IP Innovation Entrepreneurship - Food Ventures LLC - Essay Example

Bob Robson Subject: Issue of preferred stock as a source of finance Formation of a company A company comes into existence after going through a series of processes that can be described as promotion, incorporation, capital subscription and commencement of business. Promotion is the first stage in the formation of a company. A promoter conceives the idea of an enterprise, analysis its prospects, works out a tentative scheme of organization bringing together all the factors of production and floats the enterprise. The company should be registered with the registrar of companies. The promoters must get a name for the company and also get approval of the proposed name from the registrar of companies. Although all companies operate as separate legal entities, it is obvious that they must act through human agents called directors. The director must ensure that the company is registered before it starts doing business. After receiving the necessary documentation, the registrar opens a file for the particular company. If he is satisfied that all requirements of the Act in respect to registration have been complied with, he will register the company and place its name in the register of companies. Once the certificate is issued, it acts as conclusive evidence that the company was properly formed and in accordance with all the requirements of either the company’s Act or normal company practice. Therefore it is recommended that you establish that Thelma’s Tacos, Inc. was properly formed and has a certificate of incorporation since without this the Securities and Exchange Commission cannot grant approval to the company to raise an additional capital of $10 million by issuing preferred stock to Food Ventures LLC. Sources of finance Funds are needed for investing in new fixed assets or for expanding the business, financing additional working capital as business expands and in times of high inflation to maintain the real value of working capital. Sources of finance can be classified into internal and external sources and long and short term sources. Internal sources are finances which are generated within the business (Horngren & Harrison, 2009). They comprise of retained earnings, provisions, sales and lease backs and adjustment in working capital items. External sources are finances which are obtained from the owners or the creditors. They may include ordinary share capital, preference share capital, debenture issue, trade credit, hire purchase, and loans from banks and other financial institutions. Long term financial sources provide funds that may be used for a long time. They may include share capital, debenture or long term loans, retained earnings, mortgages, sales and lease backs, institutional investors and specialised financial institutions. Short term financial sources provide funds that can be used in the business or for a short time before they are required to be repaid. They may include bank credit, trade credit, bills of exchange, factoring, invoice discounting, higher purchase and lease finance. Factors to consider before making a choice on the source of finance include Time factor – if the finances are required to make up the working capital deficiency, then short term sources of finance must be selected. On the other hand, if the finance is required to acquire the fixed assets, then long term sources of finance must be used. Cost of finance – the cost of finance should be less than the expected return from the project for which this finance is required. Size of business – large companies can acquire finance in form of proceeds from ordinary shares, debentures, mortgages and other long term loans. Small business units can get finance from banks in the form of small loans, bank overdraft, trade credit and from their own internal sources. Availability of finance – business firms should use the source that is easily available. Flexibility – business firm should use the source that is flexible whereby the business can pay the money when not in use. Mode of payment – business should use that mode which allows the repayment of the principal and the interest or reward in easy and convenient installment. Raising capital for a private company that has achieved recent success in the restaurant industry can be a great challenge facing the owners. Venture capital financing is one of the major sources of funds that are available. Before deciding on which source of funds to use, you should consider the degree of control over the company you wish to retain, the bearable amount of equity dilution, whether there is assistance in managing the company and other conditions attaching to the fund. Venture capital financing This is money provided by professional investors for investment in developing businesses. Venture capital companies differ widely in their preferred technologies, size of investment, products and stage of development of the company in which investment is made. Strengths of raising money from venture capital Plenty of money for several rounds of financing. Venture capital firms often have the resources to provide the funds needed to finance research and development and growth in multiple rounds of financing. There is huge variety of venture capitals to choose from – many venture capital firms work closely with young companies and can assist with formulating business strategy, recruiting, assembling a board of directors, additional management talent and provides introduction in the financial community. The funds are great for aggressive growth vision – venture capital firms are able to recommend strategies and approaches that make the company more profitable. Weaknesses of raising money from venture capital Giving up the control of the company – in addition to sharing in the equity, most venture capital firms insist on sharing in the control of the company. They may want the right to have a representative on the board of directors. They have to be consulted before any decision is made to get extra funds for the company – they often require veto powers over any major changes to the company’s business operations or financial arrangements. Equity financing This refers to contributions by the owners of the business. A company that wishes to raise money through equity capital invites the public to subscribe to the shares. This is done through dated prospectus. The prospectus sets out the benefits that shall accrue from investment in the company. It is a legal requirement that any company that wishes to raise money through shares to members of the public must issue a prospectus (Gibson and Fraser, 2011). No allotment of shares may be made until prospectus or statement in lieu of prospectus has been filed by the registrar of companies. The prospectus is merely an invitation to the public to make offer through application. The prospectus must include number of deferred shares, number of shares and remuneration of directors, names and address of directors, the minimum subscription, amounts payable on application and allotment, number and amount of stocks issued, names and address of the auditors and rights attached to the classes of stocks. Reports to be set out in prospectus include reports by company auditors stating profit/loss of the company in the final years preceding the issue of prospectus, rate of dividend paid in respect of classes of stock, and assets and liabilities at the last date to which accounts were made up. Investors’ liquidation preference In the event a company is liquidated, the preferred stockholders are entitled to preferential payment of their original issue price per stock in addition to any unpaid dividends that had been declared. If after realization of the assets of the company and after liabilities is paid there remains a surplus, it will be distributed to the preferred stockholders. Participating preferred According to Tulsian (2000), a company can declare dividend only in the year it makes a profit. The amount declared for dividend payment will first be payable to preferred stockholders then the remainder is what is payable to the other stockholders. A participating preferred stockholder will be entitled to share in the profit with the ordinary stockholders in whatever extra dividends paid. In this case it will appear as though the participating preferred stockholder is entitled to a double share of the company’s profit. This means that such stockholders can have excessive share of profit if a limit (cap) is not put to the extent at which they can participate in the extra profit of the company. Notice that a preference stockholder is entitled to a fixed rate of dividend whether the company made profit or not, which means in the year the company makes a loss the dividend payment to preference stockholders will be accumulated and paid in the year the company makes a profit. Therefore, it would be necessary to put a cap to participation of these stockholders since their risk of investment is also low. If the preferred stockholders are partially participating, they participate above the fixed preferential rate on a pro rata basis with ordinary stockholders subject to an additional rate specified on their share certificate (Nelson, 2006). For instance, on a 6 per cent preferred stock issue, the participation rate may be set to 10%. Therefore, the privilege of participating is limited to an additional 4%. If the preferred stockholders are fully participating, they are entitled to preferential dividend payment for the current year at the fixed rate in addition to any preference that had been accumulated and they share on a pro rata basis in any dividends that are paid above the preference rate. For instance, in a 6 per cent fully participating preferred stock issue, the stockholders receive their 6 per cent preference rate payment and an additional pro rata share in the profit based on the total value of the ordinary stock and preferred stock of extra dividend after the ordinary stockholders have been paid upto 6% of par value of the ordinary stock. Rights of preferred stockholders Preference shareholders contribute preference share capital and they do not carry any voting right. They do not exercise any control on the affairs of the company. They carry a prior right to fixed dividend from profit and to preferential payment before ordinary shareholders in the event of winding up. Dividend rights – whenever, a company realizes a profit, the profit is usually apportioned into retained earnings and the remainder is declared for dividend payment. Preferred stockholders are paid a fixed rate of dividend prior to other stockholders. Issues in dividend policy If a company pays out most of what it earns as dividend then for business expansion and other requirements it will rely on external resources like debt. Therefore, the decision of the company to pay dividends should be aimed at equitably apportioning the distributed profit and the earnings retained because dividend’s policy on a company affects the long-term funding and shareholders’ wealth. The objective of a dividend policy should be to maximise stockholders’ wealth so that the value of a stockholder’s investment is maximized. Stockholders’ wealth consists of dividend and capital gain. Dividend policy has a direct influence on these two components. A high dividend payout policy means more current dividend and less retained earnings which may consequently result to slower growth and lower market price per stock. On the other hand, low payout policy means less current dividend and more retained earnings and high capital gains which may lead to higher market price per stock. Protective provisions Before a right, preference or privileges of preferred stockholders is altered consent must be sought to majority of the outstanding preferred stock. It is recommended that you establish the protective provisions to identify the preferences of existing preferred stock and compare with the bargained preference of Food Venture in order to ensure that they do not have a right superior to existing preferred stockholder since they cannot consent to it. Anti-dilution protection A company is free to get additional capital through the issue of stock to the public as long as it has complied with all the requirements of Securities and Exchange Commission. Preferred stockholders have the right of converting their stock into common stock. A stock issue can be the initial public offer or it can be a reissue and the price at which the issue is made may be different from an earlier issue. Since a stock represents a unit of ownership in the company, issuing stocks at a price lower than the earlier issue has the effect of diluting the stock of earlier investors. Anti-dilution protection is the protection accorded to existing investors if stocks are issued at a price lower than the price paid by them. Therefore, it becomes necessary to use price based anti-dilution adjustments whereby the number of stocks of the existing stockholders will be increased by the number of ordinary stock into which each preferred stock is convertible. Preemptive rights A company retains a right to make a new issue of stock which could dilute the company ownership of the existing stockholders. The existing stockholders hold preemptive rights which allow them to purchase the new stock before the public is invited to buy. This allows the existing stockholders to mitigate against dilution of their ownership hence they will buy as many stocks in order to retain their initial interest. It is recommended that your company issue preferred stock to Food Ventures LLC only after the existing stockholders have exercised their preemptive rights of purchasing new preferred stock. Liquidation Although accountants do not believe that business firms will last indefinitely, they do expect them to last long enough to fulfill their objective and commitments. The assumption of continued existence provides the logical bases for recording probable future economic benefits as assets and probable future outlays as liabilities. This principle affects the classification of assets and liabilities in the balance sheet of the company. Therefore, any business firm whether mergers, consolidations or any other business combination is expected that at some point it will fulfill their objective and commitments. This then brings the business set up to an end hence the cause of its dissolution. Therefore, it is recommended that you have anticipatory approach and plan for this eventuality since the definition of liquidation includes mergers, consolidations or any other business combination. Davis et al. (2009), states that liquidation is a process where the life of a merger comes to an end and its assets are realized for the benefits of lenders of capital and stockholders. The liabilities of stockholders of a limited company are restricted to the stockholder’s share capital and guaranteed amount in the case of company which is limited by guarantee. In the case of company which is limited by shares, the liability of stockholders is restricted to the stockholder’s share capital. References Davis, D. et al., 2009. Companies and other business structures: commercial law. Oxford: Oxford University Press. Gibson, A. and Fraser, D. 2011. Business Law, 5th ed. Australia: Pearson Education. Horngren, C. T., & Harrison, W. T. 2009. Accounting, 7th ed. Upper Saddle River, NJ: Pearson Prentice Hall. Nelson, B. L., 2006. Law and ethics in global business: how to integrate law and ethics into corporate governance around the world. Sydney: Taylor & Francis. Tulsian, P. C. 2000. Business law. Tata: McGraw-Hill Education. Read More