Financing Issues in Creating a New Corporation

Forming a Corporation

 

Capital Structure-Debt vs. Equity

Generally speaking, corporations raise capital through debt or equity or a combination of both. Equity investments—the purchase of shares issued by the corporation—involve the acquisition of ownership in the corporation. The equity investor becomes a shareholder, acquires property rights attendant with share ownership, is owed legal duties by the corporation, is not entitled to a return of his capital, but does participate in the profits earned by the corporation through dividends and capital appreciation. Debt, on the other hand, is a loan of money that must be repaid. Persons investing capital in a corporation through debt are creditors, not owners. Creditors acquire no property rights and are owed no legal duties other than whatever contractual duties are imposed by the loan agreement. Creditors are paid interest for the use of their money and do not participate in corporate profits, losses, or appreciation. Debt investments are commonly made through promissory notes, bonds, and debentures. As a practical matter, the neat distinction between debt and equity can break down in practice because the parties have such freedom in designing debt instruments and preferred classes of shares that hybrid securities can be created in which preferred shares have characteristics of debt or in which debt securities seem very like stock, and both preferred shares and debt instruments may be made convertible into each other.

Corporate law is based on the assumption that the capital of the company is raised through the purchase of shares of stock. However, in practice, debt is usually as or more significant. Very frequently, small corporations are set up with an agreed ownership split among the founders. The percentage split may be based on many factors—personal and emotional, as well as business. Quite often, the financial resources among the founders will be varied, and the expectation will be that one of the “partners” is contributing the idea and the work, and another is going to be the source of startup capital. In these situations, the “money partner” typically finances the corporation with shareholder loans, rather than through the purchase of shares. The advantage of this approach is to permit the founding shareholder who is providing the capital to be repaid out of the first profits generated by the venture.

Another important benefit of debt financing, when the debt comes from sources other than the shareholders—”other people’s money”—is the concept of leverage. Leverage occurs when the corporation is able to earn more on the borrowed capital than the cost of the borrowing. To take a simple example, if the shareholders invest $50,000 and make a profit of $100,000, then they have doubled their money. However, if the investors borrow half, so that they invest $25,000 and borrow $25,000, and make a profit of $100,000, then they have quadrupled their money, less the cost of interest. The trouble of course, is that leverage works both ways. If the business loses $25,000, the shareholders in the first case have lost half their investment, while the shareholders in the second corporation have lost everything.

In the event of financial difficulties, creditors have greater rights in bankruptcy and insolvency proceedings and must be paid in full before any money goes to the shareholders. However, under the so-called “Deep Rock” doctrine, courts sometimes treat shareholder debt as equity when the result might otherwise be unfair to other creditors. [See Arnold v. Phillips, 117 F.2d 497, 502–03 (5th Cir. 1941).]

 

Issuing Shares

A corporation may issue up to the number of authorized shares stated in its certificate of formation, [Tex. Bus. Orgs. Code § 21.151.] and as authorized by the board of directors. [Tex. Bus. Orgs. Code § 21.157(a) (“Except as provided by Section 21.158, a corporation may issue shares for consideration if authorized by the board of directors of the corporation.”).] The issuance of shares must be for consideration received by the company. [Tex. Bus. Orgs. Code § 21.157(b) (“Shares may not be issued until the consideration, determined in accordance with this subchapter, has been paid or delivered as required in connection with the authorization of the shares.”).] However, a broad range of consideration is permissible. Shares with or without par value may be issued for cash, debt, services performed or an agreement for services to be performed in the future, a security of the corporation or other organization, any other property “of any kind or nature,” or any “tangible or intangible benefit to the corporation.” [Sec. 21.159.]

Prior to 1993, a corporation could not issue shares for an agreement to pay future consideration because the Texas Constitution provided that “[n]o corporation shall issue stock ... except for money paid, labor done or property actually received, and all fictitious increase of stock ... shall be void.” [Tex. Const. art. XII, § 6 (repealed Nov. 2, 1993).] However, that provision was repealed in 1993; and the law now expressly provides for debt, agreements to provide future services, and any “tangible or intangible benefit to the corporation.” [Tex. Bus. Orgs. Code § 21.159.]

Once “the consideration is paid or delivered,” including the receipt of an agreement for future payments, services, or other benefits, three things happen by operation of law: “(1) the shares are considered to be issued; (2) the subscriber or other person entitled to receive the shares is a shareholder with respect to the shares; and (3) the shares are considered fully paid and nonassessable.” [Sec. 21.157(b).] Therefore, the moment the corporation acknowledged receipt of the commitment to pay consideration for the shares, the shares were deemed issued, and no further consideration was owed except what had previously been agreed to and not yet paid in full.

The amount of consideration to be received by the corporation for shares is determined solely by the board of directors [Sec. 21.160 (a)(1).]—so long as the value is at least the par value for shares with par value. [Sec. 21.161(a) (“Consideration to be received by a corporation for the issuance of shares with par value may not be less than the par value of the shares.”).] In the absence of fraud in the transaction, the judgment of the board is “conclusive in determining the value and sufficiency of the consideration received for the shares.” [Sec. 21.162 (“In the absence of fraud in the transaction, the judgment of the board of directors, the shareholders, or the party approving the plan of conversion or the plan of merger, as appropriate, is conclusive in determining the value and sufficiency of the consideration received for the shares.”).] Where a corporation has accepted the consideration, issued the shares, and recognized the validity of those shares, it may not later “question the adequacy of the consideration for the issuance of the stock certificates.” [Sandor Petroleum Corp. v. Williams, 321 S.W.2d 614, 616 (Tex. Civ. App.—Eastland 1959, writ ref’d n.r.e.).]

All shares issued “are considered fully paid and nonassessable” [Tex. Bus. Orgs. Code § 21.157(b)(3).]—meaning that, once issued, a corporation may not require any additional payment other than the amount of consideration already paid or agreed to be paid in the future. If part of the consideration is future services or benefits or a debt obligation, then the corporation may require the shares to be placed in escrow until the consideration is fully paid, delivered, or performed, and may require that the shares be forfeited if the agreements are not complied with. [Sec. 21.157(c) (“This subsection applies only to shares issued in accordance with Subsections (a) and (b) and Sections 21.160 and 21.161 for consideration consisting, wholly or partly, of a contract for future services or benefits or a promissory note. A corporation may place the shares, although fully paid and nonassessable, in escrow, or make other arrangements to restrict the transfer of the shares, and may credit distributions made with respect to the shares against their purchase price, until the services are performed, the note is paid, or the benefits are received. If the services are not performed, the note is not paid, or the benefits are not received, the corporation may pursue remedies provided or afforded under law or in the contract or note, including causing the shares that are placed in escrow or restricted to be forfeited or returned to or reacquired by the corporation and the distributions that have been credited to be wholly or partly returned to the corporation.”).]

Otherwise, the shareholder may not be held liable to the corporation or its creditors “with respect to the shares,” other than on the obligation to pay to the corporation the full amount of the consideration. [Sec. 21.223(a) (“A holder of shares, an owner of any beneficial interest in shares, or a subscriber for shares whose subscription has been accepted, or any affiliate of such a holder, owner, or subscriber or of the corporation, may not be held liable to the corporation or its obligees with respect to: (1) the shares, other than the obligation to pay to the corporation the full amount of consideration, fixed in compliance with Sections 21.157-21.162, for which the shares were or are to be issued”).] This limitation of liability is exclusive and preempts any other liability under the common law or otherwise. [Sec. 21.224 (“The liability of a holder, beneficial owner, or subscriber of shares of a corporation, or any affiliate of such a holder, owner, or subscriber or of the corporation, for an obligation that is limited by Section 21.223 is exclusive and preempts any other liability imposed for that obligation under common law or otherwise.”).]

 

Corporate Debt

A corporation may incur debt for any consideration that it deems appropriate, including (1) cash; (2) property; (3) a contract to receive property; (4) a debt or other obligation of the entity or of another person; (5) services performed or a contract for services to be performed; or (6) a direct or indirect benefit. [Sec. 2.103(a) (“Unless otherwise provided by its governing documents or this code, a domestic entity may create indebtedness for any consideration the entity considers appropriate, including: (1) cash; (2) property; (3) a contract to receive property; (4) a debt or other obligation of the entity or of another person; (5) services performed or a contract for services to be performed; or (6) a direct or indirect benefit realized by the entity.”).] In the absence of fraud in the transaction, the judgment of the board of directors as to the value of the consideration is conclusive. [Sec. 2.103(b) (“(b) In the absence of fraud in the transaction, the judgment of the governing authority of a domestic entity as to the value of the consideration received by the entity for indebtedness is conclusive.”).] The consideration may be received directly or indirectly, including by another entity that is wholly or partially owned by the corporation. [Sec. 2.103(c) (“The consideration for the indebtedness may be received either directly or indirectly by the domestic entity, including by a domestic or foreign organization that is wholly or partially owned, directly or indirectly, by the domestic entity.”).]

 

Issuing certificated indebtedness

A corporation may issue a certificate evidencing the bond, debenture or other debt, which may utilize a facsimile seal, a facsimile signature of an officer, and is not subject to attack if the signature is by an officer who was no longer an officer at the time of issue. [Sec. 2.114(a).]

 

Corporate Guaranties

A corporation may also guaranty the debt of a parent, subsidiary, affiliate of the corporation. [Sec. 2.103(b)(1)] A corporation may also guaranty the debt of any other person if the guaranty may reasonably be expected directly or indirectly to benefit the corporation. [Sec. 2.104(b) (2) (“(b) Unless otherwise provided by its governing documents or this code, a domestic entity may: (2) make a guaranty of the indebtedness of another person if the guaranty may reasonably be expected directly or indirectly to benefit the entity.”).] The decision of the board of directors that the guaranty “may reasonably be expected directly or indirectly to benefit” the corporation is conclusive and not subject to attack, except that the guaranty may not be enforced by a person who participated in a fraud on the corporation that resulted in the making of the guaranty or by a person who had notice of the fraud at the time that person acquired rights under the guaranty. {Sec. 2.104(c)(1)] A guaranty may also be attacked as ultra vires if the guaranty cannot reasonably be expected to benefit the corporation—that is, a shareholder may bring an action against the corporation to enjoin performance of the guaranty, [Secs. 20.002(c)(1); 2.104(c)(2)] or the corporation, directly or through a legal representative or shareholder derivative action, may seek damages against officers, directors, or shareholders who authorized the guaranty. [Secs. 20.002(c)(2); Sec 2.104(c)(3)]

A “guaranty” includes a mortgage, pledge, security agreement, or other agreement making the corporation or its assets liable for another person's contract, security, or other obligation. [Sec. 2.104(a] The power to make guaranties under the Code does not apply to entities or to transactions that would be governed by the Insurance Code. [Sec. 2.104(d)]