Lecture 7 - Classes of Shares Flashcards
How do corporations come to exist?
o Choice of jurisdiction
o Administrative filing with secretary of state
o Organizational meeting
o Issuance of shares
How do corporations obtain funding for operations and expansion?
o Equity
o Debt
o Retained Earnings
Theories on Capital Structure Selection
o Trade-off Theory
o Market Timing Theory
o Pecking Order Theory
Pecking Order Theory assumptions
External financing reduces flexiblity more than internal financing.
As between debt and equity, equity will be a worse deal, i.e., more expensive.
Why is equity a “bad deal” for the corporation?
- equity reduces managerial flexibility (external financing reduces flexibility more than internal financing)
- equity is more expensive (equity riskier than debt. Investors will ask for a higher risk premium)
Capital Structure - Ranking
- Bank Loans
- Bonds
- Preferred Shares
- Common Shares -residual claim
Shares – Classes
o Common
o Preferred
What fundamental characteristics are always required when issuing shares?
No matter the class of a share it grants:
o Control rights
o Residual cash flow
Preferred Shares
o Priority on Dividend Rights o Liquidation Rights o Usually no Voting Rights o Redemption Rights o Conversion Rights o Protective Provisions Preferred stock combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in price. The details of each preferred stock depend on the issue.
Shares – Board Powers:
o Boards can set the terms for shares
o What limits?
♣ The charter has to set the number of authorized shares that the corporation can issue. If the board wants to increase the number of authorized shares, it has to ask the shareholders for permission.
Certificate of designation
A certificate which contains a copy of the board resolution setting out the powers, designations, preferences or rights of a class or series of a class of stock of a corporation (typically a series of preferred stock) if they are not already contained in the certificate of incorporation of the corporation. The certificate of designation is filed as an amendment to the certificate of incorporation with the secretary of state of the corporation’s state of organization.
Blank-check Preferred Stock
Authorized and unissued preferred stock, the terms and conditions of which may be expressly determined by a corporation’s board of directors.
Shares – Issuance
o Private placement
o Public offering
They differ in how much bargaining power do shareholders have vis-à-vis the corporation.
Why are the articles of incorporation characterized as the “contract” between the shareholders and the corporation?
This is not settled by the law – the certificate of designation reflects the agreement of the parties, not the requirements of the law (bargaining)
“Paradox” of Preferred Shares
“The fundamental difficulty with the concept of preferred shares is that the holder obtains neither the enforceable claim to interest and repayment of principal that is provided by debt nor the rights of the residual owner that is [sic] provided by common shares.” (Lawrence E. Mitchell, The Puzzling Paradox of Preferred Stock (And Why We Should Care About It), 1996)
Dual-Class Shares
o Adjust voting rights to allow founders to maintain control
o Adjust cash flow to incentivize managers to act for benefit of investors
Some Uses of Shares/Share Classes:
Decoupling of voting and economic rights
Negotiated protection for minority shareholders
Negotiated governance rights for equity investors (e.g., VC, private equity)
Incentive compensation for officers and employees
Defensive measures - poison pill and blank check authority.
How do preferred shares reduce management flexibility?
♠ Negotiated dividends
♠ Contingent (dependent) voting rights
Poison pill
a tactic utilized by companies to prevent or discourage hostile takeovers. A company targeted for a takeover uses a poison pill strategy to make shares of the companys stock look unattractive or less desirable to the acquiring firm.
