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Corporate Finance 2


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What is an objective?
An objective specifies what a decision maker is trying to accomplish and by so doing, provides measures that can be used to choose between alternatives.
Why do we need an objective?
1)If an objective is not chosen, there is no systematic way to make the decisions that every business will be confronted with at some point in time.
2)A theory developed around multiple objectives of equal weight will create quandaries when it comes to making decisions.
3)The costs of choosing the wrong objective can be significant.
Characteristics of a Good Objective
1)It is clear and unambiguous
2)It comes with a clear and timely measure that can be used to evaluate the success or failure of decisions.
3)It does not create costs for other entities or groups that erase firm-specific benefits and leave society worse off overall. As an example, assume that a tobacco company defines its objective to be revenue growth.
The objective in decision making
1)In traditional corporate finance, the objective in decision making is to maximize the value of the firm.
2)A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.
3)All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.
Why traditional corporate financial theory often focuses on maximizing stock prices as opposed to firm value?
1)Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).
2)If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.
3)The stock price is a real measure of stockholder wealth, since stockholders can sell their stock and receive the price now.
For stock price maximization to be the only objective in decision making, we have to assume that
1)The decision makers (managers) are responsive to the owners (stockholders) of the firm
2)Stockholder wealth is not being increased at the expense of bondholders and lenders to the firm; only then is stockholder wealth maximization consistent with firm value maximization.
3)Markets are efficient; only then will stock prices reflect stockholder wealth.
4)There are no significant social costs; only then will firms maximizing value be consistent with the welfare of all of society.
Agency costs
refer to the conflicts of interest that arise between managers, stockholders, bondholders and society.
Conflicts of interest between the different groups.
1)Managers may have other interests (job security, perks, compensation) that they put over stockholder wealth maximization.
2)Actions that make stockholders better off (increasing dividends, investing in risky projects) may make bondholders worse off.
3)Actions that increase stock price may not necessarily increase stockholder wealth, if markets are not efficient or information is imperfect.
4)Actions that makes firms better off may create such large social costs that they make society worse off.
What can go wrong for SHs?
1)Have little control over managers
2)Managers put their nterests
above stockholders
What can go wrong for society?
1)Significant social costs
2)Some costs cannot be traced to firms
What can go wrong for bondholders?
Can get ripped off.
What can go wrong for financial markets?
1)Delay bad news or provide
misleading information
2)Markets make mistakes and can overeact
SH interests v. Management interests
Theory: The stockholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors.
Practice: Neither mechanism is as effective in disciplining management as theory posits.
The power of stockholders to act at annual meetings is diluted by three factors
1)Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings.
2)Incumbent management starts off with a clear advantage when it comes to the exercising of proxies. Proxies that are not voted becomes votes for incumbent management.
3)For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.
The CEO hand-picks most directors..
1)The 1992 survey by Korn/Ferry revealed that 74% of companies relied on recommendations from the CEO to come up with new directors; Only 16% used an outside search firm.
2)Directors often hold only token stakes in their companies. The Korn/Ferry survey found that 5% of all directors in 1992 owned less than five shares in their firms.
3)Many directors are themselves CEOs of other firms.
Directors lack the expertise to ask the necessary tough questions..
1)The CEO sets the agenda, chairs the meeting and controls the information.
2)The search for consensus overwhelms any attempts at confrontation.
The (managers of ) target of a hostile takeover buy out the potential acquirer's existing stake, at a price much greater than the price paid by the raider, in return for the signing of a 'standstill' agreement.
Golden Parachutes:
Provisions in employment contracts, that allows for the payment of a lump-sum or cash flows over a period, if managers covered by these contracts lose their jobs in a takeover.
Poison Pills
A security, the rights or cashflows on which are triggered by an outside event, generally a hostile takeover, is called a poison pill.
Shark Repellants
Anti-takeover amendments are also aimed at dissuading hostile takeovers, but differ on one very important count. They require the assent of stockholders to be instituted.
When managers do not fear stockholders, they will often put their interests over stockholder interests
2)Golden Parachutes
3)Poison Pills
4)Shark Repellants
5)Overpaying on takeovers
Stockholders' objectives vs. Bondholders' objectives
In theory: there is no conflict of interests between stockholders and bondholders.
In practice: Stockholders may maximize their wealth at the expense of bondholders.
How do SHs maximize their wealth at the expense of bondholders?
1)Increasing dividends significantly: When firms pay cash out as dividends, lenders to the firm are hurt and stockholders may be helped. This is because the firm becomes riskier without the cash.
2)Taking riskier projects than those agreed to at the outset: Lenders base interest rates on their perceptions of how risky a firm’s investments are. If stockholders then take on riskier investments, lenders will be hurt.
3)Borrowing more on the same assets: If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off.
Firms and Financial Markets
In theory: Financial markets are efficient. Managers convey information honestly and truthfully to financial markets, and financial markets make reasoned judgments of 'true value'. As a consequence-
1)A company that invests in good long term projects will be rewarded.
2)Short term accounting gimmicks will not lead to increases in market value.
3)Stock price performance is a good measure of management performance.
In practice: There are some holes in the 'Efficient Markets' assumption.
Managers control the release of information to the general public
1)they suppress information, generally negative information
2)they delay the releasing of bad news (bad earnings reports, etc.)
3)they sometimes reveal fraudulent information
Even when information is revealed to financial markets, the market value that is set by demand and supply may contain errors.
1)Prices are much more volatile than justified by the underlying fundamentals
2)Financial markets overreact to news, both good and bad
3)Financial markets are short-sighted, and do not consider the long-term implications of actions taken by the firm (Eg. the focus on next quarter's earnings)
Financial markets are manipulated by insiders; Prices do not have any relationship to value.
Firms and Society
In theory: There are no costs associated with the firm that cannot be traced to the firm and charged to it.
In practice: Financial decisions can create social costs and benefits.
1)A social cost or benefit is a cost or benefit that accrues to society as a whole and NOT to the firm making the decision.
-environmental costs
-quality of Life' costs
2)Examples of social benefits include:
a)creating employment in areas with high unemployment
b)supporting development in inner cities
c)creating access to goods in areas where such access does not exist
Social Costs and Benefits are difficult to quantify because ..
1)they might not be known at the time of the decision (Example: Manville and asbestos)
2)they are 'person-specific' (different decision makers weight them differently)
3)they can be paralyzing if carried to extremes
Traditional corporate financial theory breaks down when ...
1)The interests/objectives of the decision makers in the firm conflict with the interests of stockholders.
2)Bondholders (Lenders) are not protected against expropriation by stockholders.
3)Financial markets do not operate efficiently, and stock prices do not reflect the underlying value of the firm.
4)Significant social costs can be created as a by-product of stock price maximization.
When traditional corporate financial theory breaks down, the solution is:
1)To choose a different mechanism for corporate governance
2)To choose a different objective:
3)To maximize stock price, but reduce the potential for conflict and breakdown:
a)Making managers (decision makers) and employees into stockholders
b)By providing information honestly and promptly to financial markets
Choose a different objective function
1)Firms can always focus on a different objective function. Examples would include maximizing earnings, maximizing revenues, maximizing firm size, maximizing market share, maximizing EVA
2)The key thing to remember is that these are intermediate objective functions.
To the degree that they are correlated with the long term health and value of the company, they work well.
To the degree that they do not, the firm can end up with a disaster
Managers taking advantage of stockholders leads to
much more active market for corporate control
Stockholders taking advantage of bondholders has lead to
Bondholders protecting themselves at the time of the issue.
Firms revealing incorrect or delayed information to markets has lead to
Markets becoming more
“skeptical” and “punitive”
Firms creating social costs has lead to
More regulations, as well as investor and customer backlashes.
What is the best defense against a hostile takeover?
Run your firm well and earn good returns for your stockholders
The Bondholders’ Defense Against Stockholder Excesses
1)More restrictive covenants on investment, financing and dividend policy have been incorporated into both private lending agreements and into bond issues, to prevent future “Nabiscos”.
2)New types of bonds have been created to explicitly protect bondholders against sudden increases in leverage or other actions that increase lender risk substantially. Two examples of such bonds
a)Puttable Bonds, where the bondholder can put the bond back to the firm and get face value, if the firm takes actions that hurt bondholders
b)Ratings Sensitive Notes, where the interest rate on the notes adjusts to that appropriate for the rating of the firm
3)More hybrid bonds (with an equity component, usually in the form of a conversion option or warrant) have been used. This allows bondholders to become equity investors, if they feel it is in their best interests to do so.
The Societal Response
1)If firms consistently flout societal norms and create large social costs, the governmental response (especially in a democracy) is for laws and regulations to be passed against such behavior.
2)For firms catering to a more socially conscious clientele, the failure to meet societal norms (even if it is legal) can lead to loss of business and value
2)Finally, investors may choose not to invest in stocks of firms that they view as social outcasts.
Objective. For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected:
Maximize Stock Price: This will also maximize firm value
Objective. For publicly traded firms in inefficient markets, where bondholders are protected:
Maximize stockholder wealth: This will also maximize firm value, but might not maximize the stock price
Objective. For publicly traded firms in inefficient markets, where bondholders are not fully protected
Maximize firm value, though stockholder wealth and stock prices may not be maximized at the same point.
Objective. For private firms...
Maximize stockholder wealth (if lenders are protected) or firm value (if they are not)
Three major decisions in corporate finance
1)Investment decision
2)Financing decision
3)Distribution decision
When stock price is not a good objective:
a. Info may not be readily available to traders who are moving stock prices
b. In long term the value of the firm may not be what the stock price says it is
c. Subject to manipulation by the board (may want to pump up the stock price to benefit their own compensation)
d. Stockholders have little control over managers
e. Managers put their interests above stockholders
Hierarcy of senior upon liquidation
1)Secured debt
2)Unsecured debt
Secured debt:
1)Has collateral in addition to creditor’s claim
2)May have lien on an asset of the corporation
3)Low risk
4)If not enough assets to pay everyone, secured creditor can claim those assets for full payment of debt owing to him, even if they are the only assets around-->so other creditors get nothing
Unsecured debt:
general creditors-->benefit = slightly higher return
Subordinated debt:
Agreed to have its debt rank below that of other creditors.
Residual claim on the assets of corporation-->get periodic return on investment (dividends) in exchange for lower priority
a. Preferred: a preference as to dividends and on liquidation
b. Common: more residual possibilities but more risk
Unlimited Liability:
1)General partnership:
o Creditors have recourse against the general partners
o Joint and several liability: creditors have right to go against partners individually or together
2)Limited partnerships
a. Only LPs have limited liability-->claimants don’t worry as much about how a C merges its assets or what projects it engages in
b. Not as much jockeying for protection
Policy of Unlimited Liability
a. Checking corporate power: limit growth through debt financing b/c of risk of liability, protection of creditors
b. May be more efficient for small, closely held companies that can contract with creditors to limit liability of owners.
Problems of unlimited liability
a. May lower small investments by wealthy investors b/c of high risk with little return possibility
b. Higher transaction costs b/c owners would be more heavily involved in managerial supervision
Limited Liability
• If the assets of C are insufficient to pay creditors’ claims, then in the absence of some special guaranty, a creditor can’t get assets beyond the debtor creditor’s assets
Policy of limited liability
o Entity theory:C is a separate entity and thus debts of the C are not debts of the SHs as individuals
o Concession theory:C exists only by virtue of governmental concession
Benefits of limited liability
o Reduces costs of operating a corporation b/c lowers monitoring costs-->makes diversification and passivity a more rational strategy
o Reduces necessity of monitoring other SHs-->no longer matters how wealthy other SHs are
o Promotes free transfer of shares so gives managers incentives to act efficiently
o Makes it possible for market prices to impound additional information about the value of the firms
o Allows more efficient diversification
o Facilitates optimal investment decisions
Exceptions where some form on unlimited liability seems desirable:
⬢ Misrepresentation: party responsible should be held personally liable for debts induced by misrepresentation. Perhaps directors should also be liable to give them incentives to monitor this behavior
⬢ Involuntary creditor: Would focus incentives to adopt cost-justified avoidance precautions on people in corporation best able to respond to those incentives.
⬢ Employee: As a class they probably face the most severe informational disabilities, have the least ability to diversify risk of business failure and may have the strongest equity argument (in terms of relative capacity to absorb losses)
Four protections debtholders want to preserve likelihood that C will be able to repay debt:
1)Corporate debtor has substantial assets
2)Restrict C from incurring debts to other general creditors
o Don’t want C to over-leverage itself b/c will impair ability to collect debt upon liquidation
3)Corporate assets remain free and unencumbered by any prior liens
4)A cushion of protective assets is preserved and no junior interest make off with assets of C while creditor’s claim is still outstanding and unpaid
a)Limit payment of dividends (no special dividends or dividends in excess of 6%)
• C could still repurchase shares (treasury shares)-->would allow them to give $ to SHs without violating this provision
b)Ask for pledge of C’s stock
Cross-default provision
Make debt due and payable upon default on any other obligation-->debt is automatically deemed in default on such an occurrence
⬢ May require C to report a default on other obligations
Structuring C to maintain limited liability:
o Single new C: all projects would be J&S liable for losses of one project-->LL
o 6 separate Cs: each project would only be liable for its own losses-->protects individual investments by separating them out
 Issue of enterprise liability: piercing of C veil if don’t separate individual from C.
• So may be seen as one big C if not careful
 High transaction costs
o Stock of 6 Cs owned by a holding company: Less likely to find piercing
 May be marginally better than 6 separate Cs but not enough to really matter
Other options for LL:
o LP: one GP still needed
o LLC: case law is not as developed
o S-Corp: tax law distinctions only
o LLP: used mainly for professional groups (lawyers, accountants, etc.)
 Ps aren’t jointly and severally liable but still liable for their own wrongs
Factors considered when piercing C veil:
1)Tort claims v. contract claims
2)Fraud or wrongdoing
3)Inadequate capital (crucial)
4)Failure to follow corporate formalities
Tort claims v. contract claims
Involuntary creditor doctrine
o More likely to pierce tort claims b/c it creates an involuntary creditor
o But not dispositive-->usually requires the existence of another factor
Fraud or wrongdoing
o Usually means those controlling C have siphoned out its assets, leaving too little in C to satisfy creditors
o SH can also incur direct personal liability if gets debt for C by misrepresentation
Inadequate capital
o C does not have reasonable capital for its foreseeable business needs
o Minority view: dispositive
o Majority view: not dispositive-->still requires some other factor
 Walkovsky v. Carlton, 19662nd circuit, NY
o Zero capital: more likely to get pierced
o Siphoning of profits:
 May start with adequate capitalization but SH drains out all profits or capital while C operates
 May also be considered fraud or wrongdoing
o Failure to add new capital: Capital diminishes from poor economic conditions, unintentional mismanagement or other factors and is not replenished. Not as likely to result in piercing
o Business grows and no new capital is added.
Walkovsky v. Carlton
1966, 2nd circuit, NY
⬢ D owned stock in 10 Cs, each owning 2 cabs. Cabs were insured for minimum amount with no other assets.
⬢ P is injured by one of the cabs and sues D personally.
⬢ Court: Cannot pierce veil simply b/c of inadequate capital.
o Policy to hold more insurance is a matter of legislature, not the courts
Liability under CERCLA
• Owner/operator is liable for clean-up costs of debtor’s security
• Fleet Factors-->11th circuit, Georgia
• How to avoid liability?
o Don’t take part in day-to-day management
o Restrict authority to direct securities issues
Fraudulent conveyance law
⬢ Contains moral principals governing the conduct of debtors toward their creditors
o Truth, primacy and evenhandedness
Types of statutory approaches to restricting payment of dividends:
1)Insolvency test
2)Balance sheet surplus test
3)Earned surplus test
4)Ratio/assets surplus test
Insolvency test:
 Prohibits C from making distributions that would render it unable to pay its debts as they become due. In RMBCA.
Balance sheet surplus test
 Restricts dividends to the C’s assets in excess of its liabilities and stated capital.
• Can’t pay dividends out of Ls and SC
 Stated capital, DGCL §154: if shares issued without par-->amount of total consideration determined by directors to be stated capital
• If directors fail to designate only a portion of consideration as capital on a timely basis, all of the consideration will be capital
• Gives directors discretion to determine how much is stated capital and thus, results in low level of creditor protection
Earned surplus test
 Dividends are paid from C’s earnings, not capital.
 Earned surplus: retained earnings of the C over the life of the C until the dividend is declared.
• Dividends from earned surplus are a return on capital, not a return of capital
Ratio/asset surplus test
 Dividends are paid freely out of RE, like ES test.
 If RE are insufficient, may pay dividends out of capital if, after the distribution:
• The C’s ratio of assets to liabilities exceeds 1.25:1 and
• Its current liquid assets at least equal its current liabilities
Fiduciary duty analysis
1)Do they have a FD?
2)What is the standard for FD?
b)Duty of Loyalty and Duty of Care
i)Entire fairness test or intrinsic fairness test
A)Unfair dealing: Weinberger
B)Fair price: fairness opinion, other prices/alternate prices, informed vote
3)Things to consider:
a)Duty of care:
 Alternatives-->legitimate business purpose
 Timing
• How much time took?
• Right before something big?
 Access to the investment banker
 Amount of deliberation
 How much does the disclosure count for? Was it really informed?
b)Duty of loyalty:
 Conflict of interest with investment
 Insider information
Tests used by statutes for dividend restrictions
o §170: Dividends out of surplus (balance sheet test)
 If no surplus, can come out of net profits in current or preceding year. [(a)(2) nimble dividends]
o §154: surplus is excess of net assets over capital
o §6.40: Insolvency test or Balance Sheet Test
• No nimble dividends exception
Debt v. Equity Trade-off:
• Tax benefits of debt: interest payments are deductible.
o But if in start-up stage and not losing money, not paying taxes and thus, no tax benefits
• Added discipline of debt: equity creates no claim on a company’s assets, except a residual claim
o Debt is a fixed claim on the company’s assets
• Bankruptcy costs: Starts high, ends low
• Agency costs: High at beginning with few assets but low at end when not purchasing any new assets anymore.
• Need for flexibility: Needs more flexibility at beginning when establishing itself than at end when it has no new investment needs
• Net trade off: Equity is more prominent at first, then debt later on.
“Modern legal capital rules are wholly ineffective in protecting creditors.”
• Low par stock provides very little protection (very little capital)
• Trust fund theory: capital is to be protected from low level shareholders (their perverse or conflicting interests to siphon out the money from below).
• Other ways a C can operate in favor of SHs and to the detriment of debt-holders:
o BoD is making the dividends decisions. Whenever they have the legal right to make dividends, subject to its fiduciary duty obligations, it can.
 This has to do with the apportionment of corporate governance authority as between SHs and debt-holders or other claimants on corporate assets
 When you have a conflict of interest among different claimants have to ask yourself who runs the company and for whose interests
o Corporate lawyers must still know about dividends statutes
Gabelli & Co. v. Liggett Group, Inc
1984, Delaware
o Minority SHs sued Cs to compel the payment of a dividend by claiming majority owed them a fiduciary duty.
o No right or entitlement to dividend:
 Decision to declare dividend within discretion of the directors-->BJR
• Limit: heightened intrinsic fairness test:
o Requires both a fiduciary duty and self-dealing
 Fiduciary duty: can only be owed by controlling SHs to minority SHs (not to other controlling SHs)
• Owed to all in a close C
 Self-Dealing: Sinclair Oil-->can’t benefit majority SH at the expense or detriment to minority SH (nobody got a dividend here)
o Court: SHs had to prove that the dividend was withheld as a result of an oppressive abuse of discretion in the context of an unfair merger.
 SHs could not prove that the C abused its discretion by not declaring the dividend.
 Remanded to decide on intrinsic fairness
o Other argument possibility: Failure to pay the dividend didn’t get incorporated into the price of the merger buy-out
 If they can prove self-dealing, then merger price can be looked at
Conflicts of interest among CS holders:
• The value of a minority SH’s shares might be valued less b/c of the market, what a willing buyer would pay, etc. (marketability and minority discounts)
o Closely held corporation: potential for freeze-out by majority, loss of control or say in corporation, possibility of oppression and persecution
o Publicly held firm: don’t worry too much about oppression
 A SH has an exit opportunity (marketability) so SH can sell shares if doesn’t like behavior of majority
o Remedies:
 Court ordered redemption
 Forced dissolution (only allowed in extreme situations)
Redemptions and repurchases
• An alternative way to take money out of firm and give to SHs
o Creditors don’t like b/c they diminish C assets
 Hence, there on restrictions on their use
Made upon a decision of the BoD, not pursuant to any previously-arranged agreement.
o C makes a repurchase of existing outstanding shares in the open market, sometimes by a lotteryresults in fewer shares outstanding and outstanding shares now have a higher ownership interest.
 Treasury shares: authorized but unissued (repurchased)
 Increases debt-to-equity ratio
 Market signal: If you are confident that your stock price is undervalued, buying it back symbolizes this.
Usually effected pursuant to a previously-arranged agreement, which may be in the C’s charter or in a contract with SHs.
o May sometimes be accomplished selectively (not on open market)
o DGCL §151(b): permits a C to subject any class of stock to redemption
 at option of C, OR
 at option of SH
 judicially ordered as less extreme remedy than dissolution
Alaska Plastics, Inc. v. Coppock:
o Threshold Question: Is there a fiduciary duty?
o Minority SH not notified of several shareholder meetings. However, she attended a meeting during which she ratified merger.
o C gave her a lowball offer for her shares.
o She sued C for an involuntary liquidation of the corporate assets.
o Court:
 Involuntary liquidation is a severe remedy not favored by the courts.
• So Trial court had ordered a repurchase of her shares at FV
o Second rationale for repurchase: requirements for IL have been met but too extreme a solution
 Trial court failed to make the necessary finding as to whether the acts of the other shareholders were illegal, oppressive, or fraudulent.
• A low offer is not a breach of fiduciary duty on its own
• Without evidence of self-dealing, only get appraisal rights in merger
• Oppression:
o Reasonable expectations of minority SHs
o Proof that controlling SHs took unfair advantage of minority
 Held that the forced buy back could not be justified as a result of a "de facto merger" because the had approved of the transaction and her interest in the C remained unchanged.
 Remedy for breach of FD = equal treatment
If there is a pattern of behavior that is detrimental to one of the SHs and as a capstone of that conduct there is a low-ball offer, it could constitute breach of fiduciary duty.
 Massachusetts
Equal opportunity doctrine
Iif one SH is treated in a particular way, then all SHs have to be treated that way (no selective repurchase)
o Argument 1: if there were a per se rule in a jurisdiction for equal opportunity against selective repurchase.
o Argument 2: beneficial to all the SHs so best for the C as a whole
o How do argue:
 1) jurisdiction would adopt per se rule
 2) even if no per se rule: no reasonable business justification
Issuance of new shares would dilute the other SHs holdings:
o Voting dilution: don’t own same percentage of the company as they did before
o Economic/equity dilution: share of economic value of the company goes downvalue of individual share goes down
o Book value dilution: Temporary reduction in book value per share but creates earning power for C.
Preemptive rights
Have to be in the certificate of incorporation if they exist
o SHs are given the opportunity to take part in a new issuance in proportionate to their current ownership-->to retain the same level of ownership. Right to subscribe to new issuance.
 Protects against voting dilution (can have same % of shares before and after), equity dilution, and book value dilution (what value is lost on old shares is gained on new shares)
 Will not help protect you against the reduction in the original value of your shares ($10 to $8 value)
How might minority SHs be better of with a majority SH involved?
• Agency problem: management may act to the detriment of SHs in order to meet their own objectives
o Majority could also cause an agency problem by acting opportunistically.
o But majority could protect against management agency problem
 Large SH has the incentive to monitor the C’s actions-->since they hold such a large block of shares, the costs of monitoring may be worthwhile.
Squeeze out:
Forcing out minority SHs through oppressive behavior of the majority on the minority
o Designed to reduce the value of the minority’s equity interest.
o Repetitive, opportunistic behavior on the part of the controlling SH that is intended to oppress the minority and reduce the value of their investment, the liquidity of their investment, etc.
 Alaska Plastics: legal recourse for the oppression
• Remedy is unknown without oppression
Freeze out:
• Forced disinvestment of the minority by the majority.
o Go private to get rid of public SHs
o Treats SHs as if they owned stock that is redeemable at option of C without SHs having known this
o Coercive but it is not on its own illegal.
 Legal mechanism for eliminating minority SHs
Devices for freezing out minority SHs:
 Short-form merger: majority has right to cash out minority without their consent
 Reverse stock split which leaves minority with only fractional shares. Corporation Codes allow this.
• Leader v. Hycor
Minority objections to being ousted:
1. Paid for right to be investors, not to be liquidated.
2. Not happy with liquidation price.
Close Corporation
SHs owe each other a FD regardless of ownership %-->Donahue
⬢ Strict duty of utmost good faith and loyalty.
⬢ Technical definition: Statute-based
o DE: §342--> can be held by stockholders of record not exceeding 30.
⬢ Loose definition:
o Concentrated pattern of ownership
o Thinly traded stock-->not a very active trading market
⬢ Liquidity concern (so no clear exit path)
⬢ If no clear exit, need more protection from breaches by other SHs
o Leader v. Hycor: Massachusetts (state-law based)
⬢ Reverse stock split led to all minority owning fractional shares.
⬢ Under DGCL §155: C is allowed to cash out fractional shares
⬢ So all minority SHs are eliminated by being cashed out
⬢ Standard of review: Legitimate business purpose test, Wilkes
⬢ Majority said that wanted to go private b/c detriments of being public outweighed the benefits
⬢ Now, with Sarbanes Oxley, Cs can argue that detriments of having to follow SO outweigh benefits of being public
o An argument to go private for legitimate reasons
⬢ If D can satisfy LBP test, P can still rebut that showing by coming up with a more narrowly tailored way of achieving that purpose that is less harmful to minority.
⬢ If LBP test is satisfied and not rebutted: only recourse available is appraisal. So remanded for fairness of the price.
⬢ Affirmed the propriety of the DE block method
Techniques for freeze-out:
• Short-form merger:
o The A can unilaterally decide on merger and T has no say
 T has no FD to SHs b/c no decision-making authorityno say/rights = no dutiesonly A has FD
 Duties have to come from A to minority SHs
o DGCL §253: Short-form merger statute90% of shares of stock are owned by another C.
• Long-form merger:
o Majority of T and A have to approve the transaction: FD at both levels
o FO technique b/c minority won’t really have a say in merger.
• Reverse stock split
• Dissolve C: Sell business assets to controlling group for cash. Board would vote to dissolve C. Cash is distributed out to all SHs. Majority puts assets in new C.
o Can also dissolve without the sale by distributing assets to majority and cash to minority.
• Dual class structures:
o Decouple the vote from the shares by issuing some stock with more voting rights to founders/ownershelp to avoid voting dilution from IPO (Google)
 Different dividend rights? Exchange offer: where C is already public with one share, one vote stock and wants to consolidate controlso gives public SHs higher dividend rightsa sweetener
o Ben & Jerry’s: Gave nontransferable Class B stock (10 votes) as stock dividend to Class A stock (1 vote) SHs. Can be converted into transferable Class A stock.
 Long-term strategy: Overtime, most people would convert to A so could sell. Control would stay with long-term holders.
 Not allowed by NY stock exchange
Stock split v. stock dividend
Same result-->own more shares
Standard of review for freeze out depends on jurisdiction
 Massachusetts: Legitimate business purpose test
• Even if reject this test, saying it applies only to close Cs, still need to look at business purpose of transaction in order to determine if there was a breachb/c can show if duty of care and duty of loyalty was breached
Weinberger v. UOP:
o Minority was cashed out in a merger between C and its majority owner.
 Merger was for $21/share  up to $24/share would be fair.
Burden of Proof (Weinberger)
 P must demonstrate unfairness (fraud, misrepresentation, etc.)
 Then burden shifts to C to prove entire fairness (heavy burden)
• Fair dealing + fair price
o Fair dealing: how transaction is timed, initiated, structured, negotiated, disclosed to directors, and how director and SH approval was obtained
 Here: Candor (conflict of interest with Lehman and didn’t disclose reports to minority), timing, lack of negotiation
o Fair price: economic factorswhether price is fair
 “Delaware block" or weighted average method of valuation should not control.
• Endorsed a more liberal approach requiring consideration of all relevant factors pursuant to DGCL § 262(h)
• Legitimate purpose test: overturned hereno longer good law in DE
 But an informed vote of the majority of the minority or by a fully functioning independent committee shifts burden back to plaintiff to show the transaction was unfair.
• C has to prove that there was an informed vote
o Not informed here b/c minority never saw report saying that up to $24/share would be fair
Remedy (Weinberger)
 If no unfair dealing: Appraisal remedy
• Damages based on the value of shares.
• If only contesting the price
• No claim of fraud, misrepresentation, self-dealing, deliberate waste of corporate assets, etc.
 Unfair dealing: equitable remedy  broader remedies
• Recissory damages (removing the benefit to the parent of the merger)
• Enjoining a merger
• Undoing the merger if not too much time has elapsed
Purpose of appraisal remedy:
Concern about hold-out problem.
 Merger used to require unanimous approval by target SHs. So even a single SH can veto the transaction.
 Legislature changed to majority approval. In exchange gave the appraisal remedy. All that a SH needs to get this remedy is dissent. DGCL 262(d). Don’t have to show any breach of FD
 Determines FV of sharesPossibility of getting a lower value
• Cannot take into account as an element of value any value that would arise from the accomplishment of the merger.
• Have to value company as if there were no merger transaction.
• There are sometimes synergies for acquirers that result from the fact of the combination (more efficient operationseliminate redundant transactions/operations).
Valuation methods:
⬢ Discounted dividends: valuing a company based on its future stream of dividends/earnings (actual payouts or ability to make payouts)
⬢ Book value: not frequently usedapplicable for certain industries
⬢ Multiple of earnings: use P/E ratios from comparable companies
Return is a function of:
o TV of money (return available from risk-free investment)
o Riskpossibility that expected return will not materialize
Present Value
o Why prefer money today: Opportunity cost and Risk of future event
o PV = xn / (1 + k)n
 xn = money to be received in future
 k = interest rate
 n = future years
o If compounding more than once per year: PV = xn / (1 + k/m)nm
Future Value
o FV = x (1 + k) n
o If compounding more than once per year: FV = x (1 + k/m) n m
Payment of a constant sum of fixed intervals over a period of years
The probability that the outcome will diverge from the expected outcome.
o Different stocks and different companies have different risk levels
 Measure risk of particular company relative to a basket of stocks that forms the index of the market as a whole.
 Risk premium: actual rate of return over the risk-free rate
Expected return
Probability x Return, summed for all potential outcomes
o Probability: k = (P1)(k1) + (P2)(k2) + (P3)(k3), etc.
Risk Aversion
Most people are risk averse
o Riskier proposition requires a higher return to attract people
o Discount rate for riskier company will be higher
o Efficient frontier: points between the risky and the no risk that will give the optimal return
 Portfolio theory: optimal return from diversify risk
Types of risk
o Firm specific risk: nonsystematic risk
 Example: Firm is subject to impending litigation
 You can diversify it awaySo differences in risk won’t be compensated for
o Systematic risk: affects general market as a whole
 Do have to compensate investors from taking on systematic risk, b/c can’t diversify it away.
Not a valuation method
o What rate of return can we expect from an investment given its level of non firm specific risk?
 Measures of the riskiness against market as a whole to determine rate of return we can expect on a given investment
o Goal variable of CAPM: Ei = Ef + Bi(Em-Ef)
measure of the relationship of the risk of an individual security to the risk of the market as a whole (slope of the line)
• Higher Beta = higher risk (more volatile)
• 1: moves with same volatility as market.
• Greater than 1: more volatile than market.
• Less than 1: less volatile than market.
• 0: Ei always equals Ef. Horizontal line.
o No matter what change we observe in the market, there is no change for the individual stockEi = Ef
 No risk
How to get beta?
o Public company: Regression analysis of stock performance to market performance.
o Private companies: no public information.
 Look at comparable public company or a private company that was recently sold.
ECMH: Efficient Capital Market Hypothesis
o Price of securities traded in public capital markets fully reflect all information concerning those securities.
Noise theory
Public capital markets are infected by substantial trading based on information unrelated to fundamental asset values (“noise trading”)
Three valuation methods
1)Kitchen sink method 262(h)
2)DE block method/weighted average metho
3)Book value method
Kitchen sink method
o Can take into account all relevant factors
o Constraint: exclusive of value arising from accomplishment of merger (no speculative value)
In re Spang Industries:
PA-->valuation method outside of DE.
o Used 3 methods of valuation
 Net Asset value
 Investment value
 Actual market value
o Weighted average method is not the only possible method to use.
Net Asset value
: share which the stock represents in the value of the net assets of the C. Gave greatest weight to this method.
⬢ Two approaches to NAV:
o (1) Adjust BV to current value and goodwill
o (2) Multiply BV to get to market value
Investment Value
Estimate of present worth in light of past, present and prospective financial records of the company and is obtained by capitalizing earnings. Given little weight here b/c company understated assets and overstated liabilities.
• Possibility: Look at past value and prospective performance.
o If losing money and never expects to make moneyclose
o If doing wellworth more than sum of parts
 Don’t use NAV-earnings based method best
Two steps in capitalization process
o Calculate representative annual earnings figure
 Earnings before depreciation may be better b/c depreciation is not reflective of how well the company is doing.
o Choice of a capitalization ratio which reflects the stability and predictability of earnings of the particular C
 Ratio: reflects how much someone would pay to get earnings of this company
 VE = E/R
• V= valuation based on earnings
• E=earnings (use EPS)
• R=cap rate
• R= 1/(P/E)
 Get P/E ratio from similar company
• Same industry, growth rate
Actual market value
Price at which the stock was selling on the market prior to the action which is objected to, disregarding any change in price due to action. Given little weight b/c stock was lightly traded
Book value
o Total Assets-Total Liabilities
o Represents liquidation value, not value as a going concern
 Doesn’t account for any appreciation (historical costs/prices).
 Needs to treat corporation as sum of the parts. Don’t value the parts individually
o Adjust to show current value of assets and adjust for goodwill.
 Multiply book value to approximate market value. Look at multiples from comparable public companies.
• Get market to book ratio: only accurate if traded heavily
• Divide by that company’s book value
Fairness opinions
Developed because of Smith V. Van Gorkim. No real financial analysis, market check. Relates to BJR and that as long as board does work is ok.
B When it comes to sales and mergers there is no real BJR because the inside management is necessarily self conflicted.

When are fairness opinions used: when company is going to go public.
Enterprise value
equity + debt – cash
Reason not to do a market check
it would be so disruptive (the due diligence) to business that the company will break in the progress.
How do we know if a premium is reasonable?
Look at available data on what is a reasonable premium- for a company this size and this industry. See what other people are willing to pay. Make sure break up fee is not large, and that the board has an out.
Fairness methodology
A Market check
B Discounted cash flows.
C Transaction method: go back five years
D As long as intrinsic value is not more than offered, it is fair.
• EBITDA: Add back interest, taxes, depreciation and amortization to EPS.
• Might look at cash flow instead (IP companies in early stages won’t have big earnings b/c of heavy expenses but may have revenues).
o Discounted cash flows: Want to look at company’s actual payout of dividends or its ability to pay out dividends.
 Reasons company may not pay out too much dividends:
• High growth company may think investing money in business is better than giving it out as dividends.
 High compensation to directors = constructive dividends
Problems with earnings
• Dampened by depreciation expense which doesn’t really capture how successful the company ismerely an accounting convention
o A non-cash expense that is treated as an expense on the income statement but does not necessarily reflect that the company is less profitable but it makes it look as if company is less profitable.
• Earnings is not necessarily an accurate representation of value of company
• Earnings may not be totally accurate b/c private companies with SHs who are the key employees at firm may minimize taxable income by inflating expenses (so they and the corporation are taxed on less)
• Relatively excessive compensation  deflates earnings
o When selling company, third part won’t overcompensate executiveswill pay market value.
• So if paying excessive compensation, add back to earnings to lead to higher capitalization of earnings.
Other ways to value company
• Take flow of either:
o amounts company actually distributes (i.e., dividends) or
 look at dividend paying history of C
o dividend paying capacity (company may wish to keep money within company rather than paying out to SHs as dividends)
 Depreciation is not factored into dividend paying capacityuse cash flow available for distribution from Statement of Cash Flows
• Equation: V = D/k
o Use CAPM to get k. CAPM: Ei = Ef + B(Em-Ef)
o Payout ratio: actual dividend payment/EPS
• Get paid out first in bankruptcy. So want the company to play it relatively safe. Not as risk-seeking as shareholders may be. Only risk their own investment.
• Are not owed any fiduciary duties (even if they are convertible bondholders)
o Protect themselves with contracts
 Private placements allow greater ability to negotiate changes in obligation when circumstances change
o Exception: Might get FDs when company is in vicinity of insolvency.
 Rationale: Debtholders become new equity holders in company. No equity anymore. So bondholders now get FDs.
 Insolvency:
• Bankruptcy test: liabilities in excess of assets
• Equity test: inability to pay debts as they mature (assets lack liquidity)
o Hard for directors to have two masters (SHs and creditors)
 If conflicts of interest need to give the board some guidance as to whose interests to serve. Usually no identical/aligned interests.
 Law has given board ability to choose SHs interest over creditors
Equity holders
Don’t get paid until debt is paid off so want company in engage in riskier, and thus potentially more lucrative, investments.
Debtor protections
1)Contractual-->restrictive covenants
1)Financial covenants
2)Debt restrictions
3)Restricted payments
4)Restrictions on distributions from subsidiaries
5)Restrictions on selling assets and subsidiary stock
6)Transactions w/ affiliates
Financial covenants
i. Financial covenants: if company doesn’t have a certain net worth, ratio of current assets to liabilities, EBITDA
1. Asset backed loans: can only borrow up to value of hard assets (A/R and inventory)
2. Enterprise value: based on how much profit you make
3. Private placement bonds: fewer covenants
4. Publicly issued bonds: fewer covenants
5. Investment grade bonds: basically no financial covenants
Debt restrictions
1. Limits ability of company to borrow money
2. Protects first debtor from too much debt later on which would limit first debtor’s ability to collect at default
Restricted payments
1. Affiliated debt: unless you meet certain financial covenant restrictions on paying off debt of SH.
2. Paying subordinated debtsuperior wants first payment
Restrictions on distributions from subsidiaries
Can’t take money from or leverage the subsidiary
Restrictions on selling assets and subsidiary stock
Prevent them from taking a price that lender thinks is too long or selling the asset and just taking off
a. §548: Fraudulent Transfer code
i. Every state has a corollary statute that is available outside of the bankruptcy code for fraudulent conveyances or fraudulent transfers
May avoid transfer of interest if meets test:
1. Intentional fraudulent conveyance: purpose is to delay, hinder or defraud any creditor
a. Badge of intent:
i. Transfer to insider (family, friend, etc.)
ii. Out of ordinary
iii. Anticipation of levy/judgment
iv. Lack of fair value
v. Lack of possession: transfer something  you don’t get to keep possession
1. CA: if don’t transfer possessionthe transfer is conclusively fraudulent vis a vis creditors (there are some exceptions)
vi. Secretive transfer
2. Constructive fraud: result more important than intent
a. Less than fair value
b. Rendered insolvent by transaction or
i. Balance sheet insolvency: assets are less than liabilities
ii. Equitable insolvency: unable to pay debts as they become due
c. Inadequate capital for the business in which you are engaged
Preferred Stock
DGCL §151: Enabling statute allowing C to issue PS (1 or more classes of stock)
o Each class of stock may have such voting powers, designations, preferences, and relative participating optional or other special rights, limitations or restrictions as shall be stated in the certificate of incorporation or any amendment thereto.
⬢ Primary feature: preferences relative to common stock
⬢ Ability to issue PS has to be in charterfeatures of PS are highly customized
⬢ Lies on boundary btwn debt and equityHYBRID
Problems with CS:
o Downsides: highest risk security
o Upsides: get residual benefitshigh risk but possible high return
How PS solves these problems?
• No interest payments duestill equity
• Dividends are owed, which can be onerousbut they remain at the discretion of BoD.
o Guttmann v. Illinois: 2nd circuit, Indiana
 Where directors did not abuse their discretion in withholding dividends, no right survived to have those dividends declared and that the directors had no discretion to declare those dividends subsequently.
Features of PS:
1)Dividend provision
3)Liquidation Preference
4)Voting rights
5)Redemption provisions
Dividend provisions
 Certificate of designations: contract between the company and preferred stock holdersspecifies rights and preferences
• In CA, it is called the Certificate of Determination
 By custom only, PS par value equals the total amount invested
 Problems with dividends:
• Discretionary
• Even if they do get paid, they get paid on a class by class basiscan be paid to CS but not PS
• Designed to protect the PS from CS siphoning out money even though CS is lower in priority.
• Middle of road provision:
o PS gets to participate in dividend without converting but if it had converted
 If they convertlose the preferences of PS
 Cumulative provisions:
• Dividends cumulate or accrue
• If don’t pay PS dividends one year, must make back payments before can pay any dividends to CS holders
• Tend to be onerous so don’t see them much
 Things to consider: If dividends are cumulative and if there are fully participating (get whatever CS on dividendsnot at liquidation)
 As long as company doesn’t issue anymore CS in the meantime, PS holders will be able to keep % ownership upon conversion
• Potential for problems if new stock is issue:
o Maybe offer right of first refusal?
Liquidation preference
o Indifferent to higher valuation 1x or lower valuation 3x. Almost always can get founders to get multiple on liquidation preference. In northern CA only about 24% have multiple of liquidation provisions. Much higher back East.
o Ever agree to a cap on participation? Yes.
Voting rights
only one vote per PS
 Is it as if converted?
 Can they vote?
Wood v. Coastal States Gas Corp.
o PS objected to settlement agreement b/c would not receive any shares of spin-off Csaid it violated their conversion rights
 Own same % of C but value of C decreases after spin-offlose a large asset (the other C)
o Court:
 Distribution of stock to CS holders was permissible and could be made w/o adjustment to conversion rate
 PS holders were not entitled to vote on the settlement plan b/c requirements of the certificate for such a vote had not been met
• Didn’t have fully participating stocknonvoting
 PS holders not entitled to dividends of spin-off C.
o Calculation of SE/share
 Subtract value of spin-off C from total pre-spin-off C
 Divide by number of fully diluted shares
• Fully diluted: Take every possible conversion right and treat everyone as if they converted (consider options issued to executives)
 SE/share
How PS holders can protect themselves:
 Prohibit this type of stock dividend or make them fully participating in dividend
 Require change in conversion ratio on occurrence of certain things
• Proportionate adjustment
 Maybe: get whatever you contract for and get FDs for everything you don’t contract for
• Once it is considered and passed on, you SOL
Price-based dilution
dilutes value of PS investment
 New issuance at price lower than conversion value
• Reduces per-share equity value of C to original investor
 Can mean two things:
• Any future issuance of CS at less than conversion ratio or any other instrument convertible into CS at an imputed conversion value of less than conversion ratio
• If issue stock at less than FMV
 Should original investor have any protection?
• Preemptive rights
• Right of first refusal
o Give offer to existing SHs firstwill only maintain % ownership
o Problem: Deter others from buying shares
• Right of first offer:
o Offer to investor 1st but don’t have to come back to you if you turn it down
o Can also have deal where C has to come back to investor at the endkeeps the C acting reasonable in its offer negotiations with SH in the first place
o Every time conversion value goes down, the conversion ratio goes up.
How to mitigate the effect of price-based dilution and still address the concerns of the investors?
• Broad based Weighted average formula:
o CSIOS prior to deal + CS issuable for consideration at conversion price
CSIOS prior to deal + CS issued in deal
o CSIOS = fully diluted shares
• Narrow-based formula: don’t use fully diluteduse only those shares that are issuable upon conversion of the particular series of stock that we are trying to protect
o Not spreading the dilution to any other equity holders
• Treating it as if it only hit PS and was not felt by any other classtreat it as if it had a disproportionate impact on PS
Importance of conversion right:
⬢ If company had done really well and was liquidating
o No upside/residual value with PS: just original investment and maybe cumulative dividends
o CS: get to participate in residual value (upside of C performance)
⬢ As long as value of company is greater than original value
⬢ What do you lose?
o Preferred status
o Adjustment advantage of anti-dilution provisions (ratchet)
Ways to protect conversion rights
o Dynamic adjustment in contract so continuously adjust
 Ratchet down: assumed we have a price-based anti-dilution provision in the certificate. Take old conversion price and multiply it by a ratio less than 1.
• Full ratchet: Take it down to new price
• Narrow based WA: use convertible shares only
• Broad based WA: fully diluted shares (convertible shares and CS)
Kirk Kerkorian: Owned 69% of MGM Grand's issued and outstanding common stock and 74% of its Series A Redeemable Preferred Stock. Set up a merger where MGM merged with shell subsidiary of Bally Manufacturing.
Preferred rights are measured by legal standards relating to the contract.
Rights shared with CS holders may be measured by equitable as well as legal standards
d Three of plaintiff’s claims fairly implicated fiduciary duties:
i a fair allocation of merger consideration
ii exercise of due care in negotiating the merger
iii a prohibition on self-dealing
e Things that are wrong with this
i Two masters: the preferred complain that they did not have enough but to give the preferred money would have been to take it away from the common
ii Uncertainty: FD are not rules they are standards
iii Greater rights with regards to non-preference matters- things that are not in contract are protected but those things that are, are not.
Stuctured Finance
• Securitization: creation of securities out of a pool of assets
o Idea: take a particularly risky asset, when put with similar assets, the risk goes downdiversification
 If you aggregate thousands of risky receivables, risk goes down
How much cash is available for distribution?
• Start with EBIT
• Less for taxes which won’t be available for distribution (prior obligation)
• Less capital expenditures (amount of money C needs for investment in capital)
• Less working capital (operating expenses)
• Plus depreciation and amortization
• = Cash generated by firm available for all claimants (includes debt and equity)
Why would you want to keep your financing away from main C?
B/c main C could be subject to massive liabilities
Risk in investments
o Investors have less control over risk usually b/c those developing the process know a lot more about it then investors
How do VC's value companies?
• Look at how much they are going to put in and how much more money they will have to raise over time. When you get to the end and you distribute cash, they look at what they will be getting back. Then you calculate the return over the time they predict for the investment. So figure out what you need at the end.
o Figure out what you think you can sell the company for.
o Determine % of ownership desired by dividing what you need at end over expected sale price.
o If you aren’t going to sell any additional stock is this enough money to help the C run?
Option pools:
in general there is an option pool somewhere between 15-25%. Stock options for executives.
⬢ The earlier stage the company is, the higher its going to be
o Need those options to attract the employees that you need to attract
⬢ For option pool would ask for list of their hiring plans. Start assigning options to each person. Monitoring of their giving out options
o In general they always need more than they put down b/c they will ask you to increase size of pool for specific employees. Question is if it dilutes founders and investors or just founders.
o Compromise: Will guess on original option pool. If it goes over, founders bear first 5% of rollover.
⬢ After first 5%, VCs start sharing in dilution

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