Capital Structure, Preferences, And Classes Of Securities

AuthorJames D. Cox/Thomas Lee Hazen
ProfessionProfessor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
§ 18.1 Choices in Debt and Equity Financing
The “capitalization,” financial str ucture, or permanent fina ncing of a cor-
poration is based on the issuance of capital securities. Permanent fina nc-
ing includes not only common stock but also senior secu rities, which can
be (1) an equity interest by way of preferred stock or (2) bonds and deben-
tures, which a re the long-term or funded debts. Debt obligat ions are
issued against t he corporation’s actual or prospect ive earning power even
more than against its assets. The power to issue bonds and other debt
obligations is not dependent, as stock issues a re, on express authorization
by the corporate charter. Debt financing thus provides more f lexibility
because there generally is no need for prior shareholder approval.
A sound and well-balanced capital structure must be carefully
planned. The choice between stocks and bonds of different varieties
depends on many considerations, including whether the business has
an established earnings record, the ratio of propert y to its obligations,
the rate of return t hat must be paid, probable marketability and attrac-
tiveness to investors, advantages under federal and state tax laws, and
the effect on the f uture credit and ability of the corporation to sur vive
business cycles.
The tax laws encourage debt fina ncing by treating i nterest pay-
ments, but not dividends on stock, as deductible from cor porate gross
income.1 In order to safeguard against abuse due to thin equit y financ-
ing, payments on the debt instr uments may be treated for tax purposes
as disguised dividends.2 Similarly, too high a debt-to-equity ratio may
lead a bankruptc y court to classi fy debt as stock for the purposes of sub-
ordinating claims of shareholder/creditors to those of other creditors.3
Attorneys are frequently asked to assist in evaluating the financial
soundness of a firm’s capital struct ure. The choice among different
kinds of securities should be determined by the organizer and manag-
ers, considering the inducements needed to attract different ty pes of
investors and the control of management. They must f urther adequately
anticipate the corporation’s future fi nancial needs. Questions that inevi-
tably arise include: (1) How can the company raise money at the lowest
cost? (2) What are the tax advantages of different forms of securities?
(3) How can control be reserved to the organizers without requiring
them to invest too large an amount in the corporation? (4) To what
extent can the company meet fixed financial charges when its income is
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fluctuating? (5) How can the company best ensu re its credit for future
financing to meet expansion and growt h?
Preferred shares, which are frequently viewed as a hybrid of debt
and equity, may be advisable as an alternative to pure debt because pay-
ment of dividends is not a mandatory fixed charge a nd non-payment
will not entail foreclosure or receivership. In addition to the ability to
pass on payments without being in default, there is usually no maturity
date for retirement of preferred shares, and t he redemption provision, if
any, is normally an option in favor of the corporation. In the absence of
a prohibitory covenant, the corporation has t he power to borrow money
by issuing notes or bonds that take priority over the preferred sha res.
Preferred shares may be desirable because they tend to attract a ty pe
of investor different from those who invest in pure debt instruments.
Special features, such as the right of conversion into a different type of
security, further expand the alternative vehicles for raising capital.
The issuance of senior secur ities such as bonds a nd preferred shares
may be attractive to t he issuer for various reasons. First, sen ior securi-
ties create “leverage” for the common shares—t hat is, a greater chance
of possible gain to the common on the tota l capital investment. Second,
senior securities represent money invested for a li mited return on t he
basis of a stable income to the investor; therefore, they have no claim
on capital appreciation or increased corporate income. Third, preferred
shares facilitate retention of voting cont rol by the initial or current inves-
tors, as all senior securities usually have at most only contingent voting
rights. This reduces the amount of investment necessary to obtain vot-
ing cont rol by way of e ither init ial inves tment or subs equent acquis ition.
Fourth, preferred shares and bonds can be used to tap the reser voir of
savings of those who seek to avoid the risk s of common stocks.
§ 18.2 Bonds and Debt Financing
Bonds or debentures are essential ly promissory notes with more elab-
orate provisions than ordinary commercial loans. They are generally
long-term, but in times of f luctuating interest rates shorter-term instr u-
ments are not uncommon. Despite its existence as a corporate debt, the
longer-term instrument has led to the view of bondholders as “joint
heirs in the corporate fortunes—part icipants in the success or fa ilure
who have been given preferential rights in t he common hazard.”
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