional Differences between convertible and nonconvertible debt holders: First, convertible bonds typically pay a rate of interest lower than that paid on nonconvertible bonds. This lower rate reflects the fact that the conversion right has value. Second, convertible bond holders customarily accept subordinated status Third the indenture for convertible bonds typically contains less restrictive financial covenants than does an indenture for nonconvertible bonds When issued, a convertible bond’s straight bond value is worth less than the face value of 1000. The difference between the convertible bond’s 1000 dollar face value and its present value at issuance is the cost of the conversion right to the convertible bond holder. The value of the conversion right (conversion value) upon issuance of the convertible bond is substantially less than the bond’s 1000 dollar face value as the conversion right is similar to an out of the money call option. Example: suppose the conversion price of a convertible bond with a 1000 dollar face value is 20 dollars per share and that the issuer’s common stock is trading at 17.50 dollars per share. At issuance therefore the conversion value of the convertible bond is only $875. This is calculated by first determining how many shares the bond holder would receive when she converts. The answer is 50 shares (1000/20). However, when she receives her fifty shares their market value is only 17.50 per share. Thus the conversion value of the convertible bond is only $875 (50x17.50). Converting a convertible bond before the issuer’s stock price rises up to the conversion price makes no sense. o Antidilution provision 6. Subordinated debentures: 5,000,000 debenture 2010. Then issue another 5,000,000 in 2012 issue and subordinated to the 2010. Payoff time. If I have 10 million or more I have no problems paying off creditors. What happens if I have 8 million dollars who gets what: 2010 gets five and 2012 gets 3. If not subordinated each get four. Reasons for use: protects 2010 issue recipients from getting shorted. This is a provision that the 2010 issue recipients would want in their debentures. C Mechanics of subordination o When an issuer has multiple classes of debt securities outstanding (e.g. bonds and debentures) the priority in which debt holder of different classes are repaid is crucial. Ranking among classes is particularly important when the issuer declares bankruptcy or is seeking to liquidate o The concept of subordination refers to one class of debt holders standing behind another in order of payment. A given issuer for example may have senior debt securities, senior subordinated debt securities, and subordinated debt securities outstanding at any given time. Holders of the senior debt securities rank ahead of the holders of the other two classes of debt securities. Holders of the senior subordinated debt securities rank ahead of the holders of subordinated debt securities. Thus the subordinated debt securities are the last to be paid. o For a given issue to be subordinated its indenture must so provide Indenture (1) the formal agreement between a group of bondholders and the bond issuer containing terms of the debt. (2) a deed, written contract, or sealed agreement. The term derives from an old practice of actually indenting the deed by cutting or tearing it in half with a jagged or indented edge so that the two parts could subsequently by matched by the grantor and the grantee. o Thus, subordination is a topic of negotiation. In return for accepting additional risk relating to subordination investors in subordinated debt demand a higher interest rate. In fact subordinated debt securities are referred to as both high yield debt securities and junk bonds. These bonds are considered high yield because they yield about three to five percent more than regular investment grade bonds. 7. Convertible debentures
• Characteristics/Reasons for use • Mechanics of conversion o A simple conversion: $1000 debenture and the stock is selling at $80 a share. This bond is convertible into stock at about a hundred dollars per share. This means that if you pay 100 dollars a share for the stock and you use this bond to pay for the stock which gies you ten shares. WHEN YOU CONVERT AND YOU BUY THOSE TEN SHARES OF STOCK AND YOU GIVE THE CORP THE BOND IN PAYMENT, AFTER THAT YOU ONLY OWN THE STOCK NOT THE BOND. YOU ONLY OWN ONE OR THE OTHER. THEREFORE YOU WOULD NOT CONVERT UNTIL THE SHARES ARE SELLING FOR MORE THAN 100 DOLLARS A SHARE NOT WHEN THEY ARE EIGHTY A SHARE. IF THE STOCK IS 120 YOU GET $1200 IF YOU CONVERTED OR SOLD. IF YOU CONVERTED AND HELD AND IT WENT DOWN TO 90 YOU ARE 100 DOLLARS UNDER WATER WITH NO INTEREST. o A problem: what happens if after you buy the bond and before you convert there is a two for one stock spree. It is selling at 120, I have a two for one stock split and the stock is going to sixty dollars a share. What does this do or could this do to your conversion: the conversion is worthless pretty much. Could I really sell these convertible bonds to you. No. if the stock splits then you would put in an anti-dillution provision that says when there is a two for one split we will either reduce this price to fifty or increase the shares to one twenty. You put in an antidillution provision the effect of which is that immediately after the corp transaction is you get the same benefit of the bargain the minute after the deal that you had before. o Stock split: An increase in the number of outstanding shares of a company's stock, such that proportionate equity of each shareholder remains the same. This requires approval from the board of directors and shareholders. A corporation whose stock is performing well may choose to split its shares, distributing additional shares to existing shareholders. The most common stock split is twofor-one, in which each share becomes two shares. The price per share immediately adjusts to reflect the stock split, since buyers and sellers of the stock all know about the stock split (in this example, the share price would be cut in half). Some companies decide to split their stock if the price of the stock rises significantly and is perceived to be too expensive for small investors to afford. also called split. o Anti dilution provision: The right of current shareholders to maintain their fractional ownership of a company by buying a proportional number of shares of any future issue of common stock. Most states consider antidilution provisions valid only if made explicit in a corporation's charter. also called subscription privilege or subscription right or preemptive right. o There are two ways of drafting an anti-dilution provision: I can either do it in a broad general way which says if there is a corp transaction which alters the capital (the stock) then appropriate adjustment will be made in the conversion feature. If you use the broad trigger: the result being appropriate adjustment everyone will agree what that adjustment will be. 8. Interaction of redemption and conversion provisions: you have a bond issue with a redemption feature and a conversion feature. You have a convertible bond that is redeemable. Assuming that the conversion feature is in the money meaning that the price of the stock in the conversion ratio that if the holder converted they would make money. For corporate purposes you want everyone to convert to stock and get rid of the debt how do you make the others convert: you threaten to recall the bond. So assuming that you call the bond in and you give notice and you say in sixty days this bond will be redeemed and interest is cut off and you must come and get your money. If you call you get 1200 and not 1000, every lucid person will convert. I can force a conversion by calling the bond. What is sometimes done is that a friendly investment banker will do is put in a stand by purchase agreement: they basically buy up the unredeemed bonds and they get the conversion feature. They provide the money for the issuer to pay off the bond holders and they make the money on the conversion. So the conversion profit an investment banker will take the issuer out on converted bonds. So therefore the issuer will be able to wipe all the bonds off the balance sheet and stop paying interest and not come up with any cash. • Explanation Stand-by purchase agreement An agreement with a third party, typically a bank, in which the third party
agrees to purchase tender option bonds (typically variable rate demand obligations) tendered for purchase in the event that they cannot be remarketed. Unlike a letter of credit, a standby bond purchase agreement does not guarantee the payment of principal and interest by the issuer and is not an unconditional obligation to purchase the tender option bonds. E. Trust Indenture Act: 1939. o This act evolved from the Securities act and exchange act and represented another way to control the securities industry after the 1929 crash. o The primary purpose of the Act was To provide full and fair disclosure to debt holders, not only at the time when the corporate issuers originally issue debt securities, but also throughout the life of those securities. To provide a tool whereby debt holders may organize for the protection of their own interests and To ensure that the debt holders will have the services of a disinterested indenture trustee which conforms to the high standards of conduct observed by trust institutions. The TIA generally applies to the sale by issuers of debt securities and interests in debt securities to the public. It does not apply in the private transactions. TIA sets forth eligibility requirements for indenture trustees and prohibits conflicts of interest involving trustees at any time. TIA also sets for certain statutory duties and obligations of the trustee such as the issuance of periodic reports to debt holders. Additionally it grants trustees certain powers such as the right to bring suit against the issuer on behalf of the debt holders in the event of a default by the issuer. The TIA specifies certain duties and obligations which a trustee must fulfill when performing its role as indenture trustee. A given duty may depend on whether a default has occurred. Prior to default its duties are limited to those expressly set forth in the indenture. Must give notice to the debt holder of any defaults within 90 days. Thereafter the trustee must exercise the rights and powers vest in it by the indenture. As a result of the 1929 crash we had the 1933 and 1934 acts. A provision of the 33 act mandated a study of the issues concerns in publicly traded debt. 1933 act applies to debt and equity is just a disclosure statute. As a result of that study congress enacted the trust indenture act of 1939. The best way to explain this is to first explain what the trust indenture is: if the corp goes to the bank, they get a loan and sign a loan agreement. However, if the corp issues public bonds or bonds in a public offering that is traded it cannot enter into a loan agreement with each bondholder Therefore to provide an agreement in lieu of the loan agreement with the bank, there is an indenture agreement between the issuing corp and a bank which serves as trustee of the indentured. The bonds are then issued under and subject to the indenture and it is the job of the trustee to act on behalf of and protect all of the bond holders. Since the indenture is drafted before the bondholders buy their bonds and since the bondholders cannot individually or collectively negotiate the indenture why is the indenture self-policing, that is, why does the issuer and investment banker representing it and the trustee prepare a good or fair indenture that protects the bond: because there will not be anyone to buy it if there is not an agreement. So if it was not a good or fair indenture then they could not sell the bonds. But prior to the trust indenture act of 1939 there was no federal legislation governing the trustee and the indenture. o Application of the Trust Indenture Act of 1939: it applies to any public issue of bonds where the face amount of the issue is in excess of 10 million dollars. the Act provides certain qualifications for the trustee. The trustee must be a corporate entity with some capital. It also imposes duties and responsibilities on the trustee. Three other things o it says that certain provisions must be in the indenture: mandatory o certain types of provisions may be in the indenture, not mandatory, it is permissive o prohibited provisions. Certain provisions may not be contained in the indenture. COVENANTS
Affirmative and negative: the typical trust indenture has both affirmative and negative covenants. Affirmative covenant says that a corp shall do something. Negative covenant: the corp shall not do something. Subordination of future debt will be a negative covenant. o A debt indenture contains two types of covenants: affirmative and negative. Covenants are designed to ensure that the issuer operates in a way most conducive to fulfilling its promise to repay the debt holders. Affirmative covenants are promises that the issuer makes to perform specified affirmative acts. For example, an issuer may promise to 1 maintain its properties and corporate existence 2 pay its taxes, 3 deliver financial information to the indenture trustee and 4 obtain and maintain insurance on its properties. Negative covenants are issuer promises not to engage in specified acts. They often are referred to as thou shall nots. Negative covenants include Limitations on incurrence of indebtedness: these prevent the issuer from increasing its debt load unless it is generating enough cash flow to easily satisfy the principal and interest payments on the debt securities in question. o The debt holders worry about this addition debt because the additional debt increases the issuer’s leverage, thus raising the issuer’s default risk; additional debt increases the number of creditors vying for the issuers assets in the event of a bankruptcy or liquidation; the increase in risk associated with additional debt often diminishes the value of the existing debt securities. Restricted payments: keep money within the issuer for use of servicing the debt securities in question. This provision usually prohibits the issuer from distributing its cash to its equity holders either through the payment of dividends or through repurchases of stock or purchasing or redeeming any indebtedness of the issuer subordinated to the debt securities in question. Asset sales: this covenant prohibits the issuer from selling substantial assets unless no default or event of default exists; the issuer receives consideration for the assets at least equal to the fair market value. Usually requires the funds gained from the asset sale to be reinvested into the corporation. o No action clause: indenture trustee is the one who sues. No action by the bondholders. Usually there is a provision to protect the bondholders if the issuer and the trustee are in bed together and the trustee does not want to sue him. Junk Bonds: they are high reward and high risk bonds. Because they are risky they pay more interest than the market rates. They are risky and sell at 15% interest. Any time a debt interest is paying more than a market interest something is up. o JUNK BONDS: historically they came out of leveraged buyouts LBO and they were high risk. Because in a leverage buyout the corp issuing the bonds had low equity and financed the purchase of the other corp mostly with debt. High risk=junk. In order to sell them they had to pay more than the going rate on corp bonds. Historically many of the companies that were involved in leverage buyout went broke and the bond holders took a beating because there was no one beyond the purchasing or acquiring corps that were guaranteeing those bonds. Only benefit is that you are getting more interest because there is higher risk. Junk Bonds: Bonds issued by companies that are thought to be highly speculative. Junk bonds have ratings of BB (S&P) or BA (Moody’s) or lower and are dubbed "speculative-grade" due to having a higher risk of default. Also referred to as high-yield bonds because they offer higher yields than investment grade securities. Wall Street slang for bonds listed at below investment grade (below the top four ratings) by agencies that rate bonds. Such bonds are frequently unsecured or thinly backed by company assets, and thus carry a relatively high level of risk for investors. Consequently, the bonds must pay high yields, commonly three to four percent above high-grade corporate bonds. Some junk bonds are issued by those seeking to raise funds to finance their buying of stock and takeover of
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corporations, the assets of which are liquidated to pay for redemption of the bonds. Most junk bonds fall into one of two categories. The first consists of bonds that were investment grade bonds when issued but which have been subsequently downgraded to junk status due to increased default risk associated with the issuer. Second consists of debt securities originally issued as junk. Two subcategories. o Junk bonds issued by low rated companies simply as a means of financing their ongoing operations, bonds issued by companies that simply do not qualify for ―investment grade‖ rating. o Second, consists of junk bonds issued in connection with corporate takeover transactions such as LBOs. Industrial revenue/private activity bonds: A financing technique in which a municipality or its development corporation issues bonds to finance revenue-producing projects. Revenue thus generated is used to pay the debt service on the bonds. o A tax-exempt bond issued by a state or local government agency to finance industrial or commercial projects that serve a public good. The bond usually is not backed by the full faith and credit of the government that issues it, but is repaid solely from the revenues of the project and requires a private sector commitment for repayment. o Industrial revenue bonds now called private activity bonds: motivating force here is the internal revenue code. First a tax exempt bond that is only bought by high bracket taxpayers pays roughly 1/3 less in interest than a corp bond. However, in other words if you were going to buy a corp bond and get a bond at 6% you could get a tax exempt bond for 4% and your net would be the same. However, what is going on: the tax exemption is allowing the state or local gov to sell bonds at a 1/3 of the corp rate is a subsidy to the state. The buyer is in the same position. So what is happening is that the federal government is subsidizing the state and local governments. o In late 1960s, assume you have a corp paying 6% on its bonds, and you have a govt entity wanting to attract corps. The government can issue bonds for 4%. In a normal municipal bond is tax exempt under 103. The government bonds are called general obligation bonds (G.O. Bonds). These governments said we will issue industrial revenue bonds under our tax exemption then we will loan or lease the facility to the corp that will cut its costs to four percent. The catch was that the government bonds were only backed by the flow between the corp and the government not the obligations of the state or local government. In government bonds you only care that the bonds are backed by the government’s revenue you don’t want their products like fire trucks and shit. o NOW THESE ARE CALLED PRIVATE ACTIVITY BONDS: very restrictive rules on what the proceeds can be used for. When they issued them for private use they were called as industrial revenue bonds. They were defined in the code as being used by private businesses. They changed the name to private activity when they restricted the use to be used narrowly. o These are very limited today. o Municipal bonds: bonds issued by states and local governments and are almost always tax exempt so they pay less interest. So if the market rate is 3% and the average person buying these bonds is probably buying them with 2% interest they are getting the same as the 3% people because they are getting tax exemptions. Federal government is subsidizing this. Without the tax exemption they would have to pay market value. 2. Most municipal bonds /state bonds are called general obligation bonds and tax exempt. They are backed by the total revenues of all sources by the state. Since a cant print money can a bank go bankrupt. o Industrial revenue / private activity bond: starting back in the 1960s Leasing Transactions: o A comparison of operating and financing leases: Operating Leases: treated as leases for tax and accounting purchases. An operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an airliner, a ship, etc.) being leased. An operating lease is commonly used to acquire equipment on a relatively shorto
term basis. Thus, for example, an aircraft which has an economic life of 25 years may be leased to an airline for 5 years on an operating lease. The determination of whether a lease is a finance (also called capital) lease or an operating lease is defined in the United States by Statement of Financial Accounting Standards No. 13 (FAS 13). In countries covered by International Financial Reporting Standards, the tests are defined in IAS 17. In July 2006, the FASB and the International Accounting Standards Board (IASB) announced the commencement of a joint project to comprehensively reconsider lease accounting. In July 2008, the boards decided to defer any changes to lessor accounting, while continuing with the project for lessee accounting, with the stated intention to recognize an asset and obligation for all lessee leases (in essence, eliminating operating lease accounting). The projected completion of the project is now 2011.   In the context of cars and other passenger vehicles, under an operating lease the lessor leases the vehicle to the lessee for a fixed monthly amount, and also assumes the residual value risk of the vehicle. This provides a way to lease a vehicle where the cost of the vehicle is known in advance – however, operating leases can be an expensive option as there is a risk premium priced into the monthly payments. Short term leases. Where the risk is with the lessor and the lessor pays most of the expenses esp taxes and insurance. Examples: personal lease of a car. Lease a car for a weekend from Hertz. Corporations rent cars for a year or two which are clearly leases. They rent trucks as needed. Building companies rent cranes or heavy equipment. Risk is with lessor. When you lease a car the risk is really with hertz. Usually the clue here is that the lessor is in the leasing business. That is there business. Automobile industry. When a company needs equipment the corp can 1. Buy it with cash 2. It can buy it and take out a loan and give the purchase property as security. 3 It can go to someone in the finance business and buy it for them and then lease it. o Financing Leases may not be treated as leases for tax and accounting purchases. Lessor is generally in the finance business and not in the leasing business. Vendor, lessee, lessor, bank(maybe). The lessee goes to the vendor and selects what it wants. If it is going to finance it with the loan: it will buy it from the vendor with money from the bank and give the bank security. When leasing: why would a lessee corp lease rather than buy: lack of cash, based on their credit rating they would pay a much higher interest rate than the interest rate that will be built in by the lessor or, the lease will provide level payments over a longer period of time than the loan, 2 more reasons: based on prior loan and debenture issues the lessee corp may not be able because of covenants to put any more debt on its balance sheet and finally: tax issue—depending on the tax status of the lessee the depreciation the lessee wont get the benefit from the tax credit because they don’t have enough tax payments to use the credit. Usually under financing lease: the lessor would buy from the vendor and the vendor would give title to the lessee leases from the lessor. The lessor may have to go to the bank to get the money to buy it. finance lease or capital lease is a type of lease. It is a commercial arrangement where: the lessee (customer or borrower) will select an asset (equipment, vehicle, software); the lessor (finance company) will purchase that asset; the lessee will have use of that asset during the lease; the lessee will pay a series of rentals or installments for the use of that asset; the lessor will recover a large part or all of the cost of the asset plus earn interest from the rentals paid by the lessee; the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option purchase price);
The finance company is the legal owner of the asset during duration of the lease. However the lessee has control over the asset providing them the benefits and risks of (economic) ownership.
Economics of lease for a financing lease: there is a formula: the cost of the equipment plus an interest factor plus a profit factor minus the estimate of the residual divided by the rental period or term of the lease. The only risk with the lessor is the residual. 4. Legal treatment of the lease: legal purposes if it is set up as a lease it is generally a lease. There is no policy reason to upset the treatment. If the two parties want it as a lease it’s a private transaction. However the question is 5. Accounting treatment of lease: Will the auditors treat it as a lease. Under GAAP you can usually tell the long term leases 6. Federal income tax treatment of lease: will the IRS treat it as a lease. For tax purposes if it is not a lease then the deductee does not get to deduct the lease payments, it is set up as an asset and a loan and all they can depreciate is an interest factor and it hurts them most of the time. Generally, there can be no title transfer to the lessee for no payment or nominal payment. Can’t be transferred for no consideration. Must be some profit to the lessor and have some profit in the deal. The lease can’t be for the entire life of the property. The lease payments can’t be over 70 or 90 percent. In other words, the lease payments cant equal the total cost in the end otherwise there is no risk or profit by the lessor. IX. Sale and leaseback transactions: Sale-leaseback An arrangement in which a seller deeds property to a buyer for cash or other consideration, and the buyer simultaneously leases the property back to the seller, usually on a long-term basis. Leaseback, short for sale-and-leaseback, is a financial transaction, where one sells an asset and leases it back for a long-term; therefore, one continues to be able to use the asset but no longer owns it. The transaction is generally done for fixed assets, notably real estate and planes, and the purposes are varied, including financing, accounting, tax. conceptually is pretty much the same as leasing except in a sale and leaseback the corporation owns the property. They either paid for it in cash or financed it. And now in order to raise cash or because the property is depreciating or because it is financed and they want to remove the debt from the balance sheet or if it is substantially depreciated if they sell it at more than book value. If they can sell it for 50 and lease it back for 20. So that is a gain of 30. When they sell it for fifty they will lease it back. The lessor will use fifty in setting up the lease payments, they are getting income now and deductions later which jack up earnings. This is done more with real estate to get rid of their mortgages. The lessee gains on the sale. A. Reasons for use: to get debt off your books i. SECURITIES: Investment that signifies evidence of debt or ownership of a company or other assets. Some of the most frequently used types of securities include stocks, bonds, options, and futures. ii. EQUITY SECURITIES Simple concept: holders of equity preferred in common own and have the right collectively to manage the company and to receive whatever distributions there are via dividends, stock repurchase, and liquidations. The distributions of dividends are subject to restrictions. A. Stock as ownership 1. Voting/management interest of stock: most coprs can have voting stock or nonvoting stock. If it has multiple classes of stock it can have class voting whereas you can say regardless of the percentage that the preferred stock owns they can elect two out of the seven directors. Preferred stock generally is nonvoting but it could be voting. In preferred stock there is a catch. If it is nonvoting it provides that the corp is in default in the dividends on arrearages for so many quarters, so preferred stock gets to elect 2 out of 7 if it continues they get to elect more. 2. Financial interest of stock C Distribution of dividends C Liquidation distribution
C Appreciation/depreciation/market risk Usually closely held corps don’t pay dividends and they keep the money in there to pay salaries. The salaries must be reasonable. In the publicly held where some of the shareholders are employed, some of the profits are distributed on the dividend route. Preferred stock gets a preference in dividends and then the common stock gets its dividends out of current earnings. It gets liquidation preferred earnings and the common gets the residual. The common stock gets most of the increase in value by the appreciation. If preferred stock is not convertible it is not worth much more than the liquidation. If I buy a 100 preferred stock and it has a 110 liquidation value, it should not be worth more than 110. The common stock is worth what is left. Earnings can be distributed to shareholders through redemptions: the corp repurchasing stock from the shareholders from bare market value. You would not buy preferred stock at more than the liquidation: you may want to buy it up a little more so you don’t have to pay the dividends. REDEMPTION: "Redemption" and "payment" are used interchangeably and refer to the payment of what a bond or note is worth in cash (currency) or via check or credit to an account as requested by the bond's owner or co-owner or by a person legally entitled to make such a request according to governing regulations and law. REDEMPTION: o The indenture relating to a particular issuance of debt securities may provide for optional and/or mandatory redemption of those securities by the issuer prior to their maturity date. After the date the issuer fixes for redemption, debt securities no longer earn interest. After that date, debt holders are only entited to receive the redemption price from the issuer. Therefore, debt holders have an incentive to turn in their debt securities on or before any redemption date. o Optional Redemption: the ability to pay off debt securities prior to their maturity is something most issuers seek, and against which most investors fight. When interest rates fall an issuer may seek to refinance existing debt with lower interest rate debt. Doing so, prevents existing debt holders from continuing to receive their now above market return. o Indentures ordinarily contain a compromise. The issuer receives the ability to redeem its debt securities early, but only after a period of years transpires during which redemption is prohibited. This period of years is referred to as the debt holders call protection, because the issuer is prohibited from calling away the debt securities from the debt holders during this period. Thereafter the issuer has the option of redeeming some or all of the securities at a premium that declines to zero over subsequent years, plus accrued and unpaid interest if any to the date of redemption. o Mandatory redemption: many indentures require an issuer to redeem some or all of the debt securities prior to their maturity upon the incurrence of certain events. For example, an indenture may require the issuer to offer to repurchase debt securities if the issuer’s cash flow from operations is greater than a predetermined benchmark. Another mandatory redemption trigger stems from the assets sales covenant. If the issuer has not redeployed excess proceeds from asset sales within a specified period of time, it must offer to buy back securities with those excess proceeds. Another mandatory redemption trigger is a change in control. Change of control is : the sale of all or substantially all of the assets of the issuer, any person becomes the beneficial owner of a specified percentage of the issuers voting stock through a tender offer made to the issuer’s shareholders. o Events of default: All indentures define event of default and specify the consequences of the occurrence of such an event. 1. Default in the payment of interest or principal the failure of an issuer to make a scheduled interest or principal payment referred to as a payment default is the most fundamental default. A grace period may attach to a default on an interest payment, usually thirty days but not the principal payment. If the issuer misses a principal payment or fails to make an interest payment
following the expiration of a grace period the indenture trustee may declare the full principal amount of the debt securities plus any accrued interest and unpaid interest immediately due and payable. This is known as ACCELERATION of the debt. 2. Breach of any covenant or warranty. 3. Bankruptcy or insolvency.
B Preferred stock o Preferred stock is a hybrid security featuring characteristics of both debt and equity. It is called preferred because its holders have a dividend preference and a liquidation preference over common shareholders. o Generally, the preferred shareholder’s dividend preference requires the issuer to pay preferred shareholders their dividend before it can pay any dividend to the common shareholders. Their liquidation preference means that in a liquidation context, the issuer must pay preferred stockholders their contractual liquidation preferences (a specified dollar amount) prior to distributing any assets to common shareholders. Because of these preferences preferred stock is less risky of an investment than common stock. Characteristics of preferred stock: They have a dividend and liquidation preference over common shareholders. o 1. Dividend preference: dividends are payable at the discretion of the company’s board of directors. When dividends are paid preferred stockholders must receive their fixed dividends before the company can pay any dividends to the common shareholder. If the preferred stock is CUMULATIVE then the preferred stock dividend preference extends to any previous dividends known as a dividend arrearage that the board did not declare. When it is cumulative: For example, assume that ABC corp has a series of cumulative preferred stock outstanding that has a stated dividend of 2.80 per share per year payable in equal quarterly installments of .70 cents. ABC must pay each quarterly installment to the preferred stock holders before any dividends can be paid to its common shareholders. Therefore, assuming abc has not paid its preferred stockholders their last three quarterly dividends (2.10 (.70x3)), it must pay that arrearage, 2.10, in addition to the quarterly dividend for the current quarter (.70) to the preferred stockholders before paying any dividends to the common stockholders. o 2. Liquidation preference: the preferred stockholders dividend preference benefits them if the company succeeds. Their liquidation preference helps protect them if the company fails. In the event of any voluntary or involuntary liquidation dissolution of the company, the company must pay preferred stockholders their stated contractual liquidation preference prior to distributing any assets to its common shareholders. The liquidation preference is a dollar amount usually equal to the par value of any given series of preferred stock. Paying the preferred stockholders their liquidation preference is akin to paying back bond holders the face value of their bonds. If the company does not have enough to pay all the preferred stockholders then what it does have is divided up pro rata. While the preferred stock holders are above the common stock holders in a liquidation they are behind the creditors. Therefore the value of the preferred stock holders liquidation preference may be illusory if the company is highly leveraged when it liquidates o Noncumulative dividend rights: when preferred stock is noncumulative its contract states that preferred stock dividends that the board does not declare and pay in any quarterly period will not accrue. The declaration of dividends including preferred stock dividends is within the discretion of the company’s board of directors. Therefore, its decision not to pay a quarterly noncumulative dividend means in almost all jurisdictions that the dividend cannot legally be paid at a later date. Even if the board is willing to do so and the company has the available funds as a matter of law the board cannot declare the dividend
However, if a quarterly noncumulative dividend is not paid on the preferred stock the company cannot pay a dividend on its common stock. o Cumulative dividend rights: when preferred stock is cumulative its contract states that preferred stock dividends that the board does not declare and pay in any quarterly period are not extinguished but rather accrue. o Importantly, accrual occurs regardless of the financial condition of the company. before the company can pay any dividends on its common stock or any other stock junior to the preferred stock in question the company must pay all cumulative preferred stock dividends both the current quarterly dividend and the entire arrearage. The vast maj of preferred stock is cumulative. o There are junior and senior preferred stock holders: subordination. o Preferred stockholders usually receive very little voting rights. o Preferred stock contract may require or allow the company to redeem some or all of the outstanding shares of a given series of preferred stock. Preferred stockholders whose shares have been redeemed no longer are stockholders of the company once the redemption date has passed. The shares of those preferred stockholders who have not turned them in by that date merely represent the right to receive the redemption price, without interest, from the company once that date has passed. o Preferred stock is callable or redeemable if the preferred stock contract grants the company the option to redeem it in whole or in part at specified redemption prices. The redemption price is usually the liquidation value of the preferred stock plus a small premium. When the preferred stock in question is cumulative the redemption price will also include any accrued and unpaid dividends. o Conversion: the preferred stock contract may grant conversion rights to the preferred stockholders these rights allow them to convert their shares of preferred stock into shares of the company’s common stock at a specified conversion price. o Until the preferred stockholder converts he enjoys a liquidation and dividend preference over common stockholders. Thus a convertible preferred stockholder has the downside protection of preferred stock and the upside potential of common stock. Conversion price usually set between 20-30% above the current trading price o The contract may contain covenants. B. Preferred stock 1. Corp needs legal authority to issue preferred stock : today under most statutes and articles and bylaws that is not a problem. C Statute: all statutes today allow preferred stock, common stock, voting and nonvoting warrants, options allow them all. The net worth section of a balance sheet of a big corp will show 5 or 6 classes of preferred or common stock have each a little different characterizes from the other be it on the vote or the liquidation value or the dividend. Assuming you have no problem creating preferred stock. Characteristics you can put into the preferred stock: o 1. By definition preferred stock has a dividend and liquidation preference. Otherwise why would you buy it. C Articles and director resolutions 2. Dividend preference of preferred stock: it can be cumulative or noncumulative: meaning if the corp skips one quarters dividend then in subsequent quarters before it can pay a dividend on the common stock it must pay the arrearage. Assuming a corp is four quarters behind it wants to pay a dividend on the common stock it must first pay the arrearage. this is all cumulative. If noncumulative it only has to pay that quarters arrearage. o Preferred stock although it has a stated dividend it does not get paid directly, the board of directors must declare the dividend., if they want to pay the dividend in the common o 100, 100,100,100: if they want to pay dividend in the fourth quarter for common stock they must first pay all quarters for the preferred. This is under a cumulative. Under noncumulative if you want to pay a common stock dividend you only need to pay the preferred stock dividend first for that quarter only. o if cumulative they can never pay a common stock until they pay up the preferred stock’s
dividend. SO far, a dividend on preferred stock has better tax treatment than interest on a bond. 3. Liquidation preference of preferred stock: preferred stock always has a liquidation preference. The preferred stock is preferred over the common as to dividend and liquidation value and it comes between that and the common stock. Preferred stock can be voting or nonvoting. 4. Typical voting rights provisions of preferred stock C Voting or non-voting : where it is nonvoting there is a provision giving it votes to possibly control the board where the corp is in arrearage on the dividends. This is one of the self-policing mechanisms to force the board to pay the dividend otherwise the common shareholders lose control of the board. Also the preferred stock can have class voting, where the preferred as a class elects a stated number of directors not in proportion to the number of shares. Some corps have common stock of different classes with different weights on the vote. 5. Convertible preferred stock: this is almost identical to convertible bonds. Characteristics/reasons for use: preferred stock like the bonds are convertible to common stock, it is given up in payment. It can be stated that the conversion ratio can be stated in dollars or in numbers just like the bonds. Mechanics of conversion the mechanics are the same. Antidilution provision same as the bonds. Because the same gimmick would be available. And the marketing is the same. It gives you some downside protection. And the right to convert on the upside to get common stock. Whether you issue convertible or not is more of a marketing issue than a legal issue. If you issue convertible preferred then maybe you will pay less of a dividend if you issue straight preferred or less of a liquidation fees or less votes or maybe you must make it convertible because no one will buy it. What Does Anti-Dilution Provision Mean? A provision in an option or a convertible security. It protects an investor from dilution resulting from later issues of stock at a lower price than the investor originally paid. Also known as an "anti-dilution clause". Investopedia explains Anti-Dilution Provision These are common with convertible preferred stock, which is a favored form of venture capital investment. Convertible subordinated debenture puts it above preferred stock and common stock. 6. Redemption provisions of preferred stock: preferred stock can have a redemption or call feature like a bond. Reasons for use: same. If you can call the preferred stock and things are going well and you have cash, you can get rid of the dividend just like the interest in bond, you get rid of a layer that is above the common stock in liquidation. In other words, if a corp has only common stock outstanding and no preferred and no debentures it will not issue preferred stock or debentures unless it needs cash that the common shareholders are not wanting to put in. If you have convertible preferred that is redeemable it is the same with a bond: if the conversion feature is in the money, if after conversion the holder of the preferred you can call by wiping out the preferred. 8. Exchangeable stock: preferred stock that is exchangeable or convertible into stock owned by the issuing corp other than its own stock. Its sitting with a portfolio with tradable marketable stock, and your preferred stock is exchangeable to that stock or the stock of its subsidiary. It is rarely done because the problem is: the conversion of preferred stock into common stock is tax free the exchange of ABC corp is taxable. Meaning that you have income in an amount equal to the spread when you do it. The reason this is bad is that is called dry income. You have income on your tax return and then you must come up with cash from other sources to pay the tax. C Characteristics/mechanics of stock C Federal income tax treatment C. Tracking stock: What Does Tracking Stock Mean? 1. Common stock issued by a parent company that tracks the performance of a particular division without having claim on the assets of the division or the parent company. Also known as "designer stock". 2. A type of security specifically designed to mirror the performance of a larger index. Investopedia explains Tracking Stock 1. When a parent company issues a tracking stock, all revenues and expenses of the applicable division are separated from the parent company's financial statements and bound to the tracking stock. Oftentimes, this is
done to separate a subsidiary's high-growth division from a larger parent company that is presenting losses. The parent company and its shareholders, however, still control the operations of the subsidiary. 2. There is not much tracking of stock left. During the tech boom you have tech companies selling at 30 or forty times their earnings. The investment bankers come up with tracking stock. Where you have an industrial company selling for 10 or 12 times earnings with a tech divisions, but if the tech company was different would be selling at 30 or 40 times earnings. These industrial companies asked the investment bankers what they could do. 3. The traditional way: take the tech division and drop it down into a newly formed subsidiary and then take the stock of this newly formed subsidiary and take the stock from this and then spin it off to the shareholders. So the banks created a stock of the big company. Common stock. According to the documents tracked the performance of this tech division. And they were allowed to go public with it. 4. Problem with this : if you sell with the division can you legally distribute those proceeds only to those shareholders. If the shareholders were the same as the big company then no problem. But if someone went on the market and bought the tracking stock how do they get that division. And where do creditors stand. This is not really around anymore—tracking stock. The tracking stock was somewhere short of a real spin-off. spinoffs are very common and not difficult to do them in a manner that is tax free. What Does Premium Mean? 1. The total cost of an option. 2. The difference between the higher price paid for a fixed-income security and the security's face amount at issue.******** Investopedia explains Premium 1. The premium of an option is basically the sum of the option's intrinsic and time value. It is important to note that volatility also affects the premium. 2. If a fixed-income security (bond) is purchased at a premium, existing interest rates are lower than the coupon rate. Investors pay a premium for an investment that will return an amount greater than existing interest rates. Common Stock unlike creditors and preferred stockholders, common stockholders generally are not contract claimants of the corporation. Indeed very few rights of common stockholders are typically spelled out in a corporation’s charter, with an exception being made for certain hybrid forms of common stock. Rather, common stockholders as the equity owners of a corporation are residual claimants. In an earnings context they have a claim on the corp’s earnings subject to the dividend preference of the preferred stockholders. In liquidation context, they are entitled to any assets of the corp that remain after the corp pays off all its contract claimants. Dividend payments to common stockholders are not guaranteed. They are payable at the discretion of the board. Common stockholders elect the board of directors and vote on many fundamental corporate transactions. Each share of stock typically entitles its holder to one vote. Most corps typically have shares of only one class of common stock outstanding. These shares represent the entire equity interest in the corp. the corp can issue more than one class of common stock. Common stock: i. as an overview: there is not much to say. a. 1. Common stock normally controls the company. b. 2. Normally common stock gets the residual proceeds after all the senior securities are paid off. if it is successful it reaps the benefits. If it goes south it is the first to lose. c. 3. Generally the way it is structured with preferred stock. If the company does well and it is a tradable company, most of the appreciation of market value attaches to the common stock. In other words, if the preferred stock is 100 dollars and a 10 percent liquidation premium it wont sell for much more than 110 bucks. So if the company does well it is the common stock that will do
well. You can have various classes of common stock with various rights. When you have multiple classes of preferred and common you need differences between the classes, but this is not hard to structure. Common cant be the same as preferred The rest of the outline on equity will be shuffled. Issues related to common stock see below E. Dividend declaration/distribution: does common stock have any inherent right to a dividend? Not unless it is declared by the board. There is no right to a dividend unless the board declares the dividend. But preferred stock even if it has a right to it does not get it unless it is declared. Typically a dividend declaration is fairly simply and boilerplate. Basically says there should be paid a dividend of ten cents a share to shareholders of record on x date payable on y date. I In a closely held corp this is meaningless because the same shareholders own the same number of shares on all days. But in a publicly traded company the market takes care of figuring out who is entitled to what. In other words, if you buy it in the declaration date then you get it, if you sell it then you don’t. In a closely held corp you want the shareholders to have buy and sell agreements that state that when a shareholder dies another shareholder can buy them out. F. Stock dividends and stock splits: o Stock dividends: are dividends that are paid to stockholders in the form of stock rather than cash. The stock a company distributes may be shares of its own stock. o STOCK SPLIT: Like a stock dividend, a stock split is also an accounting adjustment that does not result in the company transferring assets to its shareholders. A stock split simply increases the number of outstanding common shares but on a much larger scale than a stock dividend. A company effects a stock split to make its common stock more affordable on a per share basis to a broader range of investors. Example, many can’t afford 100 shares at $100 per share. However, they are more likely to be able to afford 100 shares at $20 a share. Hence a company will often split its stock when its share price is perceived by management as too high in order to bring that price back down into a more affordable trading range. When a stock split is declared the company’s stock price tends to trade slightly above. Take the example, where a company announces a 2 for 1 split of its shares currently trading at $50. When the split is effected the price of the stock will likely trade at an initial price slightly higher than $25. The reason for this: stock splits are usually a good sign that the price will raise and the effect of a reduced trading price is often an increase in the demand for the stock because the stock is more affordable on a per share basis. Reverse stock split: When a company declares a reverse stock split the number of its outstanding shares decreases while the per share trading price increases. Example: suppose abc corp had 100 million shares of common stock outstanding, and that its per share trading price was 1 dollar. If abc declared a 1-for-20 reverse stock split the number of outstanding shares would decline to 5 million (100 million / 20) while the per share trading price of those shares would increase to 20 dollars ($1 per share x 20). A company conducts a reverse stock split for two reasons: first, a reverse split is used to increase the per share trading price of the company’s common stock. Second, it can be used to eliminate minority stockholders. What Does Stock Split Mean? A corporate action in which a company's existing shares are divided into multiple shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because no real value has been added as a result of the split. Investopedia explains Stock Split For example, in a 2-for-1 split, each stockholder receives an additional share for each share he or she holds. One reason as to why stock splits are performed is that a company's share price has grown so high that to many investors, the shares are too expensive to buy in round lots.
For example, if a XYZ Corp.'s shares were worth $1,000 each, investors would need to purchase $100,000 in order to own 100 shares. If each share was worth $10, investors would only need to pay $1,000 to own 100 shares. Simple example of this, John owns ten shares of stock if you have a 100 percent stock dividend they send you ten more stocks. So you have twenty. The economic effect of a stock dividend and stock split. Is the same. To the corporation economically it does not make any difference how to double the shares. There should be no dilution. I’m not saying that if I have a two for one stock split and it is tradable and it is 10 dollars a share I am not saying that it will sell at 5 dollars a share. Corps do stock splits when their shares get up to a certain value to increase the value. Ex if shares are up to 100 dollars they split them and make them 50 dollars each so people are more likely to buy stock at 50 dollars a piece other than 100. It brings more people in. Bottom line from the standpoint of the issuing corp economically it makes no difference. From the standpoint of the shareholder it makes no difference, unless by the split by bringing down the price disvalues the stock by putting more stock out there and making it cheaper because there is more market activity with cheaper stock. The only difference: when is a stock split or a stock dividend different: when it gets to 2 for 1 it gets to a split. On the lower end it is a stock dividend. The only person it makes a difference to is the accountant and their treatment of the capital stock section of the balance sheet. A reverse stock split. Say you own fifty shares, now you one 25. The stock is worth more now. ****A convertible security contract, including contracts for warrants, will typically include antidilution provisions which protect security holders against company actions that dilute the common stock they receive upon conversion or exercise. Thus, antidilution provisions cover stock splits and stock dividends. Also included in an antidilution provision are adjustments for reverse stock splits, although these adjustments protect the company rather than the convertible security holders. Antidilution provisions typically seek to adjust the conversion price based on a proportional formula. The conversion price must be adjusted so that a convertible security holder receives that number of shares of common stock for each convertible security after the action in question had he converted immediately prior to that action. For example, in the event of a 2 for 1 common stock split, the conversion price is divided by 2. Thus a convertible security holder receives twice as many shares of common stock when he converts following the split. This is needed because after the split shares of the company’s common stock are only half as valuable. In the event of a 1 for 2 reverse common stock split, the conversion price is doubled. Thus, a convertible security holder receives half as many shares of common stock when he converts following the reverse split. This is needed because after the reverse split shares of the company’s stock are twice as valuable. What Does Reverse/Forward Stock Split Mean? A stock split strategy that includes the use of a reverse stock split followed by a forward stock split. A reverse/forward stock split is usually used by companies to cash out shareholders with a less-than-certain amount of shares. This is believed to cut administrative costs by reducing the number of shareholders who require mailed proxies and other documents. Investopedia explains Reverse/Forward Stock Split For example, if a company declares a reverse/forward stock split, it could start by exchanging one share for 100 shares that the investor holds. Investors with fewer than 100 shares would not be able to do the split and would therefore be cashed out. The company would then do a forward stock split for 100 for 1, which will bring shareholders that were not cashed out to their original number of shares. 1. Characteristics/mechanics 2. Accounting treatment 3. Federal income tax treatment Why would a publicly traded corporation want to buy back its own stock. This is repurchases. G. Repurchase of stock by the issuer: corps buy back their own stock. o This occurs generally when the corp believes that its stock is undervalued.
Number 2 the corp has sufficient cash. Number 3: the corp thinks that by buying up the stock and reducing the number of outstanding shares as compared with the earning from that cash or buying another business you will do more to increase the earnings per share. o It’s a better use of the money. So when you have a depressed market this is a typical ploy. So when you have corps with a low market with excess cash and undervalued stock and no place to park the money they may believe that the best move to maximize shareholder value would be to repurchase its stock. 2 ways to repurchase stock: go out in the market and buy it. This eliminates tax issues for the shareholders. The other way is a self tender see below 1. Reasons for repurchase: don’t repurchase when you wont increase the earnings per share. 2. Self-tender offers : a typical tender offer is where an acquiring company puts out a tender offer to shareholders of target if you tender your stock on x date to me I will pay you y dollars which is usually a premium of what it is selling at now. This is how you acquire it if the board of target wont do it. A SELF tender is simply where the issuing company puts out a tender offer to its own shareholders and says you tender your shares to me by y date and we will give you x dollars and usually with a premium to encourage it. Through the selling shareholder the tax issue is a little different. Under the redemption rules of 302. Sometimes you are subject to the federal securities laws here. Self tender offer is a company buying its own shares from its own company. Tender offer is an offer to buy shares from another company.
LIQUIDATION PROBLEM: YOU HAVE A BALANCE SHEET. THE FIRST THING YOU ARE GOING TO DETERMINE IS WHAT ARE THE PROCEEDS AND THEN APPLY TO DEBT AND EQUITY TO DETERMINE WHO GETS WHAT. THE PROBLEM IS NOT SET UP SO THERE IS MORE THAN ENOUGH MONEY THAT PAYS EVERYONE OFF. IN FIGURING IT OUT THE EASIEST WAY IS TO LOOK AT THE BALANCE SHEET AND THEN LOOK AT THE FOOTNOTES BECAUSE THE FOOTNOTES WILL BE INSTRUCTIVE. MAKE SURE TO FIGURE OUT DEBT IN ORDER OF PRIORITY AND THE STOCK. A general partnerships can elect going forward to be a limited liability general partnership making it like an LLC and generally speaking those laws were put in to accommodate large professional partnerships that found it cumbersome to transfer from partnerships to LLC. Then you have limited liability entities: in the case of the sole proprietorship or limited partnership you really did not need protection for the creditors because if the ship was going down and the owners drained out the assets and did not leave enough money to pay the creditors the creditors could go after the owners. In a limited liability entity like a corp or LLC the owners are not responsible for the debts of the entity. Distribution Laws Distribution: If a corp could make a distribution to a shareholder and after the distribution there was not enough left to pay the creditors the creditors are out of luck and the creditors would not realize this until it is too late. In other words, there are three shareholders and the corp is barely solvent and they are paying huge dividends and they keep paying big dividends. The creditors are out of luck. Therefore, state statutes have always put in restrictions on distributions to shareholders primarily dividends to protect the unsecured creditors. To make sure that there is enough money left to pay. Always been a statute in the corp area. In the noncorp area the llc statutes have a provision in each state comparable to the provision the state has for the corporations. We are trying to protect the unsecured creditor that has not protected itself. And to make sure that after there is a dividend to make sure there is enough money left to pay the creditors. The creditors have two means of self-help: they can take a security and a guarantee. Most lenders of any significant amount will seriously consider taking security. Number two, in an unsecured loan like a bond the loan agreement or the indenture in which the bonds are issued generally has contractual restrictions that are a lot tighter and clearer in applicable than the statutory ones.
The DISTRIBUTION statute he gave us: prior to 1980 you had these provision restrictions that generally said you can only make a distribution or pay a dividend out of surplus. This led to a lot of fighting as to what is surplus. NOW there is an objective test. o More likely than not in practice, you only need to look at the balance sheet and you can see if they can pay it out or not and don’t have to apply the statute. They got 10 mil in assets and 1 mil in liabilities and they want to pay off 10000 dollars. No prob. o The statute says 6.40: the board of directors can authorize distributions to the shareholders subject to the restrictions in C. C is the test. o You apply the test in C and see how much you can distribute. o Knee-jerk reaction is that this test is a restriction on the payment of dividends and that is it or is it a restriction on more than dividends. o Does this only apply to dividends or more: IT APPLIES TO MORE. It applies to cash dividends, property dividends, it applies to redemptions, repurchases, partial liquidations. IT DOES NOT APPLY TO COMPLETE LIQUIDATIONS BECAUSE there is a different provision that applies to this. The only thing that it does not apply to is stock splits and share dividends or stock dividends. It does not apply to stock dividends because it does not decrease their assets. It just dilutes their stock. It just plays with the numbering shares. It does not reduce the stock just plays with the numbers. It applies to any payment distribution to a shareholder. o If that was not true, if it only applied to dividends in the corp sense you could get it around it easily. You could do a pro rata redemption of stock each year. A pro rata redemption of stock each year would leave each shareholder in the same proportionate position. More likely or not would not result in ordinary income in the tax code. I could get around it by calling it something else. o A pro rata redemption is the same as a dividend, I get cash and I own the same percent of the company I did before but I own less shares. Every shareholder is in the same position as before. That is why a pro rata redemption is taxed as a dividend otherwise I could get around it. o Something can be a redemption for state law purposes and a dividend for tax purposes. o First thing make a distribution to a shareholder regardless of what you call it only if you can make it and its not prohibited, you could say under the test of subsection c. o Subsection C says: NO DISTRIBUTION MAY BE MADE IF AFTER GIVING IT EFFECT 1 OR 2. So after the distribution (money given out as a dividend or whatever), not before, whether 1. The corp would not be able to pay its debts as they become due in the usual course of business. (this is the insolvency test) Or 2. The corps total assets would be less than the SUM of its total liabilities plus the amount that would be needed, if the corp were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution (this is the objective test). As a practical matter it is easier to apply the objective test first. The second part The objective test: it says that you cannot make a distribution to the common shareholder IF after giving the distribution effect the assets would be less than the liabilities plus what you would have to give upon liquidation and dissolution to the preferred stock that comes before the common stock. So you can dist to the common shareholder only if you leave enough assets to pay the liabilities and any shareholders (like preferred stock) and to pay them whatever you have to pay them on dissolution. The calculation is easy if only common stock. But if there is a lot of preferred stock it is harder. If you have preferred and common and you have a higher number for preferred and a lesser to the common. The common shareholder cannot take a distribution if it would not leave enough to the debt holders and if there was preferred stock it would not leave enough for them.
If you fail either test then you cant distribute. If you pass this test then you must see if you pass the insolvency test. This is because you could have net assets on the books but could not pay debts as they become due in the usual course of business. The easiest example: if you pass the quantitative objective balance test (the numbers work) but if you have debts due the next day then you cant pay your debts off If the distribution fails any part then it fails. In the real world the test is seldom applied. Most corporations that are doing well it is clear that they can distribute enough to cover a normal dividend. If a corp is short of assets it will be very clear at the balance sheet that they cant distribute. Also in the case where the corp probably cant pass the statutory test you never will get to the issue that is they wont have enough cash. As a practical matter there is no question, they don’t have enough cash to make dividend distributions. REVIEW: you cant make a dist if after giving it effect (making the calculation) they aren’t solvent. WHAT YOU WILL DO. If you think that it is close you will run the test and see how much you can distribute. In other words: balance sheet test: assuming the sheet is legitimate. If you have four dollars of assets and 2 dollars of liability and no preferred stock you can distribute 2 dollars of stock. Not to say we have four dollars of assets then we will distribute x and will that leave us enough. Don’t do the latter method. If you apply the balance sheet test first, although it is the second test in the statute, it is probably easier. Because it is an objective test. If you fail it after you come up with the number you don’t have to deal with the insolvency test because it is more confusing. The objective test: if after the dist the corp assets are less than the sum of the liabilities plus whatever is nec to take care of equity holders that have a preference ahead of the intended recipients then no dist can be made. The insolvency test: the corp cant pay its debts as it becomes due in the usual course. It is very possible you pass the second test the balance sheet test on paper and you fail the first one on lack of liquidity or some big debt. EX: lots of assets but it is all in vacant land and you are in 2010 and no way to sell it and you have some debts coming. EXAMPLES: o If there is common stock only. Do assets minus liabilities give u so much and that is what you can distribute. You can distribute whatever is left after you pay the liabilities. You cant leave the creditors behind. o If you have preferred stock, it is assets minus liabilities minus whatever it would take to satisfy the preferred stock upon dissolution. Example, liquidation value which is either stated or face plus premium. If it is cumulative preferred whatever arrearage you must clean up. Just be careful to include everything you have to pay with preferred to clean it up and then pay the common. o If you have preferred and common, this test will produce two numbers: one for the preferred and one for the common. Obviously the common number is lower than the preferred. 640 D, under the statute: the board can make a determination on financial statements that are prepared on the basis of reasonable practices and principles or other method that is reasonable. If the balance sheet, financial statements, are prepared under GAAP (if you are publicly held and audited) the comments says that they assume to be reasonable. This means that GAAP is reasonable they don’t have to be prepared under GAAP,
but you have no presumption if they are not prepared under GAAP. If they are GAAP with minor exceptions this is one thing. If they are not done on a tax basis and regulatory accounting then this would be a problem, Under either test: when you use the balance sheet if the balance sheet is prepared under GAAP that is considered reasonable. Unless the board has actual knowledge to the contrary, which should be obvious, the board can rely on statements prepared by experts or in-house accountants, the board can make this judgment based on the statements they were given as long as they don’t have information to the contrary. The board can also rely on inside and outside experts to advise it. The board is generally not responsible if things go wrong if it gathered all the information and asked all the questions and made a decent judgment. Because otherwise you really could not be a member of the board. Because under the business judgment rule if this was not the defense anytime a decision went the wrong way you can be sued. Business judgment rule applies in this situation. Other assumptions which come into play in the insolvency test o Insolvency test: First, if you have an audit generally speaking you are ok. If you don’t get a going concern opinion. A going concern opinion is not good. The other two assumptions you can make in applying the insolvency test to see whether the corp would be able to pay its debts as they become due You can assume that the marketplace will stay the same in that there will be a continuing demand for your product. You can assume that if you have long term debt that you will be able to refinance it as it becomes do. The banks will be willing. In both of these, you need to be careful that you don’t have knowledge to the contrary. EXAMPLE The board has not started discussions with the bank to refinance and the bank said there may be a problem. Have to be careful. Also that you don’t have some knowledge on falling demand for the products. If the board is going to get hit with actual knowledge to the contrary it will be about financing. Regarding tangential discussions they have been made aware that there will be a problem for refinancing. o Section 830 — directors: a director that votes for a distribution that exceeds what is authorized under 640 is personally responsible for the excess if the plaintiff which in this case would be a creditor probably, establishes under 830 that the director did not conduct themselves under 830. 830 is a long section that basically has the rules on using inside and outside experts and has standards of conduct. o Under 833 if a director is responsible and it is clear what the damages are the director is responsible to the corp for the excess subject to contribution from every other director that could be held responsible. This means that you can go after the deep pocket director. And allow the deep pocket director to go after the other directors. o It will be hard to prove knowing. May only have to prove conspiracy. C Sanctions — shareholders 4. Application to non-corporate limited liability entities XI. Stock warrants: stock warrant - a type of security issued by a corporation (usually together with a bond or preferred stock) that gives the holder the right to purchase a certain amount of common stock at a stated price; "as a sweetener they
offered warrants along with the fixed-income securities" A stock option is a contract between two people that gives the holder the right, but not the obligation, to buy or sell outstanding stocks at a specific price and at a specific date. Options are purchased when it is believed that the price of a stock will go up or down (depending on the option type). For example, if a stock currently trades at $40 and you believe the price will rise to $50 next month, you would buy a call option today so that next month you can buy the stock for $40, sell it for $50, and make a profit of $10. Stock options trade on a securities exchange, just like stocks. A stock warrant is just like a stock option because it gives you the right to purchase a company's stock at a specific price and at a specific date. However, a stock warrant differs from an option in two key ways: A stock warrant is issued by the company itself New shares are issued by the company for the transaction. Unlike a stock option, a stock warrant is issued directly by the company. When a stock option is exercised, the shares usually are received or given by one investor to another; when a stock warrant is exercised, the shares that fulfill the obligation are not received from another investor, but directly from the company. Companies issue stock warrants to raise money. When stock options are bought and sold, the company that owns the stocks does not receive any money from the transactions. However, a stock warrant is a way for a company to raise money through equity (stocks). A stock warrant is a smart way to own shares of a company because a warrant usually is offered at a price lower than that of a stock option. The longest term for an option is two to three years, while a stock warrant can last for up to 15 years. So, in many cases, a stock warrant can prove to be a better investment than a stock option if mid- to long-term investments are what you seek. WARRANT This simply gives the holder or investor the right to buy a fixed number of shares for a fixed period of time; it could be open ended for a fixed price. A warrant could give you the right to buy 100 shares of stock at 100 dollars in may 2009. You obviously don’t exercise the warrant unless it is in the money, meaning that the value of the stock at the time you exercise it is above the purchase or strike price in the warrant. In other words, the right you have to buy at 100 is valuable because the stock is worth more than 100 dollars. It gives you a call on the stock. 1. The holder of the warrant can be given the warrant in various corporate transaction s or 2 it can buy a warrant. Least common are people buying warrants. You might get the warrant in a package in stock you bought or with debt. If the issuer is floating debt by offering a warrant with the bond it can do one of two thing: it can pay less interest and/or it can pay market interest but sell the bond where otherwise they would have a difficult time selling the bond. You get it as some kind of corp transaction. Also the warrant can be given as ―compensation‖ for services rendered. Generally speaking you don’t give warrants to employees. Employees get employee stock options. The only person who really gets warrants as compensation is an investment banker who would get warrants as part of its compensation for bringing an offering to market. The business adv of giving an investment banker the warrant as compensation. the warrant is not valuable unless post offering the stock goes up. this gives the investment banker every interest to try to create a market for the stock and making it go up and then calling it. Depending on whether you bought the warrant or got it as compensation there are different tax consequences. If you get it in a capital transaction as part of a package with other debt and stock you may have split it and pay other taxes. Just like convertible preferred stock you have the dilution issue see below A. Reasons for use and dilution of stock interests B. Characteristics/mechanics of warrants : mechanically you use employee stock options to employees and warrants are the same thing but you don’t give them to employees. C. Antidilution provisions: convertible debt, convertible preferred stock, warrants, and options all have to have an antidilution provision. This provision basically gives the holder possession of the convertible instrument, the warrant, or the option immediately after the transaction, or these
benefits you have with respect to corporate stocks could be wiped out by splits. Most of these types have provisions that tell the holder what his or her rights are in the case of a merger. You have to tell the holder what their rights are when something happens to that stock. If there is a change in it where do they stand. D. Accounting treatment of warrants: the accounting treatment on the corporation depends upon the nature of transaction, compensation or capital, E. Federal income tax treatment of warrants Long term capital gain: What Does Capital Gain Mean? 1. An increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short term (one year or less) or long term (more than one year) and must be claimed on income taxes. A capital loss is incurred when there is a decrease in the capital asset value compared to an asset's purchase price. 2. Profit that results when the price of a security held by a mutual fund rises above its purchase price and the security is sold (realized gain). If the security continues to be held, the gain is unrealized. A capital loss would occur when the opposite takes place. Investopedia explains Capital Gain o 1. Long-term capital gains are usually taxed at a lower rate than regular income. This is done to encourage entrepreneurship and investment in the economy. XII. Employee stock options: stock goes directly to the employee and not through a qualified plan and the employee has the option of what to do. You could base the incentive plan on the increase of the stock on the market. o Only talking about publicly traded companies. Nothing in corp law that says private corps cant have them. Whenever you want to give equity to employees of a closely held you give them the stock. Because there is no market you can usually place a low value on it for tax purposes and give it to them outright and everything after that is long term capital gain. o Peak use of stock options was in the late 90s to the early 2000s by publicly traded companies especially by dotcoms and high techs where the price of the stock was going up. o Why were stock options at a peak at this time: 1 it provided cash compensation for the employees when they did well. 2. There was no negative cash flow for the corporation or in other words ABC corp gives X employee stock options the stock goes up X sells and gets the cash equal to the increase. X is happy there has been no outflow of cash to the corp. If the corp gives the employee cash or bonus there is a cash outflow. 3. In a publicly traded company there were no earnings hit. In other words, the corp did not have to reduce its earnings by some amount. You had cash for the employee, no cashflow for the corp, no accounting hit for the corp, and probably had a tax deduction. Look at the trick: no accounting hit, positive cash for the employee, and small positive cashflow to the corp for the tax benefits for the deduction. o Problems: there was a dilution with respect to the other shareholders. However most of these companies had so many shares outstanding that dilution made no difference. In other words, if ben owns 1000 shares of his company and I issue stock options technically ben is diluted but technically the price on the market was not damaged. o There was in retrospect a HR problem. When the market flattened and they stopped using stock options for compensation. To be competitive in the market place some of these companies were facing the issue. o MECHANICS OF A STOCK OPTION: there is a stock option plan that authorizes a committee to award or grant options. The plan is customarily adopted by the shareholder. o Generally speaking, the directors can adopt a stock option plan and don’t need approval from the shareholders. Nowadays, they are all adopted by shareholders because of exchange rules. o Number 2, plan is adopted which defines loosely the class of employees that can receive options as a ten year life. States the number of shares that options can be issued for. Usually provides for installments. o Number three, there is a grant. Usually happens once a year. This is when the committee meets
and says we give stock options to the following employees and give them the number specified and the strike price or option price is X dollars which is always the fair market value on the date. Usually it provides that the options will vest in four or five equal installments. So if we have an option for 10000 shares vesting in 5 equal annual installments. Each year after the grant for five years 20 percent of the options vest and can be exercised. Usually you can only exercise when you are an employee. The options must vest prospectively even if there are no installments. Meaning that the consideration for the options is that Employee X works for another year and then he can leave. If they are vested and exercisable immediately. Once an option vests it can be exercised. Meaning that if you have an option to buy 1000 shares at 10 dollars a share and you give the company 10000 dollars and they give you 1000 shares. Most corporations today have put in place a procedure with their investment banker where X wants to exercise the option and they buy sell in one day and X gets a check for the money minus taxes. Basically I exercise and I get a check for the spread minus the federal income tax. I don’t borrow money I don’t pay interest and not at risk of market fluctuation. If you exercise and you hold you are at risk and you could lose. If it is a non-statutory option which is subject to ordinary income tax. o Bottom line: most employees utilize the plan set up by the corp and the investment banker given by letting them do the work and you get a check. So you have a plan, a grant, an exercise, and sale or later sale. There are corp law issues involved, federal income law issues, securities issues— disclosures and registration—accounting issues, finance issues, HR issues. o As with convertible debt, stock option plans have anti-dilution provisions see below B. Characteristics/mechanics of options o Options are most commonly used of all derivatives. An option gives its holder the right but not the obligation to buy from or sell to the option writer (the counterparty) a specified asset on or before a specified expiration or maturity date at a specified price. o The main emphasis is on the right not the obligation o As an option holder, you can choose to exercise the option or not. It is your prerogative. o However, this right is not free. The option holder must pay a price for the option to the option writer. This fee is called an option premium. o Those seeking to acquire options can do so either in the private or the public markets. o The private market for options consists of individuals acquiring custom-tailored options that meet their particular needs, most typically risk reduction. o The option holder’s counterparty in these transactions is normally a brokerage house or investment bank. Before writing the option, this counterparty will negotiate over its terms with the prospective option holder. o The public market for options, by contrast, consists of individuals and institutions seeking to hedge positions or engage in speculation. o Options are comprised of five key variables or terms The underlying asset upon which the option is written Whether the option is put or call The strike or exercise price of the option The expiration or maturity date for the option and The manner in which the option can be exercised. o Almost any asset can serve as the underlying asset of an option, including goods, real estate, intellectual property, stocks and contractual rights. In the financial world, the assets upon which options are most commonly written are common stocks. o Types of options: put or call o CALL OPTION: A call option gives its holder the right to BUY or call away hence the term call, the underlying asset on which the option is written from the counterparty at a specified price, called the strike or exercise price on or before a specified date. The writer of the call option must be prepared to sell the assets stated in the option contract at the stated strike price. To the extent the current market or spot price of the asset upon which a call option is
written rises above the strike price, the call option becomes intrinsically valuable. The reason for this is simple: having the right to buy a particular asset at a price below the current market price is valuable. By analogy, just think how valuable a 50% off coupon on something you really need to buy is to you. Any option including a call option has two components of value: intrinsic value and time value. Intrinsic value depends on the relationship between the current market or spot price of the underlying asset and the option’s strike price or exercise price. If in the case of a call option the spot price is above the strike price at any point during the option’s term, the call option at that time is in the money (it has intrinsic value at that moment). If exercised you would receive the difference between the spot price and the strike price. If however, the spot price is below the strike price at any point during the option’s term the call option at that time is out of the money ( it has no intrinsic value at that time). If the spot price is exactly the same as the strike price the call option is at the money but has no intrinsic value until the spot price rises above the strike price. Any option including a call option also has time value. To the extent time remains until the option period expires, the spot price of the underlying asset could change. If during the time remaining the spot price rises from out of the money to in the money, or if currently in the money to further in the money intrinsic value or additional intrinsic value is created. Thus the longer the period of time that a given call option has before expiration the greater its time value. An option’s time value, however, gradually declines to zero over its term. Example see page 163-64. You buy 100 shares of yahoo call option which is currently trading at $12 a share for a modest premium, which sets the strike price at $15 dollars a share with a call option for six months. Because you speculate the stock to rise in the next six months. You still need to pay an option premium. But once the spot price or market price rises above the $15/share you are in the money and exercise the option. PUT OPTION: The other type of option is the put option. A put option gives its holder the right to sell (or put to) the underlying asset on which that option is written to the counterparty at the strike or exercise price on or before a specified date. The writer of the put option must be prepared to buy the assets stated in the option contract at the stated strike price. As the value of the asset upon which a put option is written falls below the strike price the put option becomes extrinsically valuable. The reason is simple having the right to sell a particular asset at above the current market price is valuable. By analogy just think how valuable a contract to sell your home at top dollar is when the home prices begin to fall. Like the call option the put option has both intrinsic and time value. If in the case of a put option the spot price is below the strike price at any point during the options term the put option is in the money, it has intrinsic value. If the spot price is above the strike price it is out of the money. If the spot price is equal to the strike price it is at the money. Like the call option the put option also has time value. To the extent time remains until the option period expires, the spot price of the underlying asset could change. If during the time remaining, the spot price falls from out of the money to in the money or if currently in the money falls even further into the money intrinsic value or additional intrinsic value is created. Thus the longer the time before the given option’s expiration the greater its time value. The options time value gradually declines over time. Example, suppose you think that yahoo’s stock which is trading at 12 dollars right now will decline over the next six months. So you purchase a put option from a brokerage firm, a counterparty. For a modest premium you can purchase a put option on 100 shares of yahoo with a strike price of 10 per share that lasts six months. When initially written you are out of the money but if the spot price falls below $10 a share you are in the money and exercise the option making the brokerage firm buy your stock at 12 dollars a share thereby
making a profit. Expiration or Maturity date: the expiration date will be the time period that the parties agree. They usually run for less than one year. The longer the option time the higher the premium because of the greater likelihood it will move into the money. Manner of exercise: o An American style option can be exercised by its holder at any time on or before its maturity date. Thus if a given option moves quickly into the money its holder theoretically could exercise the option and reap its intrinsic value. Rarely does this occur. To do so would unnecessarily waste that option’s remaining value ( the chance that it will move further into the money.). Physical settlement and cash settlement: o An option gives the option holder the right but not the obligation to sell or purchase the underlying assets upon which the option written at the strike price. Exchange traded options, other than those written on stock indices, are normally settled physically. This means that the stock underlying an exchange traded option must be bought and sold if the option is in the money when exercised. By contrast, private options (over the counter OTC options) are almost always settled in cash. This means that to the extent a private option is in the money upon exercise, the counterparty must pay the intrinsic value of the option to the option holder in cash. The option premiums: these will be set according to many variables like: the trading volatility of the underlying stock, the manner of exercise, the proximity of the strike price to the current market price of the underlying stock, the duration of the option, the interest rate environment and other macroeconomic variables. What Does Strike Price Mean? The price at which a specific derivative contract can be exercised. Strike prices is mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold. The difference between the underlying security's current market price and the option's strike price represents the amount of profit per share gained upon the exercise or the sale of the option. This is true for options that are in the money; the maximum amount that can be lost is the premium paid. C. Antidilution provisions: so if we have a 2 for 1 stock split we will double your options and split your strike price then you are in the same position as you were before. As far as drafting one in a plan. You copy the last good one in the firm. Under normal corp law you can do retroactive transactions and it is legit: example, I can enter into an employment contract on july 1st retroactive to January 1st and give him the salary from jan 1st forward. You can get into a sales contract in july effective in june. Federal income tax treatment of options : under the tax law, there are two options: statutory options— options that qualify under the code for favored tax treatment and nonstatutory options which don’t qualify under the code for favorable treatment. The rules and definitions for a plan for options that qualified for favored treatment have changed over the last 20 years to the extent that almost all qualified options were used with favorable tax treatment. Now the defintions are such that it is impossible to qualify any significant number of options for favorable tax treatment. Usually to qualify for a favorable tax treatment the employee must hold the options for some time. Now a rule saying that to be statutory the employee cannot have options or shares with a market value of more than 100,000 dollars. Without going into detail. Most companies now use options called nonstatutory. 1. Statutory options: A type of employee stock option which provides tax advantages for the employer that a non-qualified stock option does not, but which is subject to more stringent requirements. In general, an incentive stock option must only be granted to employees, under a specific plan document that states how many options will be given to each employee, within 10 years of receiving shareholder approval and the exercise price must equal or exceed the market price at the time of grant. The option can only be exercised within 10 years of receipt, and there are several rules governing how exercise of the option affects the employer's tax burden. o differences in tax treatment. Statutory options, when plan adopted no taxes for anyone. With the grant of option no tax effect. Upon exercise NO tax effect. When you sell it if you meet all the eligibility rules like the holding period you have long term capital gain. However, if you exercised and sold before the prescribed holding period then you get ordinary income treatment and waive
the tax benefits. 2. Non-statutory options A type of employee stock option which is less advantageous for the employer from a tax standpoint than an incentive stock option (ISO), but which is less restrictive and generally easier to set up and administer. The most important difference is that the exercise of ISO does not result in a tax burden, while the exercise of a non-qualified stock option does (except in very specific circumstances). also called non-qualified stock option. o are today: no tax when plan adopted, no tax on the grant assuming that the option is not traded and does not have an ascertainable value, on the exercise the spread is ordinary income to the employee and the employer gets a deduction for that amount and there is withholding. Then obviously you hold the stock and anything you get is long term capital gain. Most of them exercise and sell the first day. Just like a cash bonus. E. Accounting treatment of options: NONSTATUTORY stock options, before 1995 companies did not take a hit when gave out these options to pay employees. If they would have been required to take hits they would have had losses to show their share holders. Starting in 2004, they put rules in that required a hit with various effects on things. Now corps must take a hit. Today corps are not using stock options as much. Right now the corp generally uses a nonstatutory plan, the employee exercises and sells in the same day, pay ordinary income tax on the spread, pay no interest and not subject to any market risk. What is wrong with backdating: What Does Backdating Mean? Dating any document by a date earlier than the one on which the document was originally drawn up. Under most circumstances, backdating is seen as fraudulent and illegal, although there are some situations in which backdating can be used in a legal and beneficial way, such as backdating a claim for a past period. it is between the employee and the company. it is not hurting any third party. It is part of the compensation. must distinguish true fraudulent backdating where they met at july 1 and picked the lower price of march 1. Some other times it was just done sloppily. The question is if it was really backdated. What were the violations of law. One, as a practical matter if granted it at less than market value then it created a tax issue for the employee and an accounting issue for the corp. TWO, the description of what was done in the securities filing was false. THREE, if it happened after a certain date there is a provision that says if an option is granted to certain executives you must file a notice with the SEC and this was not filed properly because it filed in july 1 and not in march 1. They should have created them at a strike price of july 1 but they did it when the price was later. They built in a gain. D. XIII. Use of stock as compensation or as a measure of cash compensation: stock as a measure for compensation. generally speaking corps pay base salary in cash. Publicly traded corps pay bonuses and the bonuses are mostly part of incentive or target compensation plans. In other words, sales hit a certain level, your sales hit a certain level. In a bonus or compensation plan there are two ways of paying the bonus. 1. You can pay it in cash or 2. The corp can pay it in stock. See below A. Stock as a bonus: if it pays it in stock it can pay it in more than one way. o First, it can give the stock outright to the employee in his or her name. and then it could give you stock in one of two ways: totally unrestricted stock (you get it clear and you can sell it) or you have to stay there for two years otherwise you forfeit it (restricted stock). The taxation to an employee when the stock is given is controlled by section 83 of the code, generally the rule is that the stock is taxable when it is first non-forfeited-- at the end of the earn out. There is sometimes an election provision means that if you elect to pay the tax then everything after is capital gain. The company gets tax deductions for giving you the stock. In using stock the issues are what are the tax consequences to the employee, the corp, what are the accounting consequences to the corp, and the dilution issues. For tax purposes you want the income as low
as possible for financial perspective you want income high because it keeps the value of the stock high. The inside directors have a conflict of interest here because they want inflated earnings because their earnings are tied into the stock. B. Stock contributed to a qualified plan: employees can also get stock through a qualified benefit plan like a 401K. The company can contribute part or all of its contribution to the plan in company stock. C. Stock purchased by a qualified plan: This is actually the second option. When the plan buys the stock with cash contributed by the company, the plan buys a certain number of shares each month to avoid problems with trading. One of the benefits of this is that if a company has a profit sharing plan that is always buying stock. what does this do to the stock: you always have a buyer. o 2. The company can contribute cash and the plan can purchase stock periodically on the market. The enron plans were heavily invested in enron stock, employees were millionaires one day and had nothing the next. In either case no tax consequences between the two until there is withdrawn. D. ESOP E. Stock appreciation rights: this right allows over a specified period a person gets a bonus in cash based on the price of the stock at the time. So rather give him a bonus based on net earnings we give him a bonus based on the price of the stock. Nothing prevents a corp from combining more than one of these methods into a plan as a means of measuring performance. One of these: net income, gross sales, stock price, may not in and of itself be a good indicator of performance. F. Stock appreciation as a factor in a cash compensation plan: can be given as a bonus to employees. XIV. Liquidation of a corporation and allocation of the proceeds of its assets o Basically this is the theory or concept for problems 7 and 8. On this we are assuming we are out of bankruptcy and not doing it in bankruptcy. This may be unrealistic but as a matter of corp law we are trying to see how to do it without the bankruptcy rules applying over top of it. o When as a business corporate matter does a corp liquidate? A corp liquidates for good reasons and bad. Assuming that you are selling a business and if you sell a business which is encapsulated in a corp entity mechanically you can do it three ways: sell stock, sell assets or do a merger. If you do a merger then you don’t have to go through a liquidation. If you sell the stock you don’t have to go through a liquidation. The buyer might but that is not your problem. Assuming for a GOOD reason you sell the assets, subject or not subjebct to the liabilities, if you are selling a closely held business the buyer probably wants to buy assets not liabilities. Known liabilities are not a problem because they take them out of the equation. But there are contingent liabilities that don’t show up on the balance sheet. If you buy it assuming all the liabilities and pay the corp 1 million dollars you have 1 million in the corp: to complete the transaction you must get the money to the shareholders so you would have to liquidate. If on the other hand the buyer gives the corp the gross price then you have to pay off the liabilities before liquidating. If you sell the assets of the business and then you sell it, and the buyer assumes all liabilities, you have a cash amount with no liabilites after you pay your corp level tax you have to liquidate. If the buyer does not assume the liabilities you get the gross amount and not the net amount and you have to pay off the liabilities and the tax before you liquidate. This is all the good part. Partial: assume a company has three divisions and sells one division and wants to distribute the proceeds to the shareholders. This will be either a partial liquidation or a redemption and there are just tax issues to make sure that the proceeds are long term cap gain. To avoid the tax at the shareholder level on the liquidation you might want to keep the corp as holding company or investing company and not liquidate. Holding company: A company that owns enough voting stock in another firm to control management and operations by influencing or electing its board of directors. also called
parent company. Bad situation: When corp liquidates for bad reasons. Corp is either not doing well or anticipates that business in the future will be bad and they cease operations and liquidate. The issues of priority, who comes first, who gets what really relate to the latter case this case. Bad case. If you sell a good business it is rare that you will not pay off all liabilities and all preferred stock. So you have a business ceases operations because it is about to go under and there is a question of liquidation: what happens o first, you have to reduce your assets to cash. This is where we go back to the discussion earlier about liquidation value. Meaning, you cease operations and the question is what will the assets bring strictly as hard assets. Not selling to someone as a business. Receivables usually become a problem when you are reducing the assets to cash. Why assuming john is a customer and has been paid timely full amounts for years because john wants delivery next week. The moral question. I cease to operate so the customer needs a new supplier, john still owes fifty thousand. Usually they wont send the money. They will find a problem with the shipment three weeks ago that there was something wrong. Or he may say ill give you 80%. Bottom line when you reduce to liquidating value you are reducing receivables to cash there is no way you are going to collect the amount that is on the books. Even if people are not objecting to the amount since they don’t need your delivery next week they will be slow in paying. So you will compromise just to get the money and get it over with. o A business that has inventories: if I have an item in my inventory that sells normally for 10 bucks, if I cease to operate and I am going to dump it in a lot to someone. You will probably not get the 10 bucks. Say if you sell a car individually and normally for 25K and you cease business and have to get someone else to buy 20 cars, they wont give u 25k a car. If they are going to buy in bulk they will give you less. o So you will take a beating on your inventory in a liquidation. o Bottom line is that unless you have valuable intellectual property or a name to use to sell when you reduce your hard assets to cash you will end up with a number that is a lot lower than what the balance sheet shows. o The question then becomes how do you allocate the proceeds: you must pay off the debt before you can pay off the equity. Revised Model 640 it does not apply to complete liquidations but there is another section that does. You pay off your liabilities and you have to reserve enough cash to pay the transaction costs for the liquidation and if you have any taxes owed. o In concept what do you do: you first look at the debt and must pay off the debt in priority order. Within the debt category you must pay off the secured debt first. A general rule: a security is worth less or more than the debt. So if the sec is worth more you pay off the debt because the sec could take the security. What happens if the security is less than the debt, where does the creditor stand on the difference: they are unsecured and under. Then you go to unsecured (does not have a security) debt and go to issue of subordination. You have senior junior debt and must work all this out. First senior. Then you go to the unsecured junior debt. If looking at it that it is clear that there is enough to pay all the debt and you don’t know how much equity then this whole discussion becomes moot you just pay everyone. In other words if your total debt secured unsecured and contingent is 1 million bucks and after you reduce your assets to cash and you have 2 million you don’t get into this thing. o Then you get down to the equity and obviously you go to preferred stock first, then common premiums, then common. If there are series within the preferred and common you have to take that into account. It is just layers.
o Whatever is left is the residual. How does this all work if you have convertible debt and convertible preferred stock. The calculation gets very complicated. If you are going to liquidate, question 1 is: are the holders of the convertible instruments better off with the instruments they have or converted. Bottom line: is she better off with the debt or is she better off converting to equity (stocks). When you make that calculation it is very tricky because she can easily figure what she gets if she holds the debt. But if she calculates what she would get if she converted (making another calculation, remembering in this calculation what she would get if she converted from the balance sheet you have to remove the balance sheet BECAUSE THERE IS NO DEBT). IN OTHER WORDS, if you make the first calculation and she gets 1000 dollars for her bond and the stock will get 200 dollars a share and she would get five shares 1000 dollars, that is even. Not so. Because if you assume a conversion in determining how much a share would be you have to reduce the debt. Because if you convert the debt is not there. Leaving more for the shareholders. There is more shares now. In other words, if she converts were debt in making the comparison, there is less debt but more shares when converting. You must take debt out but more shares. How this effects it depends on how much debt is there. The next thing preferred stock, what would she get with convertible preferred? If you announce you are going to liquidate and if the numbers are available to the people (publicly held) if she mixes the calculation and converts you have no issues. If she does nothing or you don’t give her the info that she can do it, if the conversion would give her more do you have give the bigger amount. If the info is public then they don’t have to give her the bigger amount. If no disclosure then they have to give her the bigger amount. If you try to screw her you will get a lawsuit. XV. Use of debt and/or stock in acquisitions: this section is about the sale and purchase of a business. Starting with the premise that every entrepreneur starting with the dream of selling his or her business and in effect hitting the lottery. o If you have a sale purchase acquisition of any size there will be accounting and business issues, you have obviously federal tax issues, and if you are using stock or debt you have federal security law issues, if there is a fed sec issues then you have state law issues, and state corp law issues. o The form of the transaction or method by which it is accomplished is generally tax motivated. o The seller has a gross sales price minus the transaction costs minus federal taxes equals the net (what he or she puts into the pocket). As far as the client is concerned your goal is structure. What matters to the client is the net in your pocket. If you can structure a deal with a gross price of 90% of X but have more left at the end because less in the way of taxes that is your job. o If you represent the seller who is a small entrepreuner and never gone through one of these transactions before. What could happen is that the seller starts to negotiate with the buyer and starts to talk price and may even agree on a ballpark price before they come to you and they screwed up because they will pay more taxes or have security law problems. The ideal client before they ever talk in any detail to the buyer will sit down with lawyers and accountants and figure out a plan. o Consideration in acquisitions o Very simply, in a deal regardless of form, the consideration could be cash or debt (long term debt with debentures/bonds or it could be short term debt where they pay part of the price at the closing and the rest over a few years with a short term installment note.) o If there is debt, issues of securities could come up. The seller says what kind of security do I get in case you don’t pay. This is tricky because the buyer may offer the business it is buying as a security. In other words, if the buyer runs it into the ground and can’t make the payments you get back the failed business so generally if you are the seller and you are looking for security you want something outside what you sold them otherwise you run the risk of having the buyers run your business into the ground then not make payments and you redeem the security (your business) that now sucks. o Then you could have non-voting or voting stock preferred or common, whether the stock is voting
or nonvoting can be or will be critical depending on the form as far as the tax issues are concerned. Some forms that are tax free require voting stock. o Your seller may not care whether they get voting or nonvoting but it could bear on the taxes for the seller. o Then there can be contingent consideration: stock or cash. That is, it is additional consideration paid after the closing based upon future performance that is over a period of years after the closing. In other words, I buy C’s business and give her a million bucks and I will give you X dollars more if over the five years the business hits a certain level of sales or net profit. This is typical in the purchase of a closely held business because what you are saying to C is that if the business holds up and grows in the way you are promising that it will it is worth 2 million, and if it does not then it is only worth 1 million or in between. o This can become critical in two ways: c and her co-owners who are selling and leaving may be more critical to the business than they say because when they leave the business might be in trouble. 2. The business may depend on 50% of business in one client. The business might be worth 2 million with the client and 1 million not. So when you buy a business you are better to have a business with each 1 percent than 4 customers each 25%. o Lastly the consideration can be a combination of some of the above. Merger and Acquisition Deal Structures. o Five basic types Acquisition or Purchase: an acquirer can choose to acquire or purchase a target company in one of two ways. The first is through a stock acquisition. Here the acquirer purchases the stock of the target company from the target’s stockholders. The second is through an asset acquisition. In this situation the acquirer purchases specified assets of the target company (e.g. all assets associated with a particular line of business of the target company) and may also assume specified liabilities of the target company (typically those naturally associated with the purchased assets). Merger, Consolidation or Conversion: In a classic merger transaction one company is merged ―with and into‖ another company, which is known as the ―surviving company.‖ the stock holders of the company being merged out of existence receive either cash, securities in the surviving company, or a mix of the two as merger consideration. By operation of law, the surviving company assumes the assets and liabilities of the company merged out of existence. Thus, after the merger shares of stock in the surviving company represent an interest in the two combined companies. A consolidation is essentially a merger between more than two companies. The typical transaction involves two existing operating companies that merge with and into a newly formed third company. A conversion is a transaction where an existing corp converts into another form of business entity (such as a partnership or limited liability company) or a noncorporate entity converts into a corporation. For example, a business that is not a corp needs to convert into a corp before that business can go public by engaging in an IPO. Leverage buy out (LBO): In a typical LBO, a private group of investors borrows substantially all the money needed to acquire a controlling interest in a target company. Indebtedness (either in the form of loans and/or debt securities) is secured by the assets of the target company, and the indebtedness is serviced (i.e. paid down) with the cash flow that the target company generates going forward. Recapitalization: in a typical recap a given company will replace or swap with certain existing securities mostly debt or debt equivalents with new equity securities. Thus the company shuffles its existing capital structure in order to make the company more viable from a financial point of view going forward. Restructuring: a typical restructuring will have the company in question divesting (i.e.
selling) certain businesses or divisions in an effort to refocus its business strategy on core operations. A good example is the spin off. Here a parent company distributes some or all the shares it holds in a subsidiary to the parent’s stockholders in the form of a stock dividend. Thus, after the spin off, a parent company stockholders continue to hold shares in the parent (and now also holds share sin the newly spun off subsidiary. A. Acquisitions in general TYPES: Those seeking to acquire a business do so either by purchasing the assets (an asset acquisition) necessary to operate that business or by purchasing the equity of the company that operates that business (stock acquisition). o 1. ASSET ACQUISITION: When acquiring assets of a target company the acquirer can use cash consideration (a cash for assets acquisition), stock consideration (a stock for assets acquisition), or a mix of both. A. CASH FOR ASSETS ACQUISITION: in a cash for assets acquisition, buyer corp pays seller corp cash consideration for the assets of seller corp that buyer corp is seeking to purchase. Buyer corp may also negotiate to assume some of seller corp’s liabilities (typically those directly related to the purchased assets), but is not legally required to do so except in certain situations. If buyer corp agrees to assume liabilities the purchase price buyer corp pays seller corp should be reduced because buyer corp is required to pay those liabilites after the acquisition. Seller corp may choose to dissolve after it has sold all or substantially all of its assets. To do so seller corp must pay its remaining creditors in full and then distribute any remaining proceeds to stockholders of seller corp in the form of a liquidating distribution. Thereafter, seller corp’s certificate of incorporation is cancelled, its shares are extinguished and its corporate existence is dissolved. From a tax perspective: a cash for asset deal followed by a dissolution of seller corp is taxed at two levels. o First seller corp is taxed on any gain from the sale of its assets. o Second, seller corp stockholders are taxed on any gain they receive relating to seller’s corp’s dissolution. o There are generally no tax consequences for either buyer corp or its stockholders as a result of the transaction. D. Federal income tax treatment of acquisitions: o First we will take an all cash deal, then an all stock deal and then mix cash and stock. o An all cash deal is taxable. An all voting stock deal could be and probably will be tax free or deferred. Mixed voting stock and cash in a merger could be both taxable and nontaxable. o All cash asset deal: It is taxable to the selling corporation at the corporate level. In other words, if the excess over the proceeds over the bases being sold is gain. The sales price or proceeds is the cash grossed up with the liabilities assumed. Then you have the shareholders. If the corp then liquidates that is taxable again to the shareholders. The difference between the proceeds and the shareholders bases in their stock. The amount distributed will be less than the amount the corp gets because the corp will have to pay transaction costs and taxes. The tax basis to the corp in its assets will not be the tax basis of the stock in the hands of the shareholder. Basically double taxation. Taxed at the corporation and the shareholders. So with the same purchase price the shareholders will net less in an all asset deal than in an all cash deal. First, it is possible if the selling shareholder and the liquidating shareholders don’t receive all the cash at the closing. There are some deferred installments. This means that if you have 100 dollars of gain and 1000 dollars in payments. Rather than 100 dollar gain being reported at the closing, 10% is gain and the rest is recovery.
Second, the way you get around the double tax is don’t liquidate and keep it as a holding company. So if they wait to die until they liquidate they can avoid a lot of taxes. So they borrow against the distribution, have a good time, when they die the kids liquidate and then pay the bank off. If you want to get the same price you want a stock deal. The reason the buyer wants an asset deal is twofold: one corporate one tax. From a corporate standpoint, the buyer does not want their corporate shell that they have been running for forty years, there may be many contingent liabilities. The buyer wants to buy assets and assume only enumerated liabilities and not contingent. 2. If the buyer buys assets then they get a new basis in all the assets equal to what they are paying for. More depreciation in the future and less taxes. If they buy stock they continue everything. Buyer wants assets, seller wants a stock deal. B. STOCK for ASSET ACQUISITION: Typically, a stock for assets acquisition requires two steps. In step one, buyer corp uses its own stock as acquisition consideration to purchase seller corp’s assets. In step 2, seller corp dissolves and the former seller corp stockholders receive shares of buyer corp in the form of a liquidating dividend. A stock for assets deal is a tax free transaction. If, in the first step, buyer corp assumes all of seller corp’s liabilities which is optional the result is the same as a stock swap statutory merger. Thus, the assets and liabilities of both companies are combined within buyer corp, leaving only buyer corp stock outstanding. However, voting rights are different than in a merger and more favorable in a merger. DRAWBACKS TO ASSET ACQUISITIONS: A purhaser normally cherry picks the assets of the seller it wishes to buy. It also seeks to limit its exposure to the seller’s liabilities. These deals are very complex and time consuming. The transfer of assets must be documents.
Class notes How do you do a deal. A corp seller (target T) and corp buyer (acquiring company A). C Asset sale/acquisition o The first one we can do an asset deal. He is not dealing with consideration right now. In an asset deal T will transfer all of its assets to A and A will transfer the consideration to T. in this deal A could either assume liabilities of T or not assume the liabilities of T or assume some. Typically A will assume the liabilities of T. let’s assume I’m A and I tell T I will give you 2 million bucks for your business. If I agree to assume T’s liabilities of 600000 (assuming liabilities is a payment and so it comes off the purchase price) so A will give T 1.4 million. A may assume the liabilities because it is like cheap financing because you don’t have to come up with as much money. Also it gives you on trade payables it gives you a leg up on continuing the relationship with them. So you can either assume the liabilities or you can assume some or none. Under an asset deal where you assume liabilities do you want to put into the contract some broad lanaguage that A will assume the liabilities from the closing date. No you want to be specific as to when A will assume the liabilities. You don’t want to assume something that you don’t think you are assuming. o If you agreed to pay 2 million including assumed all liabilities of T as of the closing date, theoretically on the closing date T could have more than 2 million in liabilities. So there could be a problem. o Another variation: T could sell less than all of the assets. There could be assets that A does not want. Now after the deal, assuming everything is sold. T could either liquidate or not liquidate. If T does not liquidate you are sitting their with a holding company. T could either liquidate or not. o Also A could set up a sub and do the deal into A prime. What A is hoping for if A takes the
business of T and puts it into a separate sub. A is not exposing its assets. Another reason, if T is a quote regulated business, by the feds or state agency, you either might want to or have to put the business in a separate unit or corporate shell so as not to expose the whole company into regulation. o 1. STOCK ACQUISITION: When purchasing stock of a target company, the acquirer can use cash consideration (a cash for stock acquisition), stock consideration ( a stock for stock acquisition), or a combination of both. Acquirers seek to purchase stock of another company either for investment purposes or for control. In the former situation an acquirer will purchase an equity stake in a target company that does not confer any substantial control. In the latter situation, control of the entity is the central purpose. A. CASH-FOR-STOCK ACQUISITION: In a cash for stock acquisition, buyer corp purchases, for cash, the stock of seller corp directly from the stockholders of seller corp. because buyer corp now owns the stock of seller corp, seller corp becomes a subsidiary of buyer corp. the cash for stock transaction is a TAXABLE EVENT for SELLER CORP’s SHAREHOLDERS. They must recognize any gain on the sale of their shares to buyer corp. Most acquirers wish to purchase all the stock of their targets, thus turning those targets into wholly-owned subsidiaries. Indeed an acquirer typically makes a sizeable investment in a target. If less than all the shares of the target are purchased the acquirer owes fiduciary duties to minority stockholders of that target going forward. Accordingly, acquirers typically make a cash for stock acquisition the first step in a two step acquisition that ultimately eliminates minority stockholders. In the first step, the acquirer tries to purchase as many shares as possible from the target shareholders. In the second step, the acquirer effects a cash out statutory merger. In the second step the stockholders must approve the cash out merger. If the acquirer was successful in acquiring at least a maj stake in the target in the first step the acquirer itself will have the votes necessary to approve the merger. A cash for stock acquisition does not have to be approved by the stockholders of either buyer corp or seller corp. buyer corp has the statutory authority to own subsidiaries and its not issuing stock as acquisition consideration. Seller corp stockholders do not need the protection of a stockholder vote, because each individual seller corp stockholder can choose whether to accept buyer corp’s offer to sell his shares. If seller corp is a publicly traded company, buyer corp will make its tender offer to seller corp’s stockholders. Pursuant to the tender offer buyer corp will invite seller’s corps shareholders to tender their shares into the tender offer in return for the acquisition consideration buyer corp is offering. B. STOCK FOR STOCK ACQUISITION: A stock for stock acquisition is similar to a cash for stock acquisition. Instead of buyer corp paying cash to seller corp’s stockholders in exchange for the stock, buyer corp issues shares of its own stock as acquisition consideration. Therefore, seller corp stockholders become buyer corp stockholders after the parties consummate the transaction. Seller corp becomes a subsidiary of buyer corp, because buyer corp now owns shares of seller corp. if buyer corp purchases all the outstanding shares of seller corp, then seller corp becomes a wholly-owned subsidiary of buyer corp. A stock for stock acquisition is a tax free transaction. The result of a stock for stock acquisition is similar to a stock swap statutory
merger in that seller corp’s former stockholders end up holding buyer corp stock. However, unlike a merger seller corp’s assets and liabilities remain within seller corp. through a stock for stock acquisiton, buyer corp assures itself that the creditors of seller corp will not be able to go after the assets of buyer corp in the event seller corp is unable to fully pay them, if buyer corp wants to achieve the exact effect as a stock swap statutory merger at a later date, seller corp can be merged with and into buyer corp pursuant to the short form merger provision of section 253. C Stock sale/acquisition o Assuming that this is a stock deal: so it goes SH(shareholders of T)T. A would acquire all of the stock from T from the shareholders of T in consideration for whatever the consideration is. So after the deal T would become a wholly owned sub of A. Obviously it is also possible for A to acquire less than all of the stock. If A wants to buy the business A wants all of the stock. As a matter of executing or implementing a deal. o Stock deal is easier than an asset deal. o Two variables in a stock deal> if there is only a few shareholders A can do it by agreement with the shareholders. They will sign an agreement that they will sell all of the stock to A. what do you do if T is publicly held and traded and there are a lot of shareholders, what corporate mechanism would you use: tender offer. If A is going to acquire T’s stock by tender offer, A just makes an offer and public notice to all the shareholders that we will buy all shares tender to us by Dec 31 2010 at X dollars per share. o One last thought, if you do a tender offer but there are one or more big shareholders usually A will get a written agreement for the tender offer from that or those big shareholders that they will sell or tender their share. o With or without a tender offer you can do a stock deal also with a sub. o All cash stock deal: difference between the proceeds and the shareholders basis in their stock is taxable gain, which is long term capital gain. The buyer does not get a stepped up basis in all the assets. There is one provision where the buyer can elect to get a stepped up basis. The cost of this is a deemed sale of all the assets which is a gain that will be taxed. Stock deal: taxable long term capital gain. Each shareholder will probably have a different basis in their stock because they didn’t buy it at the same time. SECOND: THIS IS AN ALL STOCK DEAL. o Acquisition of stock. A is buying shareholders. Needs to own at least 80%. The consideration must be voting stock. Since the statute says that the acquisition of the 80% must be SOLELY for voting stock. No margin of error. If these shareholders get anything else than voting stock it kills the whole deal. You must make sure that the shareholders pay all of their costs. If it is later determined that A paid any costs that were rightly needed to be paid by the shareholders the whole deal is killed. A stock deal that is tax free is most simple. In an asset deal A must get substantially all of the assets of T solely for voting stock. Substantially all: a percentage of gross assets and a percentage of net assets. A usually assumes liabilities of T. under the rules this would break the SOLELY rule because you are acquiring other things than voting stock, liabilities. Further requirement: now says that T must liquidate. Bottom line: A can acquire the assets or stock of T solely for voting stock and will be taxed. B. Consideration used in acquisitions
C Cash C Debt C Stock You can classify the deals on consideration and also on taxability. You can have a deal which is a taxable deal, you can have a deal that is a tax free organization or you can have a mixed deal. If you have a tax free deal, the client may want assurances that the deal is tax free. Also the client can ask u for an opinion of counsel saying that it is tax free putting yourself on the frying pan. Is tax free reorganization really tax free or is that a misnomer. It is really tax deferred. Tax deferred deal means that if you receive stock in a tax free deal when he sells that stock he picks up the gain he would have not picked up if the deal would have been taxed. So when you sell you receive the built in gain, the gain that you would have paid tax before. Tax free org are really tax free until you sell the stock and then you pay the tax. Unless you die you pay the tax. C. Mechanical forms used in acquisitions: o The context of a deal: beginning to end of a timeline of what happens of the sale of a business. First thing that happens either the seller puts the business into play, puts it out on the market I want to sell it, or the seller receives some kind of unsolicited bid or offer from a buyer. At that point the next two things to do: if there is a broker, investment banker, or other type of intermediary or consultant involved you must get a written agreement with the intermediary setting forth in writing the terms, that is what the investment banker gets and what does it have to do and what’s the life or term of the engagement with this investment or other intermediary whether it is an exclusive deal or nonexclusive deal and assuming it is a six month deal that is I give him six months to sell, do I give him a tail (that is if he sells it in the seventh month). Before you do any talking to a prospective buyer you need a confidentiality agreement or Nondisclosure agreement that means that both sides will not reveal any of the confidential business information of the seller that it gains during the negotiations. o Bottom line you do a confidentiality or NDA but you must understand that if the buyer breaches there is nothing they can do because they already have the information and number two you must prove they breached and 3 you must prove damages. Bottom line you must sign it. o The moral of the story is that if a seller is giving confidential info to a buyer they must rely on two things one, they must know who they are dealing with (guy may be bad) and 2, most importantly, you don’t give the buyer the most significant business information until you are closest to closing the deal. The critical and most significant info you don’t give until you are closing and confident that the deal will be made. o Next thing the seller usually must put together some presentation materials for the buyer. Where this gets trickier is if the prospective buyer is a competitor. o You may want to qualify the buyer, see if the buyer can come up with the money. o Then at some point the parties reach an agreement in principle. That is they handshake on a deal but there is not a definitive signed agreement. o That brings the question, do you go straight to a definitive agreement or do you sign a written letter of intent. From the seller’s standpoint the problem with a letter of intent is that buyer’s counsel will insist on putting some grease on it, that there is an out, and the out will be that they can’t get the financing or in their due diligence they find something that they could not expect. Recognizing that and accepting that if I represented the seller I would rather have a written letter of intent, because that forces the parties to put the basic terms, the consideration, down in writing so you don’t come back later and say I thought you said 1 million 1 no I said a million 2. o If either or both of the companies are publicly held company at some point along this process will come the issue of disclosure, that is whether you must put out an announcement. If rumors come out and the company is asked publicly is this proof, must be careful. o Two things then proceed on parallel tracks. Buyer obtaining financing and the buyer doing its due diligence. Due diligence is a careful examination of the business. You start with the financial statements and what you have been given then you start investigating. Usually due diligence starts with buyer sending seller a large letter asking a lot of questions and asking for a lot of documents. The important thing is that if you represent the buyer you need to get everything you asked
o o o o o o
answered in writing. Because in the definitive agreement you will tie this into the representations and warranties. For example, question number 28: provide us with a list and copies of all employment contracts. Seller said we don’t have any. If you accept that, this is not tied into the warranty. So in order for it to be binding, you need them to give you a negative statement as such. You want to make sure that all the assets they said they have are there and are good and all the liabilities that are stated are not understated and no contingent liabilities. You want to know about all the leases or contracts. How much you do and what you do is determined by the buyer and the consultants experience of what kind of business you are dealing with. Want to make sure no environmental damage. Then you develop and sign a definitive agreement then you have a closing and possibly with contingent prices and other adjustments. Hopefully later you don’t have breach of warranty issues.
Bottom line: however you do it an all cash deal will be taxable if there is gain. o o o MERGERS: The third all cash deal could be a statutory merger: In most states today, you can do today an all cash statutory merger. An all cash statutory merger is taxable. Cash deal: two kinds Asset stock and statutory merger two basic types of mergers are stock swaps (stock for stock) statutory mergers and ―cashout‖ (cash for stock) statutory mergers. A. Stock Swap (stock for stock) statutory mergers In a stock swap or stock for stock statutory merger two corps (surviving corp and merging corp) each with different sets of stockholders, merge together. Merging corp merges with and into surviving corp. thus surviving corp survives the merger. Merging corp’s stockholders swap their existing shares of merging corp stock for shares of surviving corp stock (hence the terms stock swap ). As a result of the transaction, merging corp’s assets and liabilites are combined with those of surviving corp as a matter of law. Merging corp’s existence is extinguished leaving surviving corp as the only surviving company after the merger is consummated. Merging corp’s stockholders swap their merging corp shares for shares in suriving corp. merging corp stockholders thereafter are surviving corp stockholders. Shares in merging corp are then cancelled. A stock swap statutory merger is a tax free transaction.****** B. Cash out (cash for stock) statutory merger A cash out (cash for stock) statutory merger is substantially similar to a stock swap statutory merger, except that surviving corp uses cash to acquire merging corp shares rather than shares of surviving corp stock. Merging corp stockholders are cashed out and thus do not become stockholders of surviving corp. surviving corp assumes all the assets and liabilities of merging corp by operation of law. Therefore, unlike a cash for stock acquisition, a cash out merger does not result in merging corp becoming a subsidiary of surviving corp. A CASH OUT MERGER IS A TAXABLE TRANSACTION TO THE MERGING CORP STOCKHOLDERS. While pure cash out statutory mergers are possible most are usually effected as the second step or back end of a two step acquisition. The first step consists of the acquirer purchasing a majority equity stake in the target company typically through a wholly owned subsidiary formed for that purpose. If the target company is a publicly traded company then the subsidiary will purchase that stake through
an all cash tender offer financed by the acquirer *known as the parent company). The second step consists of the cash out statutory merger through which any remaining minority stockholders of the target company receive cash for their shares as part of a squeeze out. If the parent and subsidiary commence the tender offer with the approval of the board of directors of the target, the tender offer is considered friendly. Because a target company’s stockholders are entitled to vote on most statutory mergers acquiring companies seeking to acquire at least a maj equity interest in the target stock before seeking a vote on the merger, if successful a vote in favor of merger is assured because the acquirer will hold a maj stake in the target and will vote its shares in favor of the merger. C Statutory merger: o The third way to get these companies together are a statutory merger. Statutory merger A is a survivor and T disappears. A assumes title to and assumes all the liabities of T by operation of the law. To that extent it is like a sale of assets where you sell all the assets and the buyer assumes all the liabilities. Then the shareholders of T in the exchange get whatever consideration A is going to pay for each share of stock. In addition to having a stock merger where the shareholders of T become share holders of A you will have a cash merger. For practical purposes when it is all over, a merger and asset deal looks the same, except if T has contracts with third parties in the asset deal, T cannot assign or sell those leases or contracts to A without consent of the third party unless assignable by their terms. The problems there is one paper. What if T owns fifty plants and in an asset deal you have fifty real estate deals. The other problem, business problem, lets assume that T has what is now a below market long term lease. It was at market when they signed it and now it has 5 years to go and less than market value and you are the lessor, and if I come to you, you will say raise it and ill agree to sell. As a practical matter in a big company an asset deal becomes difficult today. o Also if there are regulatory issues involved a merger or stock deal may avoid issues, o The merger can also be done in a subsidiary. o In a publicly held company, an offer to buy comes in, do they have to entertain other offers? o A share exchange like a stock acquisition needs approval, and a merger needs approval. Third: A statutory Merger o There are three overriding propositions that you must meet. There must be a business purpose of the deal There has to be a continuity business enterprise. After the merger A must continue most of the business of T. There has to be a continuity of proprietary interest meaning that under the IRS position that at least 50% of the consideration in the aggregate to all the shareholders must be stock. In other words, you can do 51% stock and 49% cash. If collectively 51% of the consideration is stock and no more than 49% is cash then the whole deal is cash free and we separately deal with the cash. You deal with the cash this way: for the shareholders who receive cash their gain is taxable but not in excess of the cash they receive. As a planning device, give the old guys stock because it is tax free and give the younger guys the cash because when the old guys die the younger guys will liquidate. o The IRS position you must have at least 50% stock. o There are three numbers, the fifty is ok. A number below fifty is when you will be audited. If you want to shoot the dice you can play with the old cases. o If you are going to do cash and stock you need to do a statutory merger
ESOP An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits. Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual. When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues. In public companies, employees must be able to vote all issues. REVIEW: Exam: Saturday December 18th 1:15pm. Problem, a few short essay, multiple choice, true/false. Balance sheet: assets-liabilities = equity. Capital: your assets. Generally corps raise cash, but they could raise capital in kind. Investors can contribute assets rather than cash. Almost all businesses need capital to start. Capital structure: o Debt, equity, hybrid. o The typical hybrid looks like debt but has two parts for the periodic payment, a fixed part like interest, and a second part that is based on earnings. Hybrid: a certain amount of debt payed at a certain time, a low amount of interest always due and then a small interst due on earnings. Debt/equity packages: many times you package them together, where you use equity as a kicker—meaning if you are having a hard time raising money, you might throw in a warrant (kicker) to buy shares to entice a creditor to loan you money. Or you could sell stock and bonds as a unit. Each is separate but to get one you must buy the other. If a b and c invest in a closely held company and they split their investments between equity and debt proportionally, the irs can raise the question that the debt is not really debt it is equity. What that means is that the interest payment on the debt part that the corp is saying is deductable the irs will contend that it is a dividend and not deductable. Financial instruments that represent these debt and equity interest: o Open accounts payable o Promissory notes: they are in writing they could be negotiatable or nonnegotiable could be secured or unsecured. o Commercial paper: on wealthy people and corps who need money on short term time. It is debt, and the instrument is like a short term bond 30-60 days. The debtor is usually the type of corp whose short term needs for cash to finance its receivables or payables fluctuates so they get it short term rather than long term.
o Debenture bonds are interchangeable. Convertible bonds and convertible preferred stock. o Mechanics are the same. o What is the differences between convertible stock and exchanges of stock: convertible stock is preferred stock convertible into common stock. Exchangeable stock is stock of abc converted into stock of a third corp which abc owns. With debt in private placement, a debtor with a group of creditors in addition to a promissory note and a security agreement or mortgage in case of real estate, there will always be a loan agreement containing the terms of the loan. Basically it is in that document that the creditor bank puts all the restrictions on the borrower corporation. o If a bank is going to loan you money if all the bank does is make her sign a promissory note they have no protections or restrictions, so she could pay herself any salary or what not. So the loan agreement puts in restrictions. o They will put a provision saying no future borrowings over x dollars or no future borrowings unless that borrowing is subordinated to this one. No salaries over this. In a publicly traded bond issue, everything is in the trust indenture. In the case of a closely held corp there will be a shareholder’s buy sell agreement that will put a restriction on the alienation of the stock and two will provide a market for buying and selling the stock on the happening of certain events, like termination, otherwise there is no market and there is no way for you to force people to buy it, but you can offer to sell it. A b and c in a corp. they don’t want c selling stock to archenemy. Capital provided a governmental entity is typical that a local state or government will do something to entice or retain a business in its community to create jobs and help the economy. It can be tax subsidies it can be selling or leasing the land for less than market value. Issue governmental bonds with a tax exemption. The effect of which is you are getting money at lower interest rates. Return on equity investment and equity debt leverage: o Return on investment: defining what your return and what your investment is difficult. o If investment is 100,000 and earnings is 110,000 your return is 10,000. RETURN ON INVESTMENT: o Defining return and defining investment. No definitive answer. o Depends on whether an accountant is doing it or an analysis. o Is it your initial investment, earnings in the business what not. o You can leverage your business by using debt: VALUATION: o Book value: is the accounting concept of net worth. Assets minus liabilities. Actually valuing a business, book value is a starting point and not the true value of the business. o Market cap: price per share times outstanding share. o Liquidation value: what the company would bring if you ceased operations realized on the assets, paid the liabilities and liquidated the net. Hard assets minus liabilities and what is the good will o If you are using an earnings formula never use one year: you have something unrealistic, a blip. You have nothing to compare it to. You always use a few years average to smooth out blips. Raising capital: o Phases of financing: if you invest in round one, and venture capitalists will always put in the agreement as to whether they can be diluted out later. o You can dilute someone out unless there is an agreement. o Private placement and public offering. o Private placement: securities. Difference between primary and secondary offering> primary: when issuer corp is the seller, secondary is when one of the existing shareholders are the seller. You can combine the sellers. An offering can be a primary and secondary. An initial public offering: the first time you go public. Firm commitment and best efforts.
The underwriter and issuer make an agreement. Best efforts means that the lead underwriter and whole syndicate will do their best efforts to sell the stock. A firm commitment means that an underwriter will sell the whole offering if it doesn’t it eats it. o If an issuer sells a security it is subject to the 1933 act, the corp and insiders are issuers, a security is debt or stock. Unless there is an exemption you are subjbect to registration. o Two types of exemptions: exempt security—don’t worry about it. And exempt transactions. Generally in a closely held corp you fall within one of the private placement exempt transactions. o Exempt transaction: if issuer A sellers to shareholder B and does not have to register because it is an exempt transaction that does not give B an exemption to sell to C. B would have to qualify. o Once you are subject to registration you must disclose reports under 1934 act. Debt transactions o A corp need legal authority to issue debt because the corp is a creature of the state. o The difference between a loan and a line of credit: fairly simple. In a loan the creditor gives the issuing corp or debtor X dollars for y period at z interest payable over B years on these terms (installment what). Line of credit the bank says to the corp we will give you a line of credit 2 million over a period of 2 years. You can draw down when you want but the outstanding cannot exceed the 2 million. You only pay interest on the outstanding balance. Your accounting balance sheet only shows the outstanding balance as a liability. You probably will pay up front a small commitment fee for the bank to engage in the LOC because the bank is not guaranteed to get any interest. o There are two kinds of LOCs: A revolving account: the debtor has to contact the creditor saying I want x dollars, the debtor must repay the creditor when he has money and wants to. A sweep is an account set up at the bank usually your checking account and you just write checks and to the extent of the LOC the computer will let you overdraw the account when you have money in the account the computer will take it back. On a sweep account your interest does not start running until the check clears the account On a revolving if you write a check today that will put you in the red today or tomorrow you must draw the money down because you don’t know when it will be deposited. In a line of credit there is a loan agreement and there can be security like in a loan. The amount is not in excess of the outstanding amount. The instruments representing debt o Open accounts or accounts receivable: least formal. o Promissory note. Can be negotiable or not. o Commercial paper: short term 30-90 days. Not long term. It is a short term bond issue. It is floated by entities whose cash needs fluctuate. Sort of like a line of credit. o Bond interest: it can be simple interest bearing: 1000 dollar bond at 6 percent. It could be zero coupon: no interest paid periodically. A 1000 dollar bond issued less than 1000 calculated. So if you wanted 10% interest you would sell it for 900 dollars. It would be the same thing. o If you have a six percent bond: you could have original issue discount or original issue premium to adjust the rate if when you go to sell it and 6 percent won’t work. If 6 percent is too low then sell the bond at a discount face price. If the interest is too high then you sell it at a premium. o If the bonds are traded, they could trade at either a discount or premium to reflect the difference between the stated rate on the bond and the current market rate. Example, today’s market, if you had a 1000 dollar bond paying 6 percent, it would sell at a premium bc rates are lower today. But if you buy a 1 percent bond today and rates go up to 6 % you won’t get your face value you will get lower because no one will buy that. o Coupon and registered bond. A registered bond is just like stock, the issuing corp has a register and know who owns each bond and mail you the check. A coupon bond is a bare bond., the reason why they are called coupons is because the bond who be perforated and pull off the coupons and get the interest o Acceleration provision: without this if the debtor goes south and the creditor is scared that they wont collect, as long as the periodic interest payments are made and the debtor is not in default
until the end of the loan and don’t show up with the money. That is not acceptable, because by the time the end comes they won’t have the money. So they put in an acceleration clause: list different events that are considered a breach or default. They don’t maintain the ratio of assets to liabilities. The acceleration clause provides that upon one of these events of breach or default the term or payment of a loan is accelerated and if the debtor can’t pay then the creditor can sue. o On a ten year loan if the debtor can seek out the interest the creditor can loan for ten years without this provision. o Redemption: the debtor can redeem the note prior to maturity. Usually it is not redeemable or callable the first year or two and if so and it was a 1000 dollar bond there would be a premium. The longer the period between the redemption or call date and the maturity, the higher the premium is to pay the interest taker the money. o Example: 10 year bond if I call it after 9 years and 9 months low premium because holder is losing small interest, if it call it after only 1 month then huge premium because they lose interest. o 10 year bond: sinking fund provision. Usually pro rata the debtor issuer puts 1/10 of the money in escrow or sinking fund account to make sure that after ten years that it is paid off. as an alternative the issuer or debtor can redeem one/tenth of the bond issue each year. o Subordinated o Convertible: If you have a bond that is both convertible and redeemable and the conversion provision is in the money and the issuer would like the holders to convert to get the debt off the books and stop paying the interest. The way you force a conversion is to redeem or call it, because it is worth a lot more if it is converted than if they make the small premium on the call. You will never make 100% on the call. The trust indenture; if you have a bank and a corp with a loan, they will enter into a loan agreement. Public bond issue you cant enter into a loan agreement with thousands of people. so the issuer enters into a trust indenture with a bank as the trustee, issues the bonds under the indenture, that indenture has all the provisions, affirmative and negative covenants, investment banker picks the bank. The trust indenture is governed b the trust indenture act of 1939, which came out of the security act of 1933 and 34. Junk bonds: they still issue them. They are high risk. Junk bonds came to fore during the LBO days. Very risky and paid high interest rates. Industrial revenue/private activity bonds: see tom rickets. Wants the bonds sold to improve regularly. These are tax exempt I think. Affirmative covenant you must do something. Negative you will not. Operating lease: a short term lease where you rent the car from hertz, you rent extra trucks from ryder on a short term basis Financing lease: alternative to buying and borrowing the money from the bank with a security interest. Most airplanes are bought under financing leases. The lessor buys the equipment that the lessee wants, leases it to them for most of the life, pays most of the costs and there is a residual left. What is legally a lease in a financing lease must meet certain rules for accounting and tax purposes. If it does not meet these rules it is considered a purchase and a security interest. Cant be a lease for whole life, the lesser must have some risk and get some residual. Financing leases are common. The economics are simple. It takes the costs plus interest plus profits minus the residual and divides it over the term. Two things that will kill a financing lease for accounting and tax purposes. The lessee can buy it at the end or the lessee has to pay the lessor additional rent at the end of the difference between the residual and the real value in the end in other words no risk in the lessor or no profit in the lessor, the lessee will then practically buy it. This kills the financing loan for accounting or tax purposes. Sale and lease back is basically the same as a financing lease: but turned around. Corp a owns a piece of equipment wants to get cash so they sell it to a financing corp gets the money and then leases it back. Equity: o Stock. Holders of stock have the voting management power and financial interest represented by
periodic dividends, liquidation value, and appreciation or depreciation, market risk in the stock, subject to security laws and agreements the right to sell and realize the money. o Preferred stock: almost every state authorizes the issuance of preferred stock and the corp documents carry that out. Preferred stock generally has a preference over common stock as to dividends and liquidation. As to liquidation it comes to them before common stock. You can have series of preferred stock and series of common stock. o Dividend either cumulative or noncumulative. Cumulative: if you don’t pay it, it accumulates. Non: it does not. o If a corp wants to pay a dividend to common stock in noncum it just has to pay the dividend for the year. Cumulative it has to pay the arrearage first. You want cumulative. o Cumulative preferred stock is not like interest: you are not entitled to it at a certain point, it still must be declared. If there is an arrearage in cumulative it must be paid before the common. o Not paid automatically like debt service like the interest on bonds. o Preferred can be voting or nonvoting or class voting meaning that rather than voting share for share—common preferred---the corp can provide that the preferred stock as a class can elect x directors or preferred stock as a class must approve something. o Nonvoting, preferred stock: if there is a dividend arrearage a lot of the preferred stock would provide that if the dividends are in arrearage for x quarters then preferred stock can elect y directors and if it is still in arrearage by x date then preferred gets control of the board. o Convertible preferred stock is the same as convertible debt. o It can be callable or redeemable like redeemable or callable debt. o Mechanics are the same. o Exchangeable stock: is basically convertible stock which is exchangeable for or converted into stock held by the issuer but not its stock but of the stock of a third company. Rarely done bc it is taxable. o Tracking stock: not being used any more. It is a class of stock that basically tracks a division of a company (sometimes tech divisions). o Dividend of common stock, there must be a declaration, a record date, and a distribution. It is declared, record date: stock holders of on this date are entitled, and a distribution date: between the record date and distribution date the market price should take care of the dividend. o Stock splits: a 2 for 1 stock split is same if you have a share you end up with 2 shares. o Reverse stock split: is when five shares become 1 share and the reason for reverse stock split, it is being traded and the market price is below a buck and they keep giving continuances nasdaq will delist you if it trades under a buck. So if it is selling for fifty cents and have a 5 for 1 split then it will be sold for 2.50 a share. o Repurchase: a corp can repurchase its stock. It is done when they think the price is low and has cash, and they think that reducing the number of shares outstanding it will maximize shareholder value. o Repurchasing: it can either go on the market and buy or it can do a self-tender to its shareholders. o The limitations on distributions with respect to stock: there is a problem on this. There is a revised model bca. Read the commentary. The main thing: it applies to dividends, redemptions, repurchases, anything that is a distribution to the shareholders, usually does not apply to a liquidation. o Stock warrants/options: employee stock options: operate the same way. It gives the holder a right to buy x shares at a striking price for a period of time hopefully the stock will go up and you will make money. o Warrant is usually issued as compensation to a non-employee or given to an investor as part of a package. o Employee stock option: given to employees. Main compensation in late 1990s and early 2000s. Two kinds of stock options: under the tax code. Non-statutory and statutory Stock can be used as a bonus. Stock can be contributed to a qualified benefit plan. A qualified benefit plan can buy stock. Stock appreciation rights: a stock appreciation right is a cash bonus that is measured by the increase of the
stock price over a stated period of time, the best way of understanding it: phantom stock options: between today and end date we will give you cash bonuses. Liquidation: reduce the assets to cash, pay the debt and liabilities, pay taxes and transaction costs, then liquidate first allocate to debt: secured unsecured and then equity: preferred stock common stock. Liquidation: convertible preferred stock: better converting or not> if the company is short of money answer no. if they have money to distribute yes. You don’t have the debt and equity. EXAM: o o o o o o o o o o
Saturday: December 18th. 1:15 pm. He will take questions beforehand up through Friday. Go to his office through emails. Come in alone or with a group. Email him with questions. Give him your phone number. Open book No computer. Three hours. But you wont need all of it. The exam will have four parts. Problems—are so similar that that’s it., true false, multiple choice, one or two or three short answer, he will give you one or two pieces of papers. The questions are such that you can answer them in a page or two. Not looking for an essay. Not issue spotting. Bring a calculator.