Understanding Capital

The money invested in a business by founders, creditors or investors is the capital and is used to buy assets and run business operations. Money can be invested in any type of business: corporations, limited liability companies (LLCs), limited partnerships, general partnerships and sole proprietorships with varying ownership structures, of course.

Corporations are the only business entity that has stock authorized in its charter. LLCs issue membership interests pursuant to the terms of the operating agreement. Ownership may or may not be evidenced by a certificate and is tracked in a document similar to a stock ledger. Interests in an LLC may be tracked manually or using a software program such as Corporate Focus.

Sample ledger

Limited partnerships and general partnerships issues partnership interests pursuant to the terms of the partnership agreement. Ownership is typically not evidenced by a certificate and is tracked in the company records book as required by state laws.

Sole proprietors issues no evidence of interest. The sole proprietor invests his/her own capital and owns the business entirely.

Corporations

Most state laws provide that a corporation must have paid-in capital before business may be commenced. Certain states require a minimum paid-in capital. In that event, enough stock must be sold in order to meet the statutory requirement.

Generally, paid-in capital is the money received in exchange for the issuance of stock. Stated capital is the sum of the par value of all issued shares of the corporation having par value. Stated capital for corporations having stock without par value is the sum of the total amount of consideration paid for all issued shares. Working capital is the sum of the total assets minus liabilities of the company.

Types of Capital Stock

Authorized Stock
Authorized stock is the total amount of stock (regardless of class or series) that has been authorized in the corporation's certificate or articles of incorporation or latest amendment (the "charter") as filed with the secretary of state of the state of incorporation. Deciding upon the number and classes of authorized stock depends upon anticipated capital requirements.

All corporations must authorize at least one class of stock, which will typically be some class or series of common stock. The total authorized stock need not be issued to stockholders, however it is sometimes desirable to do so.

Increasing or decreasing authorized stock requires a resolution of the stockholders and directors and an amendment to the charter to be filed with the secretary of state of the state of incorporation. Filing fees for amendments increasing authorized stock can be costly in some states. When preparing an amendment increasing authorized stock, it is wise to check the filing fee as part of the preparation and notify attorneys of exorbitant fees. The attorney may determine a lesser practical amount of stock or s/he may request a check from the client to cover the filing fees. Service companies generally do not forward extraordinary filing fees. If the client is not going provide a check for the fees, arrangements wire transfer may be made to the service company. Being aware of the filing fee assures meeting filing deadlines.

Best Practice Tip: Some foreign states where a company is qualified to do business may require amendments to be filed to reflect increase/decrease in authorized stock in the domestic state. Consult LeapLaw's list of states requiring such amendments.

Issued and Outstanding Stock

Once authorized shares have been subscribed to via a stock subscription or authorized to be issued by a resolution of the directors (with consideration to authorized stock remaining, capital demands and preemptive rights of present shareholders) stock is issued and outstanding. The total number of issued stock must be equal to or less than the authorized stock in the charter.

Reserved Stock
Certain portions of authorized stock may be reserved for stock options plans or other business plans such as the activation of a poison pill designed to thwart a hostile takeover. Reservation of stock are authorized by a resolution of directors and stockholders and [stated in the charter]. Any class or series of authorized stock may be reserved or set aside so that it is available upon certain instances, such as:

• Exercising of stock options available in a stock plan
• Triggering a poison pill designed to thwart a hostile takeover
• An initial public offering

When stock is reserved it may not be used for any purpose other than for what it was reserved unless there is a charter amendment.

Treasury Stock
Issued and outstanding stock may be repurchased or otherwise redeemed by the company for several reasons, if provided by state laws and the charter of the corporation. Repurchased or redeemed stock that is not retired or canceled, is referred to as "treasury stock" or "treasury shares". Treasury stock remains "issued" although it is no longer outstanding because the shares
are not held by a stockholder.

A resolution of directors is required in order for a company to redeem outstanding stock as treasury stock and any other conversion activity.

A company may also have redemption rights on certain classes or series of stock. Redemption rights essentially allow the company to force redemption of certain stock. A company may want to redeem stock in order to divert a hostile takeover, reduce future cash dividends, obtain shares for distribution in an employee stock ownership plan (pursuant to Section 162(a) of the Internal Revenue Code (IRC)), to fund an exchange for an acquisition or any number of reasons.

Public companies are restricted by federal securities laws against large-scale repurchase activity. A company may not buy back stock if it will render the company insolvent.

When a stockholder sells his/her stock to the company, his/her stock certificate is received together with
a stock transfer, transferring the stock to the company. The stock certificate is canceled and the transfer is noted on the stock ledger as receipt of treasury stock. For more information regarding stock transfer and issuance, see LeapLaw's Stock Issuance Best Practice Summary.

Distinctions of Treasury Shares

Unlike issued and outstanding shares, treasury shares are not owned by an investor but are held by the corporation. Treasury shares:

• Do not have the right to vote
• Are not used to determine quorum
• May or may not be entitled to dividends, depending upon the laws and the charter
• Can be sold for less than par value
• May be sold for any consideration

Par Value

Par value is the stated value of stocks, bonds or any other negotiable instruments. Par value or no par value is stated in the corporation's charter. When par value is stated, the stock may be sold for more than the stated par value but never sold for less than par value. The par value of stock is used in several ways:

• Par value is used in the accounting methods of the company. The method used to determine the stated capital of the company depends upon the par value or no par value of the shares. For instance if the company has par value, the stated capital is the par value multiplied by the total number of issued shares. If the stock has no par value, the stated capital is the amount paid for the stock multiplied by the number of shares issued.
  
  
• Par value is also significant with preferred stock since it specifies the dollar value upon which dividends are paid.
  
  
• Par value may be used in some states (i.e. Delaware) to determine franchise tax and/or filing fees for number of authorized stock contained in the charter and/or any amendment increasing the authorized stock. For these purposes, a low par value is advantageous.

Types of Consideration for Capital Stock

Investors and creditors obtain capital in the form of securities in exchange for money, "sweat equity", services and/or property.

Equity Securities
Equity securities are securities (common stock, preferred stock, options and/or warrants) purchased by an investor when the investor takes ownership in the company in exchange for some consideration paid. Unlike debt security, the company has no obligation to repay the investor/stockholder. Stockholders are generally entitled to a right to vote, a proportionate share of earnings and share of assets in the event of corporate dissolution. The sale of equity securities will generally trigger the federal securities laws and state securities laws known as Blue Sky Laws. For more information about federal and state securities laws, see LeapLaw's Blue Sky Best Practice Summary.

Common Stock
Corporations must have at least one class of stock entitled to vote on matters presented to stockholders, typically this is common stock. Common stock may be divided into different classes or series of stock such as Class A voting and Class B non-voting. Each class will carry different preferences and/or voting rights as designated and described in the corporation's charter.

Voting Rights

Generally each share of outstanding stock is entitled to one-vote-per-share. If a corporation has only one class of stock, without series, the single class (typically common stock) must have voting rights. If stock is divided into several series or classes of stock one or more of those classes or series may have varied voting rights.

Restricted Stock

Classes and/or series of stock may be restricted in certain ways. Stock restrictions may be provided in the charter, bylaws or by a separate stockholders agreement authorized by a resolution of the directors (and shareholders). Common restrictions on stock are:

Preemptive Rights

Preemptive rights is the right to purchase a pro-rata shares of a new issue of common stock or securities convertible into common stock before new issues may be purchased by a non-stockholder, thereby assuring proportionate ownership interest in the corporation is maintained. Outside stockholders may purchase stock only if current stockholders fail to purchase their allotted shares.

Some state laws provide for preemptive rights unless otherwise denied in the charter. If preemptive rights are to be granted or denied as required by state law, the language for the charter may be as simple as:

"Preemptive rights are granted." or

"Preemptive rights are denied."

The charter may be amended to limit, grant or deny preemptive rights or preemptive rights may be specified only in certain classes or series of stock by inserting the following language:

Denying Preemptive Rights

"No holder of any stock of the corporation shall be entitled, as a matter of right, to purchase or acquire any new or additional shares of stock of the corporation of any class or series."

Granting preemptive rights to certain classes or series:

"Holders of preferred stock shall have the right to purchase or otherwise acquire their pro rata shares of any new preferred stock that may be issued by the Corporation, but shall not have such preemptive rights in connection with new issuance of common stock or any other series or class of stock of the Corporation."

Once granted, stockholders may vote to waive such rights. If preemptive rights are granted, the restriction must be noted on the legend on the back of the certificate.

Rights of First Refusal

First refusal rights are granted by a corporation entitling its stockholders to purchase stock made available when another stockholder chooses to cash out his/her investment. These rights enable present stockholders to prevent undesirable parties from becoming stockholders. If the shares are for sale at an attractive price, directors may choose for the company to buy the shares so that they can be used to attract qualified persons to replace the selling stockholder(s).

Typical first refusal language will require that the selling stockholder(s) obtain a bona fide written offer that is presented to the company and other stockholders as an opportunity to buy the stock, thereby blocking the outside offeror. First refusal rights terminate immediately upon a company becoming public. First refusal rights and any other stock restrictions need to be included on the legends on the back of each stock certificate representing the stocks that are restricted.

Right of First Refusal Language

Preferred Stock

The difference between common and preferred stock and the series and classes of each are contained in the designations, rights and preferences granted to each class. Designations are essentially stockholder rights. Rights may be liquidation rights, dissolution rights, rights of first refusal, preemptive rights and others.

The state laws of the state of incorporation may provide some designations, rights and preferences while
others are granted in the charter. Following the filing of the certificate of incorporation (or articles of organization), additional designations or preferences are generally authorized by a resolution of the stockholders and directors of the corporation.

Preferred stock carries different rights, privileges, designations and preferences than common stock that are designated in the charter or bylaws of the corporation and designed to attract investors to invest in a corporation. Most preferred stockholders are angel investors, venture capitalists or other accredited investors.

Typical preferred stockholder rights are:

• Dividend preference provides the right to collect dividends before distributions can be made to
  common stockholders.
  
  
• Cumulative dividend rights provide the right to receive undeclared dividends that have accumulated over a period of time. These accumulated dividends must be paid to preferred stockholders before any dividends may be paid to common stockholders.
  
  
• Non-cumulative dividend rights entitle preferred stockholders to preferential dividends only for the current year.
  
  
• Liquidation rights allow preferred stockholders to receive distributions before common stockholders in the event of dissolution or liquidation.
  
  
• Voting rights may or may not be granted to preferred stockholders. It is also possible that preferred stockholders are granted more than one vote per share.
  
  
• Conversion rights entitle the holder the ability to convert preferred shares for shares of another class (usually Common) at a specified rate and time. Depending on the particular company and stock preference, conversion might allow a stockholder the flexibility to convert from conservative protection of preferred stock to an interest in the basic equity growth of the company in common stock.
  
  
• Registration rights entitle the stockholder the right to include stock held in a registration statement being filed by the company to list stocks in the public market.
  
  
• Redemption rights are a greater benefit to the corporation than to the stockholder as they allow the company to force the stockholders to sell their stock back to the company at a defined time and for a defined price as defined in the charter.

Blank Check Preferred

Blank check preferred stock is authorized but unissued preferred stock that leaves the definition, terms, preferences and/or voting rights to be later fixed by the directors. Authorizing blank check preferred stock provides the board with flexibility to meet fluctuating financial conditions, and can also be used for defensive purposes, such as a private placement with a friendly investor or initiating a poison pill to block a takeover attempt. Specific state laws of the state of incorporation should be checked to verify provisions for blank check preferred stock. Once authorized, reference to blank check stock provisions in the charter should be made in a legend on the back of the stock certificate. .

Note: The issuance of preferred stock of any class or series automatically terminates an S corporation's status with the IRS.

Stock Appreciation Rights

Stock Appreciation Rights (SARs) are provide the employee the right to be paid the difference between the value of the shares on the date the SAR was granted and the value of the shares on the date the SAR is exercised. SARs are often granted in conjunction with stock option plans and provide cash in which to
purchase exercisable options.

Phantom Stock a/k/a Mirror Stock is similar to SARs and is designed to motivate and retain key employees without issuing stock and the complication of sharing ownership in the company. This type of incentive compensation is ideal for small or family-owned businesses. The basic formula is that the amount of the compensation is governed by the appreciation in the company's stock. For instance, an employee may be granted 100 phantom shares to vest over a 3 year period. At the end of the third year, the employee will not be issued stock but will be paid the value of the stock. SARs are designed to motivate and retain key employees without issuing stock and the complication of sharing ownership in the company. This type of incentive compensation is ideal for small or family-owned businesses. The basic formula is that the amount of the compensation is governed by the appreciation in the company's stock. For instance, an employee may be granted 100 phantom shares to vest over a 3 year period. At the end of the third year, the employee will not be issued stock but will be paid the value of the stock.

Warrants

Warrants represent a right, but not obligation, to buy stock at a specified price (strike price) within a
specified time period. They may be issued alone or in connection with the sale of other types of stock. A common stock warrant is an option to buy common stock opposed to a preferred stock warrant which represents an option to buy preferred stock. Warrants are similar to stock options (or call options) except in the duration of the term. Stock options tend to be for shorter periods of time while warrants may last
years and even perpetually.

Warrants in any variety may be used as inducements to investors, particularly at the mezzanine funding
level. They may be convertible into cash or stock. "Call Warrants" allow investors to profit from rising
stock prices. "Put Warrants" allow investors to profit from falling stock prices.

Warrants may also be publicly-traded and if so, must be registered under federal securities laws or blue sky laws as required with any other securities. Exercising warrants may increase the outstanding stock of the company unless they are "covered warrant options" in which the stock has already been reserved.

Issuing warrants require a resolution of the directors and enough authorized stock available to issue stock upon exercise of the warrant. A charter amendment and therefore a resolution of stockholders and directors may be required to increase authorized stock if the number of authorized stock is insufficient to cover the issue of warrants.

Warrants may be represented by a warrant certificate and are tracked as part of the stock ownership of the company on the stock ledger records. As part of a fully-diluted capitalization table, warrants will be reflected as if they have been converted to common stock.

Stock Options Call/Put Options

A call option provides an investor with the right but not the obligation to buy stocks, bonds, commodities or other instruments in a particular company at a specified price within a specific time period. Each option represents 100 shares of the company's stock.

Put options are the opposite of call options. Put options grant the holder the right to sell stocks, bonds, commodities or other instruments in a particular company at a specified price within a specified time.

Options for public companies purchased on the public market are listed on financial pages. Unlike warrants that last for years, call options expire the Saturday following the third Friday of the month purchased ("Expiration Friday"). In the event of a market holiday, Thursday is the expiration date

Debt Securities
Debt securities represent loans to the company and the creditor is a debt security holder. There are typically three types of debt security that may be held (a) promissory notes, (b) bonds and (c) debentures. Indebtedness can be secured or unsecured.

Unsecured Debt

Promissory Notes
A promissory note may be issued as a result of a simple loan, a credit agreement with a banking institution or made to investors as a way of raising money. Whatever the purpose, a promissory note (also called a loan agreement, contract or simply a "note") is a written promise to repay money borrowed. The note will typically include:

• The amount borrowed
• Fixed interest to be accrued
• Payment schedule
• Due date
• Collateral (if any)
• Discounting (if any and generally means interest is subtracted from the principal upfront)
• Rights in the event of default or insolvency

Promissory notes may be sold in the public market. Like any other security, notes are subject to registration requirements under federal securities laws and/or state securities laws (a/k/a blue sky laws); or they must be exempt from registration. Brokers/dealers selling promissory notes that qualify as securities must also be licensed by the state securities administrator of the state in which they are selling notes.

Certain variations of promissory notes may be:

• It may be convertible into common stock under certain conditions
• It may be subordinated to another lender who is a senior lender and therefore will be paid first in the event of default or insolvency
• It may be a demand note

As a negotiable instrument, promissory notes may be transferable, as are stock certificates, by using a note transfer power.

Debenture (or Indenture)
A debenture is an unsecured loan, similar to a personal loan to an individual. An indenture is an agreement executed by the corporation with the lender and a trustee (usually a financial institution) that includes the terms of the obligation, the rights of security holders, and any obligations under which the bonds are issued.

Secured Debt

Secured Note
Secured debt is an obligation that is secured by property or collateral owned by the company. In the event of default, the creditor may reach for the collateral or property in order to satisfy the debt.

Subordinated Debt
Debt may be subordinated which results from a subordinated agreement or other arrangement regarding
two or more debtor obligations that would otherwise be equal. The junior debt or lien is held subordinate
to the extent and in the manner set forth in a junior subordinated agreement or other arrangement. Simply stated, a senior creditor is the first creditor to receive payment in the event of default or bankruptcy of the debtor.

Mortgage Bond
A mortgage bond is a debt security that is generally a secured bond; secured by property owned by the corporation.

Security Agreement

A security agreement evidences secured debt obligations involving collateral such as personal property, equipment, inventory, accounts receivables. Financing statements are required to be filed by Revised Article 9 of the Uniform Commercial Code. For more information on filing financing statements, see LeapLaw's UCC Best Practice Summary.

Stock Subscriptions

New stock issuances are always authorized by a resolution of directors and issued in exchange for some consideration, that may be cash, sweat equity or debt. Stock issuance may also be conditional upon the stockholder entering a stockholders' agreement, stock subscription agreement, a stock transfer restriction agreement or some form thereof. Directors must also observe any existing stockholder rights, such as rights of first refusal or preemptive rights, that essentially prohibit the issuance of stock to a new stockholder without first offering the stock to be issued to a current stockholder. Once stock is issued pursuant to the conditions listed above, it is said to be "issued and outstanding" stock. The stockholder then owns "authorized, issued and outstanding stock".

Stock Certificates

Generally, state laws provide that stock must be represented by a certificate unless the directors resolve to provide uncertificated stock (also be noted in the bylaws). If stock is to be uncertificated, ownership is
simply tracked and recorded in the stock ledger but shares are not represented by a stock certificate. Stockholder rights are identical whether or not shares are represented by a certificate.

Forms of stock certificate for each class and series of stock are authorized by a resolution of directors and a specimen stock certificate is attached as an exhibit to the consent or minutes. If forms become obsolete or for some other reason a new form of certificate is being used, it needs to be authorized by a vote of directors.

The contents of a stock certificate and signature requirements are provided in the bylaws. Stock certificates may be computer-generated (using a software program like Two-Step Software ) or pre-printed forms depending upon the specimen adopted by a vote of directors. Generally, a stock certificate will contain:

• The name of the corporation
• State of incorporation
• Class, series and par value of stock represented by the certificate
  
• the exact name of the stockholder
• the number of shares issued to the stockholders
• Any restrictions on transfer.

If the stock certificate has been lost, the stockholder may request a replacement certificate by providing an affidavit of loss.

Best Practice Tip: Stock certificates have an inventory control number at the bottom left hand corner, such as GOES 352. This is basically the inventory control number so that ordering the certificates using this number will get the exact type and color certificate needed.

Stock Receipts

A company may maintain the original stock certificate or a stockholder may choose to possess the stock certificate. If the stockholder opts for possession, a copy should be made of both sides of the certificate and kept with the stock records of the company together with a receipt evidencing the stockholder has received the stock certificate. The receipt may be the stub of the certificate or a separate receipt.

Legends

Any restrictions on stock must be noted on the reverse side of stock certificate pursuant to Article 8 of the Uniform Commercial Code which states in part that "unless there is a conspicuous notation of the restriction application to the stock transfer or unless the transferee has actual knowledge of the restriction, the purchase of stock will be free from restrictions." Restrictions on the back of stock certificates are known as "legends"

Note: For more information on stock issuance, transfers and tracking see LeapLaw's Stock Issuance Best Practice Summary.

Stock Splits

A corporation may authorize a stock split when the price of the stock is too high. The stock split will effectively cut the price of the stock to whatever percent of the stock split. For instance, in a two-for-one split, the cost of the stock that was previously $150.00 per share will be dropped to $75.00.

A corporation may also authorize a stock split if it is having financial difficulty. A stock split would hopefully raise money since it would effectively drop the stock price. For instance, if stock is selling for $35.00 a share, a two-for-one split will cause the price of the stock to drop to $17.50 and hopefully prompt more people to buy at a more attractive price.

On the books of the company, a stock split may be accomplished in the following ways:

1. Changing the par value according to the desired split. For instance, to affect a two-for-one split the vote would authorize that the par value is cut in half that would result in distributing double shares of stock per stockholder.

2. If the stock has no par value, the stated value of each share of stock is reduced.

3. A stock split can also be achieved by transferring a certain amount of company assets from surplus to stated capital, thereby requiring additional shares to be issued to each stockholder. This method is very similar to a stock dividend but is commonly referred to as a "split" because it doubles the shares held by each stockholder.

A company may also adopt a reverse stock split to increase the perceived value of the stock of the company. A reverse split decreases the outstanding stock of the company and the shares held by each stockholder without effecting the stated capital of the company and/or the value of the stock held by each stockholder. Essentially a reverse split increases the price of the stock. For instance, if a stockholder held 40 shares of stock worth $20.00 a share, at the end of a reverse two-for-one split the stockholder would own 20 shares at $40.00 per share.

Stock splits always require a vote of directors recommending a stock split to the stockholders and a vote of stockholders authorizing the stock split. Accomplishing a stock split may also require a charter amendment to amend the par value and/or increase the number of authorized stock.

New stock certificates will be issued to represent increased shares owned and noted on the stock transfer ledger. If the stock is uncertificated, the increase will be reflected only on the stock transfer ledger. For ease of tracking stock ownership, the stock split stock entries should reflect that the stock was issued through a stock split and not as a "original issue".

Stock Ledgers

State laws of the state of incorporation provide that a stock transfer ledger (a/k/a transfer books) must be kept at the principal place of business or at the transfer agent's (bank, financial institution or law firm)
principal place of business. A stock ledger is a type of chart used to track the history of stock issuance and stock transfers. Stock ledgers can be generated and tracked manually using a preprinted form supplied by a legal stationery store, by using Microsoft Word or Excel (or equivalent) or by electronically by using programs such as Corporate Focus.

Transfer Agents

A transfer agent is typically a bank or trust company that is appointed by a resolution of directors to keep the stock records of the company, handling transfer of stock, options, warrants and other securities on behalf of a corporation. Transfer agents are contracted for public companies and/or for any company that many stockholders.

Beyond record keeping, stock ledger keeping and managing stock issuances and transfers, companies may also use the transfer agent as:

• Proxy solicitors
  
  
• Inspector of Elections at stockholder (special or annual) meetings. As Inspector of Elections, the transfer agent will act as an impartial third party who will handling all voting activity and certify to the resolutions taken at the meeting

When transfer agents are requested to transfer restricted stock, they will request a clearance memorandum from the company's counsel. This memorandum states that the stock restrictions have been cleared concerning the requested transfer.

When appointing the transfer agent, directors will often authorize officers to provide instructions to the
transfer agent. Popular transfer agents are Boston Equiserve 800-730-6001 or Institutional
Shareholder Services 301-545-4107.

Capitalization

Capitalization may be limited to common stock or it may include a combination of equity securities (evidence of stockholder ownership), including separate classes and series, stock options, warrants and debt securities. A capitalization table or "cap table" will represent all of the company's outstanding securities organized by class. Analysis of a company's capitalization or "fully-diluted cap table" assumes all of the convertible stock, warrants and vested options have converted to common stock.

LeapLaw's
Related Best Practice Summaries

Blue Sky Filings