Financing is the life blood of young, growing firms. Without funds, businesses would not be able to grow and prosper. Likewise, for established major businesses, financing provides strategic options for growth, merger or acquisitions, “going public”, restructuring, or “going private.” Corporate financing plays a crucial role in the long-term, strategic direction of a business. Access to capital can make or break a company.
The discipline of corporate finance requires both an understanding of finance, business strategy and securities laws. This module will review some of the financial and strategic business reasons for seeking financing. The term corporate “financing” or “finance” means any type of business financing, including debt or equity for operating or for investing for long-term strategic reasons. The process is not limited to corporations, as other business forms, such as partnerships or limited liability companies, raise funds from the same sources and are governed by the same laws. However, we will focus on corporate financing under the United States securities laws and regulations for private and public offerings of securities. Thus, we’ll focus on corporate financing undertaken in conjunction with strategic business objectives such as going public or raising funds from venture capitalists to facilitate growth.
This course will also discuss the roles of attorneys in all phases of the process of corporate finance, whether for private or public companies, whether in a $1 million or $1 billion transaction. Attorneys, paralegals and their consultants form an important team in advising businesses on corporate financing options and strategies. As many politicians and economists have said, small businesses, especially fast-growing ones, are the creators of jobs. Likewise, attracting innovative, growing business clients is a key strategy for law firms seeking to expand and the global growth of private funds provides new opportunities for many emerging, growing companies to find funding.
Key Players in Corporate Financings
Managing funds is at the center of any business organization. Cash flow is an overused term in popular finance, but it is critical to any business. Successful businesses are managed by people who find ways to attract customers’ funds, use these funds prudently and efficiently by properly allocating to those areas of operations that will produce the greatest returns, and reinvesting surplus funds to long-term strategic projects.
The key person responsible for these central activities is the business’ chief financial officer, who oversees the day-to-day flows of funds and directs long-term resource planning in conjunction with the company’s board of directors and other senior officers. In smaller or younger companies, the chief executive officer or president may take on the role of planning for the acquisition and allocation of funds for the company.
The Board of Directors is the governing unit of the corporation responsible for making important decisions such as approval of financings related to the public sale of equity, merger with another company or acquisition of another company.
Managing Officers, typically the company’s senior officers, prepare financing proposals to the Board for consideration. Corporate officers involved in financing decisions usually include the chief executive officer, chief financial officer and general counsel.
Investment bankers, many of whom have law degrees, play crucial roles in developing and proposing corporate strategic action and related financing to the management of public or privately-held companies. For example, an early step in the implementation of a merger or acquisition strategy begins with soliciting the advice of an investment banker to assess whether financing could be raised to accomplish the merger or acquisition. One major reason to talk to an “I-banker” first is that they have the experience of closing mergers and acquisitions as well as access to networks of investors and merger specialist that they employ. Equally important, a full-service investment bank is able to offer a wide range of services for a merger or other complex corporate transaction, such as going public.
Equally important are attorneys and accountants, who bring the legal and accounting experience necessary to document and support a corporate financing. Lawyers and accountants who specialize in mergers and acquisitions will often be needed early in the process. After identification of the target company, lawyers will prepare the Letter of Intent, that may include provisions necessary to further serious discussions between the acquirer and the target company. These provisions may include:
Non-Disclosure of Confidential Materials such as internal, non-public financial statements and tax records;
That the transaction is “subject to” the completion of a satisfactory due diligence investigation of the target company;
That the transaction is “subject to” successful financing by the acquirer.
Accountants assist investment bankers and lawyers with developing tax-advantageous acquisition/merger structures and developing post-transaction tax profiles for the new company that will be formed.
Broker dealers are in the business of buying and selling securities for others, or for their own firm accounts. The term broker dealer includes firms involved in the purchase, sale or trading of securities.
An underwriter is a person or company that buys securities from issuers with the objective of reselling them to investors.[1] Underwriters may form syndicates of underwriting firms to buy large numbers of shares from corporate issuers in an IPO underwriting. An underwriter may also be affiliated with or part of a broker dealer firm.
The Securities and Exchange Commission, or SEC, which was created by the Securities Act of 1934,[2] also plays important roles in corporate finance. We’ll look at the SEC’s function in Module 2.
State securities regulators may also be involved in corporate finance activities since state securities laws may be invoked when a corporate financing involving securities sales occurs within the state’s borders. An intrastate securities offering to investors may require registration of the securities with the state securities regulators. State securities laws are popularly referred to as “Blue Sky” laws.[3]
Advantages of the Corporate Form
Investors typically seek limited liability when considering investing in a business. Another common consideration is the ease of transferring their interests in the company, commonly referred to in corporate finance as liquidity. Finally, investors may wish to explore the potential for tax benefits associated with their investments.
Given these common investor considerations, it is understandable that the corporation is the most appealing form of a business to many private and public investors.
The corporation offers limited liability to its shareholders, who are usually not liable for corporate debts. With rare exceptions, the most a corporate shareholder can lose due to malfeasance by the company is the amount of her investment. Corporations afford the greatest liquidity as shares can be sold relatively easily. For publicly traded corporate shares, trading is as simple as a few clicks of the mouse. Finally, while corporate profits are taxed at both the corporate and shareholder levels, favorable corporate tax rules, low corporate tax rates established by the Tax Cuts and Jobs Act of 2017[4] and tremendous flexibility in tax planning often makes corporations attractive from the tax perspective, as well.
Furthermore, state laws require the installation of a board of directors to oversee and direct the corporation. The board members are responsible for oversight of the affairs of the corporation and its managers. In effect, the board represents the owners, or shareholders, of the corporation.
Still, other forms of business also provide viable vehicles for investors. In particular, limited partnerships and LLC structures provide many protections desired by investors. However, unlike the corporate form, the rights of limited partners and LLC members to participate in the operations of the business entity may, as the names imply, be limited. Limited partners and many LLC members are no more than passive investors who must leave the operations and leadership of the business entity to the general partners or managing members. Moreover, to become publicly traded on an exchange, a business must be a corporation.
Key Reasons for Financings
Let’s examine the general legal and business reasons that companies seek financings in either the form of equity or debt.
- Risks of Undercapitalization
Undercapitalization occurs when a business has insufficient funds to cover its operations. Undercapitalization may lead to serious personal liability for the shareholders of a corporation because a court may “pierce the corporate veil” subjecting its shareholders to personal liability if the court rules that justice so requires. [5]
For example, in Minton v. Cavaney,[6] a California court held that undercapitalization, as evidenced by the company’s inability to pay a wrongful death claim, was sufficient to pierce the corporate veil permitting the claimant’s estate to pursue collection actions against the company’s shareholders. The court observed that “the equitable owners of a corporation are personally liable …. when they provide inadequate capitalization …”[7] Owners of small corporations must have sufficient capitalization to operate the business and to have capital to cover potential future liabilities to be certain of the efficacy of the corporate liability shield.
- Financial Restructuring
Deleveraging is the process of reducing debt financing on a company’s balance sheet. Since the Financial Crisis of 2007-08, many non-banking businesses have undertaken massive restructuring of their balance sheets with the aim of reducing long-term debt. In place of the debt, companies have often sold equity in the company. A very strong US stock market has encouraged many public companies to sell equity to pay-off debt. While there is no hard and fast rule, most companies seek to have 50-50 balances between debt and equity on their balance sheets.
- Financing for Corporate Mergers & Acquisitions, or Purchase Assets
Businesses will often borrow and sell equity to raise funds needed to acquire other companies or some of their assets. A significant corporate acquisition usually requires a combination of debt and equity capital. Corporate acquirers may tap the massive private equity money pools to raise equity capital while relying on bank financing and bond issuance to raise the remainder of needed capital.
A merger and acquisition corporate strategy aimed at acquiring “strategic assets” is usually part of a broader operating strategy to expand or reposition an acquirer’s product line, or to enter new domestic or international markets. For example, the landmark merger of America Online and Time Warner in 2001 was an attempt by both management teams to expand into new markets and to merge new technology with old technology. AOL was seeking access to Time Warner’s entertainment assets (such as its library of videos and movies), while Time Warner was seeking entry into the “new Internet market” via AOL’s distribution channel.[8]
- “Cashing Out” Private Investors
Private investors, such as venture capitalists[9], often seek an “exit” from their invested capital within 3 to 5 years after the initial investment round [10]. For a growing company, using its cash to repay investors might be a poor decision, as their surplus cash could often be better put into expanding operations. Thus, a company might finance an investor exit by replacing early investor capital with new investor capital in the form of equity.
Sources of Corporate Financing
There are many possible sources of corporate financing.
- Banks and Other Lenders: The sources of unsecured or secured, long- or short-term debt financing include local, national or international banks, as well as other non-bond debt financiers. This type of debt financing does not involve the issuance of securities (such as bond financing would). Rather, the debt is “packaged” as either a short-term (one year or less) or long-term (more than one year) loan and is usually provided for the purpose of operating capital or purchasing equipment or corporate real estate (via “mortgage financing”).
- Private Equity Investors: A growing source of both debt and equity financing for businesses involves private equity funds. These funds are created to attract investors who may seek above-market returns via a combination of debt and equity investment in public or private companies. Hedge funds are a subgroup of private equity, as are venture capitalists.
- Venture Capitalists: Professional investors that target private start-ups and early-stage companies are known as venture capitalists. VCs attract funds from institutions and wealthy families and individuals and reinvest those funds in a variety of emerging industries and companies worldwide. VCs do not provide debt financing; rather they purchase convertible preferred stock shares offered by the investee company.[11] The preferred stock provides the VC investors with super-majority voting powers in some cases; thus, a VC can sometimes even outvote the company’s founders, as the terms of VC investors are often very favorable to the VC. Should an investee company qualify for an initial public offering, the VC may convert its preferred shares to common stock to sell them as part of the IPO. The IPO may provide the VC with the opportunity to exit from the investment. Among the main sources of VC and private equity funds are insurance companies, pension funds, hedge funds and state sovereign funds. These sources are often direct investors in major corporate financings, such as large private company equity investments.
- Insurance Companies: Insurance companies are limited by state regulators to reinvest insurance premiums in high-grade, low-risk investments. Typically, insurance companies will purchase the debt issued as part of the financing structure and stay away from the higher risk equity investments offered in financing.
- Pension Funds: These institutional investors are limited by federal and state laws in how they can invest pensioners’ retirement funds. Most of these funds will invest in the common stock offerings issued by the newly formed firms, in addition to investing in the debt side of M&A financings. Pension funds are a major source of VC funding as limited partners in such funds. State regulations limit their investment to 5% or less VC funds which are classified as alternative assets.[12]
- Sovereign Wealth Funds: A growing source of funding for mergers and acquisitions are the state-controlled investment funds of foreign governments such as China.
- Hedge Funds: These often off-shore funds seek high return assets and investments and evidence shows that they have invested heavily in major public merger deals in recent years. These global funds manage billions of investible funds and often operate outside U.S. regulations to avoid Securities and Exchange Commission and Treasury Department oversight.
Securities Laws Applicable to Corporate Financings
Under Section 5 of the Securities and Exchange Act of 1933, every company that intends to offer securities by way of interstate commerce or the use of the mails must first file a registration statement with the Securities Exchange Commission. A registration statement is a long, detailed document that summarizes the company’s management structure, its financial condition and the contemplated use of proceeds from the sale of securities.
The 1933 Act broadly defines the meaning of the term “securities.”[13] Accordingly, most corporate financings will generally clearly fall under the 1933 Act’s definition. The question, then, for corporate attorneys is whether an exemption from the registration statement is available. An exemption generally would mean a less difficult road to travel, potentially saving much time and money.
The Securities Act of 1934[14] is a companion to the 1933 Act and addresses important issues left open by the 1933 Act such as ensuring a fair and orderly capital market for the sale and purchase of securities, the regulation of broker dealers and the establishment of the SEC. The 1934 Act gave broad authority to the SEC over regulation of issuers of securities, broker dealers, overseeing the registration of securities sold via interstate commerce and issuing rules and regulations for the implementation of both Acts.
States’ antitrust laws and regulations are similar to federal antitrust laws. The key point is that states have the power to sue to block a merger, even in the absence of federal regulatory authority to block the same merger. States may also enforce laws that would impact consumers by limiting competition within the state territory. Often, states will first refer such potential enforcement to the federal government agencies to evaluate antitrust violations.
Conclusion
Corporate financing begins with an understanding of the basic reasons to obtain capital for operations and for long-term strategic investments. Attorneys play critical roles in determining the best option to use in raising those funds – whether by seeking funds from banks or other lenders or from investors, which raises the risk level for corporate managers. Attorneys work with consultants, accountants and boards of directors. Together, they select options that best minimize risk exposure while achieving the goal of raising the needed funds quickly and at the lowest costs.
In Module Two, we will discuss in further detail the registration process for the sales of securities to public investors.
Footnotes:
[1] 15 U.S.C. Section 77b(a)(11)
[2] 15 U.S.C. Section 77b(a)(5) [defines the “Commission” to mean the SEC]
[3] Hall v. Geiger-Jones Co., 242 U.S. 539 (1917)
[4] https://www.congress.gov/bill/115th-congress/house-bill/1
[5] https://www.law.cornell.edu/wex/piercing_the_corporate_veil
[6] Minton v. Cavaney, 56 Cal. 2d 576 (1961)
[7] Id. at 579
[8] https://money.cnn.com/2001/01/11/deals/hold_aol/
[9] https://hbr.org/1998/11/how-venture-capital-works
[10] http://www.streetofwalls.com/finance-training-courses/private-equity-training/private-equity-industry-overview/
[11] https://www.upcounsel.com/convertible-preferred-stock
[12] https://www.ssga.com/investment-topics/asset-allocation/2018/inst-how-do-ppfs-invest.pdf
[13] “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture,… in general, any interest or instrument commonly known as a “security”.” 15 U.S.C. § 77b(a)(1)
[14] https://legcounsel.house.gov/Comps/Securities%20Exchange%20Act%20Of%201934.pdf