Corporate Finance for Lawyers: Raising the Capital for the Business - Assignment Example

Corporate Question 1 a. Sara idea is quite practical in business but her main problem is raising the capital for the business. Her parents are not supporting of her idea and therefore refuse to give her capital to start the business. Her predicament seems sorted when she consults her lawyer who proposes different methods of raising capital for her business. Consequently, she liaises with Bob Bongars and Ami who become partners in the business and therefore makes equal contribution to the business. Ami and Bob agree that Sara should remain the president of the business and therefore oversee the daily operation of the business. To raise capital for her business, there are different ways that she can use to get money from her family and friends. The following are the main ways which she can use: 1) She can borrow the money on an agreed term base and on an agreed profit This is one of the most common methods that are used to raise money for a business. For most young people who have great ideas but cannot raise enough money to raise capital for their business, they prefer using this method since it allows the company to grow while repaying money at a later date. Borrowing from family and friends is cheap but it also comes with its own advantages and disadvantages as outlined below (McCann, 2008): The following are advantages of borrowing money from friends and families: - There is no long and expensive legal procedure before getting money. The involved parties just need to come to an agreement perhaps by writing down in presence of some witnesses and then get everything moving It takes relatively shorter time as it eliminates the formalities that would be involved in other methods of payment The two parties can agree on a longer period of time for repayment of loan based on their agreement since there is no rigid repayment framework like the one in financial institutions. This means that the period before starting of repayment of the borrowed money can be longer There will be not collateral that will be required to borrow the money like in financial institutions The borrowed money comes with low interest rate and in some cases it may attract zero interest rate compared to interest rates in financial institutions It may be relatively easier for a business with more shareholders to raise capital since each shareholder will borrow money from their friends and families which mean the amount of capital availed to start the business will be higher. The following are some of the disadvantages of borrowing money from family and friends: - The amount of capital contributed may be limited based on the financial ability of those who will contribute the money as compared to a financial institution where more money can be borrowed. In case where the business like PP Inc. is owned by many shareholders, there may be complications in repayment of the loans in case where there is disagreement between the shareholders The liability to repay the money borrowed may not rely on the financial wellness of the business but rather on the financial wellness of the individual who borrowed the money. This implies that in case where the business has more than one shareholder, the responsibility to repay the money is not shouldered on the business but rather on the individuals. Even when the business makes loss, they will still be required to repay the borrowed money. Lack of legal structure in repayment of the money may bring about complications like disagreement between the two parties on periods of repayment and the amount of interest to be repaid The borrowed money is sometimes tied to family issues especially when the money has been borrowed from family members, which means that individual may not have the freedom to use the money as she or he wants. This may limit the ways in which individual invest the borrowed money. In case of PP Inc. the company may be promoted to grow or be limited in growth by the above discussed factors. The money borrowed from family and friends may be easy to come by with little legal restrictions but it may limit the growth of the business especially considering that the company has three shareholders. However, it is one of the cheapest and most affordable means for Sara to raise capital for her business. 2) She can invite them to buy shares to become shareholders in the company The other way through which Sara can raise money from friends and family is to negotiate with the three directors so that they can sell her shares to friends and families. This means that since each of them has 10,000 shares, Sara will have to sell her shares to friends and families but this will only be if other directors agree to sell their shares as well. Advantages of raising capital through sell of shares: - Each friend and family member will contribute to the capital of the business through buying shares which equal their financial situations. This means that there is already a structure way through which the individuals raise capital for the business Friends and families will become part and parcel of the business which means they will be in a position to share profits and losses made by the business Sara will not be required to repay the money converted to shares even if the company collapse which reduces her overall liability The shareholders may be recalled to contribute more capital if the business wants to expand The following are disadvantages of raising capital through shares: - The amount of ownership in the business for Sara will be greatly reduced since she will have to sell some of her shares. This means that despite her being the brain behind the idea, her control of the business may be substantially reduced. In view of the fact that PP Inc. is a company that has three shareholders, they may not be willing to admit other shareholders to the company. If they decline to allow Sara to sell her shares, then this method may not work. In light of the above circumstance, I would advise Sarah and PP Inc. to borrow money from family and friends under an agreed term of interest and the date of repayment rather than bringing them on board as shareholders to the company. Instead of sourcing funds from different people, I would advise them to look for two or three people who have enough funds that can be invested in the business because the more they borrow from different people, the more difficulties they will face in dealing with issues arising from repayment of the money compared to when they have to deal with few people who understands the condition in the business. b. Sara hits a snag with her process and wants to source for more funds to sustain the operation of the business. This is a common situation experienced in most business especially those which are starting up and not well established. However, the amount of money required for to keep the business running is quite large compared to the start up capital. It can be quite difficult for PP Inc. to find somebody from whom to borrow $500,000. Such a situation will require raising capital by inviting more people on board to become shareholders in the company. However, not anyone wants to become a shareholder in a business that is in experimental stage and not really performing. In such situation, individual will require to be furnished by different information that will convince them that their investment is not going to waste but one time it will give returns. The following information will be required by potential shareholders to evaluate the condition of the business before deciding whether to invest their money in the business (Levison, 2006): - Investors will need to know the company more. This means that they will need to analyze the company to know its mission and vision. These two gives them an understanding of where the company is coming from and where it is going. They will need to know a little bit of history of the company including when it was started, who started it, and where it is heading to. Investors will also require knowing about the status of the company. This means that they will need to understand the article of association between different shareholders. Most investors are wary of investing in a company where there is one individual controlling majority of the shares since the performance of the company may be at mercy of one individual. They will need to know about the performance of the company. Buying shares is like investing and absolutely no one wants to put his or her investment to land in a place where it will give no returns. Investors are very concisions of the performance of the company they are putting their money in since they want maximum return from their investment. A well perfuming company is more likely to get more investors than a poor performing company. Most important, investors will need to know about returns of the company. Three most important questions that investor seeks to know about company returns include: Stability of the returns Variability of the returns Volatility of the returns These are some of the most important information that investors will be seeking to know before deciding to invest in the company. This means that Sara and other directors must be in a position to explain these factors in a clear manner to the potential investors. c. Passive investment can be defined as a financial strategy where a fund manager has limited portfolio decision and consequently make few of these decisions with an aim of minimizing the cost of transactions which include even the incidence of capital gains tax. This strategy mainly involves very limited ongoing buying and selling actions. Therefore, passive investors tend to purchase their investments with an aim of long term appreciation of the investment and limited cost of maintenance of the investment. One of the advantages of PP Inc. bringing CO on board as a passive investor is that the company will not be looking at short term gains of their investment but rather on the long term gains. This means that in the short term, PP Inc. will be in a position to restructure its operation so that it starts making good profit before CO can reclaim profits on its investment. As a passive investor, CO will not be involved in any production process which means PP Inc. will have an upper hand in running the company and protecting their patent rights. The board of director led by Sara will have time to increase investment in development of the idea without interference from CO. Therefore in the current situation that PP Inc. is in, a passive investor would appear more suitable to give the company more time to start commercial operation. However, the problem with CO proposal is that they want to be given the ability to increase their share of investment in the company if all things go as planned. This is a tricky situation comparing the financial muscle of CO with that of PP Inc. The danger lies in the fact that in the future, when the company starts making more profit, CO may reclaim ownership of the company and increasingly isolate current PP Inc. directors. Increased acquisition of the company share will assist CO to have controlling majority and therefore make crucial decision for the company. This will defiantly alter PP Inc. growth strategy. If Sara, Bob, and Ami are to take in this proposal, it must be structured in the most appropriate way that protects their interest and the interest of the young company they are trying to form. As has been discussed earlier, passive investor appears most suitable in the case of PP Inc. but it comes with its own disadvantages especially in consideration of CO proposal to increase its share of investment. There are different approaches that can be used to restructure Confederation Oil’s passive investment. These include: The most common way of restructuring passive investment is through the legal agreement that defines the terms of engagement. In most case, passive investors do not participate in the running of the business but their interest is in the long term benefit of their investment (Holmans, 2004). In this case, PP Inc. can allow CO to come on board as passive investor and provide the much needed capital and marketing resources but under an agreement on the extent to which CO can increase its share in the future (Feldman and Roy, 2004). This arrangement should have a limit on the amount of shares that CO can acquire to prevent is total take over bid for the PP Inc. The terms of engagement between PP Inc. and CO should be based on such limitation conditions and should take place only when CO agrees to such a clause in their agreement. Second, PP Inc. can agree to have CO as a passive investor with no agreement to allow the company to increase its share in the future. In this case, PP Inc. should give CO a ‘take it or leave it’ proposition. d. GES Inc. suggestion is to have the two companies come together to work to achieve their growth objectives. This is a corporate restructuring strategy which may not be a source of finance although mostly used to assist cash strapped firms by entering into operation with another company. corporate restructuring can take different forms including (Donald, 2008): Sale of all or some few assets Mergers Takeovers Amalgamation Arrangement, Divestitures Dermerger Reorganization For the PP Inc and GES Inc., the most probable corporate restructuring strategies that can be used include a merger or acquisition. In such mergers, both companies come together for joint operation pursuing similar business growth strategy and entangled business objectives. On the other hand, an acquisition involves one business totally acquiring the other as a whole. It is a takeover bid through which one company gains majority control of the other through sale of fixed and liquid assets. A merger is corporate restructuring strategy in which the two companies comes together to consolidate their operation. A merger can horizontal, vertical, congeneric, or conglomerate. A merger must happen between two companies which are in the same line of business and must also have same growth strategy (Donald, 2008). A merger usually happens to consolidate the market share of the two companies and create a more dominant business entity. However, a merger may also take place to consolidate operation of two companies to enhance their growth. There are three main motivations for a merger which include: I. Economic – A company being faced by economic problems may seek merger with another company to assist it survive in the market. In the economic aspect, the two companies may be coming together to enhance economies of scale II. Financial – The two companies may be forming a merger in order to enhance their financial position. This may include enlarging their market share to enhance their financial credibility. III. Tax considerations – Companies may form merger for tax considerations While a merger is important for growth of the company, it comes with a lot of problems especially in integration of the management between the two companies. Most mergers have ended in disastrous management situations because one company in the merger wants to control the other. Another problem that may face mergers is inconsistency in coming up with similar goals for the two company. Unlike a merger, an acquisition is a complete take over of one company by another. Through an acquisition, the company gives up all it rights of operation to the purchasing company including the name. This means that the acquiring company can change the name of the acquired company. In some case, acquisition goes with mergers. A friendly merger is considered to be joint recommendations of the need for the two or more companies to operate together which comes from the management of the companies (Donald, 2008). On the other hand, a hostile merger is an acquisition where a company makes direct appeal to shareholders. Most companies go for an acquisition when the chances of their operations are slim and hence consider a total sale. This means that while the company may retain some of the management, they may not have any say in the operation of the new company. In an acquisition some of the legal issues that have to be sorted out include regulatory issues like securities legislation, searches, due diligence, tax, contract and schedule issues, and many others. Another corporate arrangement that is possible for PP Inc. and GES Inc. is corporate alliance. This is not more like merger but takes different forms. It can be a joint venture, strategic partnership, or marketing agreement. This is an important arrangement as both companies retain their operation rights and independences. However, the arrangement may collapse when one company suffers economically which means it does not guarantee stability. In light of the above arrangements, I would recommend joint venture between the two companies. This would ensure that PP Inc retains its independence to operate with no legal issues if the company wants to withdraw from the arrangement. e. Under the loan agreement with OBIB, the provision in article 8 is a great limitation for the deal to go through. This is because the article outlines that the company should not be amalgamated, consolidated, or merge with any other person or company unless the company is not in default of its obligation or the corporation is incorporated under laws of Canada and assume obligation of this loan. This means that if the deal has to go through, either the company has to be incorporated under laws of Canada of the GES Inc. agree to take over the obligation to repay the loan. This clause affects the deal in the sense that GES Inc. has to agree to take up obligation to repay the loan and if its does not, then the deal will not go through. Since GE is incorporate into the laws of Canada as it is publicly traded, then the deal can go through. f. A public traded company can be described as a company that has been permitted to trade in securities. The company hence offers registered securities including stocks, bonds, shares, and others and sold to the general public. They are traded through the stock exchange. In some cases, the company securities may be traded over the counter (OTC) mainly through market makers using non-exchange quotation services. A public traded company has an advantage in that it can raise funds and capital through selling securities (TiberCreek Corporation, 2010). On the other hand, a private held company is referred to as a close corporation. This is a company that can be owned in two different ways either by non-governmental organizations or through ownership by small number of people of the company stock which are not traded publicly. g. The option offered to is used in most companies to motivate their employees. The option involves giving employees shares to become a part of company ownership. When employees own share in the company, they feel a part of the company and therefore they can work towards more profitability of the company. Sara has been offered this option to ensure that she feels a part of the company and therefore works more towards the success of the company. As a shareholder, she would feel she has that duty to ensure the success of the company in all its endeavors. The shares offered to Sara can be classified as common shares which are mainly held by the employees and the management. h. In light of financial performance of the company, this option offered to Sara is very important. It is evident that the company performance is health and financial projections shows that the company is poised to make further future growth. The financial situation of the company can be evidence in the following financial statements. Income of the company: - In 2007, the total income for the company from sales was 80,000. This grew to 100,000 in 2008 and to 120,000 in 2009. This represents an annual growth of 20% in profit every year. If the company maintains the current growth momentum, it means in five years by the time Sara can be allowed to sell her share, the company will be having a total sales of 220,000. The trend shows an appreciation in share price each and every year. One of the most important aspects to consider when investing in any company is the asset base of the company. As can be extracted in the company financial statement, the total asset base of the company has continued to growth each and every year. The company asset base has grown from 231,500 in 2007 to 274,000 in 2009. This means that in the three years period, the company has been able to grow its asset base by 42,500, which is an impressive growth by any standard. Growth in asset base indicates strengthening financial position of the company. Although the same trend has been experienced in growth of company liabilities, the total amount of short and long term liability is less than total assets which means the company can be given positive financial rating in terms of economic stability. The company has also shown growing shareholders equity over the years. Since 2007, the company shareholders equity has grown from 19,500 to 40,000 in 2009. As has been shown in the income statement, earning per common share has also been growing at unprecedented rate. In 2007, earning for every common share (basic option) was 0.04. This grew to 1.30 in 2009 and 2.80 in 2009. For diluted shares, they grew from 0.38 in 2007, 1.18 in 2008, and 2.55 in 2009. The trend in share prices is evidence that the company has a potential future growth in share prices. This implies that if Sara purchase common shares as proposed by the management, her shares will have earned and she may also dispose them at a higher price after the five years. In light of the above financial considerations, it is evident that the company is on an upward growth trend and the share value will continue to grow each and every year. It is important that Sara take to the option given and purchase the shares because she will cash them at a higher price in the future. With continued growth of earning per common share, it implies that she will have earned a lot before she decides to dispose off the shares. Question II In this case, the decision by GES Inc. to find a new partner in the expansion plan holds the company at random as it does not have enough funds for this expansion. Therefore Swivel comes on board but as has been expressed, Swivel does not also have enough funds to carry the deal through. Therefore, Swivel would have to borrow money through a new company 123 Ontario Ltd in order to get the money to buy out GES Inc. There are many advantages and disadvantages to this deal. First, Swivel is offering a higher price for GES Inc. shares. While the shares have been trading for a market price of $15 for the last two years, Swivel is offering a $20 per share for all outstanding shares in GES Inc. This means that shareholders would get $5 more per share compared to the current market price. The board decision to sell all outstanding shares to Swivel would therefore be in the interest of the shareholders since they are in a position to get more per share that they would have got if the share were sold at the conventional market price Second, the deal would also allow the company to expand its operation to new markets in California and other North America areas which have been identified to be moving toward eco-friendly energy. This presents a unique business growth opportunity for the company which means it would increase its profit and expand its asset base. However, there is sour bit in the deal. Swivel, which want to buy out all outstanding shares in GES Inc. does not have enough fund to fund the operation. Therefore, it is contemplating borrowing money under the new company, 123 Ontario Ltd. This company would be privately held and GES Inc. would be transferred to this company. This means that GES Inc. would be transferred to the same company that will be used to leverage the company debt. In line with the Supreme Court of Canada ruling in BCE, it is evident that this decision is likely to bring about law conflict. In share ranking, GES Inc has Class B common shares which are mainly held by employees and management, Class A preferred shares which have a dividend rights of 5%, 1998 Bonds which are maturing in 2018, and Medium-Term Notes which are due in 2011. Considering all these share rankings, the 1998 Bond holders are likely to be against the decision by the directors to take the offer given by Swivel. This is because the transfer of GES Inc. to 123 Company which will have been transferred the loan borrowed by Swivel is likely to lower the market value of the company and therefore they are likely to earn less from their bonds. However, in line with the BCE ruling, it is likely that the deal will be considered a fair deal although the bondholders will have to lose (Tory and Cameron, 2009). While the share holders will gain from the move, bondholders are likely to loss owing to the reduced rating of the company. The board of directors has however taken into the interest of the majority of the shareholders in that they are going to earn more from their share (Internationallawoffice, 2009). The company can therefore proceed with the transaction since it is difficult to come up with a structured method that will satisfy the need of all stakeholders. Bibliography Donald, D. (2008). Mergers, Acquisition, and other restructuring activist. New York: Academic Press Feldman, B. & Roy, D., (2004). Passive options-based investment strategies: The case of CBOE. Ibboston Associates, July 2004 Holmans, (2004). Choosing a legal structure. [online] available from http://www.holmans.com.au/facts2/legal.pdf [18 February 2010] Internationallawoffice, (2009). Supreme Court releases reasons for decision in BCE Inc. case. [online] available from http://www.internationallawoffice.com/newsletters/detail.aspx?g=eeadf25e-beb4-4fae-b3c4-20ad0bd1b791 [18 February 2010] Levison, P. (2006). What Investors want to know? Business Week, October 2006 McCann, L. (2008). Methods of raising Capital. Business Handbook TiberCreek Corporation, (2010). Take your company public. [online] available from http://www.tcc5.com/goingpublic.php [18 February 2010] Tory, J., & Cameron, J. (2009). ‘Directors duties after BCE: Supreme court of Canada decides.’M&A, January 2009 Read More