parent nodes: agency costs | corporate finance | corporation law | fiduciary duty
corporate finance
Types of financing options
In order of security (that is, the order in which creditors come in bankruptcy, etc.):
- bank loans: secured by "debentures," with firm assets as collateral
- trade creditors: unsecured contractual debt ("working capital float") (accounts recievable minus accounts payable)
- securities:- bonds: unsecured, long-term obligations
- notes: unsecured, short-term obligations (commercial paper)
- preferred stock: superior rights to dividends and securing debt, but no voting control
- common stock: residual claimants (share price equals discounted value of future cash flows) plus voting control
Note that corporations also owe claims to (and thus in a sense are partially 'owned' by):
- wages and benefits owed to employees
- taxes owed to the IRS
- costs imposed by government regulation
Equity value/return
(a) The directors of every corporation, subject to any restrictions contained in its certificate of incorporation, may declare and pay dividends upon the shares of its capital stock, or to its members if the corporation is a nonstock corporation, either (1) out of its surplus, as defined in and computed in accordance with §§ 154 and 244 of this title, or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. If the capital of the corporation, computed in accordance with §§ 154 and 244 of this title, shall have been diminished by depreciation in the value of its property, or by losses, or otherwise, to an amount less than the aggregate amount of the capital represented by the issued and outstanding stock of all classes having a preference upon the distribution of assets, the directors of such corporation shall not declare and pay out of such net profits any dividends upon any shares of any classes of its capital stock until the deficiency in the amount of capital represented by the issued and outstanding stock of all classes having a preference upon the distribution of assets shall have been repaired. Nothing in this subsection shall invalidate or otherwise affect a note, debenture or other obligation of the corporation paid by it as a dividend on shares of its stock, or any payment made thereon, if at the time such note, debenture or obligation was delivered by the corporation, the corporation had either surplus or net profits as provided in clause (1) or (2) of this subsection from which the dividend could lawfully have been paid.
DGCL § 170
The equity value of a corporation — the residual assets available to shareholders — are effectively the assets (capital) minus the liabilities (debt plus wages, etc.) Note that DGCL § 170 allows directors flexibility in determining dividends. Other states (California) may require a certain ratio of assets to liabilities before dividends may be paid.
The mix of equity and debt options allows a corporation to gain financing from a variety of different investors who have different preferences towards risk and return. The security of a debt and a creditor's information about debt are substitutes. The greater security of an investor, the less return the investor will demand, and the less monitoring costs the investor will spend. However, by reducing the pool of assets available to other creditors, a secured debt raises the return that other creditors may demand, as it lowers their security. But secured creditors don't raise, and may even lower, the cost of information that other creditors face, so that they need not necessarily demand a higher interest rate.
Shareholders help address the uncertainty in corporate profits, as they agree to take residual claims to the corporatoin after debtors are satisfied; shareholders agree to take an uncertain stream of earnings rather than negotiating for a fixed return. Debt holders, on the other hand, have a limited risk and return, and can better judge their information costs and the state of the corporation relevant to their investment. Debt also can keep managers in line by creating a nontrivial risk of bankruptcy.
Note the agency costs caused by the fact that shareholders, including directors who hold equity stakes in their firms, will want riskier projects that carry higher return. Creditors have means to protect their investments such as disclosure requirements, minimum capital requirements, and other contractual remedies, and piercing the corporate veil in some instances. Debtors may also be liable under a theory of 'fraudulent conveyance' if they make a transaction in order to escape paying their debts.
Note generally that with the right package of derivatives, a debtholder can enjoy the same cashflow rights as an
equityholder and vice versa. Investors also cannot easily opt out of a fiduciary duty once it is put in place. However, directors owe no fiduciary duty of disclosure to creditors, so that corporate law may unduly favor disclosure to shareholders rather than to creditors, who often form a major part of corporate finance.
In contrast, shareholders enjoy the benefit of the fiduciary duty owed to the corporation by directors.
Cases
Costello v Fazio (subordinating the claims of promoters in a bankruptcy proceeding to that of general unsecured creditors where promoters had converted nearly all of their equity interest in a money-losing firm into secured notes before incorporation so as to protect themselves)
See corporation law