Sources of Corporate Financing

One of the major reasons that promoters select the corporate form of business is the variety of funding sources available to the business they incorporate. The initial funds and property may come directly from the promoters or it may come from many investors. An important source of financing is the sale of corporate securities in the form of shares, debentures, bonds, and long-term notes.

Other sources of funding are also prevalent. Short-term bank loans may provide at least part of the operating capital of the company. Frequently, the promoters and major shareholders will be required to co-sign these notes. Often, this short-term funding will come in the form of accounts receivable financing and inventory financing.

Of course, once the company is operating profitably, retained earnings may generate an important source of funds.

With reference to stocks, if a company has only one class of stock, it is common stock. If there is more than one class, the common shareholders usually bear the major risks of the business and will benefit most from success. They receive what is left-over after the preference of other classes have been satisfied. This is usually true for both income available for dividends and for net assets on liquidation.

Common stock usually carries voting rights. There may be more than one class of common stock, however, such as Class A and Class B.

 One class may have no right to vote.

Herein, any stock that has a preference over another class of stock is called preferred stock or “preference shares”. Usually, preferred shareholders have a preference as to dividends and the distribution of assets when the company is dissolved.

The rights of preferred shareholders may vary from company to company. In some instances, preferred stock may be made convertible into common stock. And sometimes preferred stockholders will be given voting rights.

 However, usually the right to vote is granted only in the event that dividends due are not paid. Preferred stock can be redeemed, that is, paid off and cancelled by the company if the articles permit.

Shares of stock are generally issued in exchange for money, property, or services already performed for the company.

 The board of directors is entrusted with the authority to decide what is the proper amount and form of consideration for the shares.

Company articles, however, will frequently place some limitations on the discretion of the board in order to protect the rights of creditors and other shareholders.

The law requires that shares be issued only for money, tangible or intangible property and services already performed for the company. Most of the laws do not permit the promoter’s pre-incorporation services to be proper consideration for shares because the services were not technically rendered to the company. The company was not in existence at the time of these services.

Likewise, the laws do not consider promissory notes or pledges of future services to be acceptable forms of consideration for shares. This is because such promises may overstate the value of the company since they may never be performed.

The law permits promises of future services and promissory notes to be exchanged for shares since they do have value to a company. Of course, because of the risk of nonperformance, the value may not be as great as the value of services that have already been rendered to the company.

Further, the law allows the company to issue shares to the promoters in exchange for their pre-incorporation efforts because the company has benefited from such services. Without these services, the company would probably not exist.

Dr AbdelGadir Warsama Ghalib is a corporate legal counsel. Email: awarsama@warsamalc.com