1. Corporations: Formation and Financing
Chapter 38
Chapter 38: Corporations: Formation and Financing
Corporations: Formation and Financing
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Overview LO38-1: What are the characteristics of corporations?
LO38-2: What are the powers granted to corporations by the states?
LO38-3: How are corporations classified?
LO38-4: How are corporations formed?
LO38-5: What are some potential problems with the formation of corporations?
LO38-6: How do corporations get funding?

3. Chapter 38 Hypothetical Case 1
Tim Ratigan's white-water rafting service has been very successful, and he has decided to convert his form of business ownership from a sole proprietorship to a corporation. Ratigan has 135 friends, family members, and customers who would like to own stock in Ratigan's Raging Rapids Rafting, Inc., including Ratigan's college roommate George Bygraves, a citizen and resident of England. Ratigan would like to use the S corporation form of business ownership, since the S corporation includes the dual advantages of limited liability and single taxation.
Can Tim Ratigan use the S corporation form of business ownership for Ratigan's Raging Rapids Rafting, Inc.?
Chapter 38 Hypothetical Case 1: Tim Ratigan's white-water rafting service has been very successful, and he has decided to convert his form of business ownership from a sole proprietorship to a corporation. Ratigan has 135 friends, family members, and customers who would like to own stock in Ratigan's Raging Rapids Rafting, Inc., including Ratigan's college roommate George Bygraves, a citizen and resident of England. Ratigan would like to use the S corporation form of business ownership, since the S corporation includes the dual advantages of limited liability and single taxation.
Can Tim Ratigan use the S corporation form of business ownership for Ratigan's Raging Rapids Rafting, Inc.?
[Instructor: See Classification of Corporations in Chapter 38]

4. Chapter 38 Hypothetical Case 2
Best friends Phoebe Main and Franklin Kilbride love to cook. The two are so inseparable that, some time ago, those who knew them began to jokingly refer to Main and Kilbride as "Ma and Pa." One of their concoctions, kettle corn, became so popular (Main and Kilbride love to share their caloric creations) that others have encouraged them go into business and sell their kettle corn as a product. Main and Kilbride agree. They have decided to form a traditional corporation as co-owners, and they have agreed on a name for their company: Ma and Pa Kettle Corn Company, Inc.
In the articles of incorporation (the document Main and Kilbride will send to the Kansas Secretary of State's office for approval of corporate status), the two are required to indicate the total number of stock shares the company is authorized to issue. Main and Kilbride are perplexed. Both have always considered themselves good with numbers, but they cannot decide what number of shares of stock to indicate in the articles of incorporation.
What is your recommendation to Phoebe Main and Franklin Kilbride?
Chapter 38 Hypothetical Case 2: Best friends Phoebe Main and Franklin Kilbride love to cook. The two are so inseparable that, some time ago, those who knew them began to jokingly refer to Main and Kilbride as "Ma and Pa." One of their concoctions, kettle corn, became so popular (Main and Kilbride love to share their caloric creations) that others have encouraged them go into business and sell their kettle corn as a product. Main and Kilbride agree. They have decided to form a traditional corporation as co-owners, and they have agreed on a name for their company: Ma and Pa Kettle Corn Company, Inc.
In the articles of incorporation (the document Main and Kilbride will send to the Kansas Secretary of State's office for approval of corporate status), the two are required to indicate the total number of stock shares the company is authorized to issue. Main and Kilbride are perplexed. Both have always considered themselves good with numbers, but they cannot decide what number of shares of stock to indicate in the articles of incorporation.
What is your recommendation to Phoebe Main and Franklin Kilbride?
[Instructor: See Formation of the Corporation in Chapter 38]

5. Characteristics of Corporations
Legal entity
Rights as person and citizen
Creature of state
Limited liability of shareholders
Unrestricted transferability of corporate shares
Perpetual existence
Centralized management
Corporate taxation
A corporation is a legal entity with rights as a person and as a citizen. It is a creature of the state, with limited liability of shareholders and unrestricted transferability of corporate shares. A corporation has perpetual existence, centralized management, and is subject to corporate taxation.

6. Corporate Powers Corporations have both express and implied powers
Express powers: Perpetual existence; right to litigate; right to make contracts; right to borrow/loan money; right to make charitable donations; ability to establish rules for managing corporation
Implied powers: Whatever actions necessary (within the law) to execute express powers
Corporations have both express and implied powers. Express corporate powers include perpetual existence, the right to litigate, the right to make contracts, the right to borrow or loan money, the right to make charitable donations, and the ability to establish rules for managing the corporation. Implied powers include whatever actions are necessary, within the law, to execute express powers.

7. Classifications of Corporations
Public/private
For-profit/nonprofit
Domestic/foreign/alien
Publicly held/closely held
S corporation
Professional corporation
Corporations can be classified as public or private; for-profit or nonprofit; domestic, foreign, or alien; or publicly held or closely held. Special types of corporations include the S corporation and the professional corporation.

8. Public versus Private Corporation
Public corporation: Corporation created by government to administer law, with specific government duties to fulfill
Example: Federal Deposit Insurance Corporation (FDIC)
Private corporation: Corporation created for private purposes
A public corporation is a corporation created by the government to administer the law, with specific government duties to fulfill. An example of a public corporation is the Federal Deposit Insurance Corporation. A private corporation is a corporation created for private purposes.

9. For-Profit versus Nonprofit Corporations
For-profit corporation: Objective is to operate for profit; shareholders seeking to make profit purchase stock that these corporations issue
Nonprofit corporation: May earn profits, but they do not distribute these profits to shareholders (nonprofit corporation does not issue stock, nor does it have shareholders); instead, corporation reinvests profits in business
The objective of a for-profit corporation is to operate for profit; shareholders seeking to make a profit purchase stock that these corporations issue. A nonprofit corporation may earn profits, but it does not distribute these profits to shareholders; instead, it reinvests the profits in its business. A nonprofit corporation does not issue stock, nor does it have shareholders.

10. Domestic, Foreign, and Alien Corporations
Domestic: Doing business within state of incorporation
Foreign: Doing business in states other than state of incorporation
Alien: Doing business country other than country of incorporation
A domestic corporation does business within its state of incorporation. A foreign corporation does business in states other than its state of incorporation. An alien corporation does business in a country other than its country of incorporation.

11. Publicly Held versus Closely Held Corporation
Publicly held corporation: Stock available to public
Closely held corporation (aka a close, family, or privately held corporation): Generally does not offer stock to public
Stock in a publicly held corporation is available to the public. Stock in a closely held corporation (also known as a close, family, or privately held corporation) is generally not offered to the public.

12. Subchapter S Corporation
Named after provision of Internal Revenue Service (IRS) code that provides for it
Particular type of closely held corporation (no more than 100 shareholders)
Combines advantages of limited liability and single taxation
The subchapter S corporation is named after the provision of the Internal Revenue Service code that provides for it. It is a particular type of closely held corporation, with no more than 100 shareholders, that combines the advantages of limited liability and single taxation.

13. Formation of Corporation
Promoters organize corporate formation
Subscribers offer to purchase stock in corporation in formation process
State selected for incorporation
Corporate existence begins through the efforts of promoters, who initially organize corporate formation. During formation of the corporation, subscribers offer to purchase stock, representing ownership in the corporation, and promoters select a state for incorporation.

14. Considerations When Selecting a State for Incorporation
How much flexibility does the state grant to corporate management?
What rights do state statutes give to shareholders?
What restrictions does the state place on the distribution of dividends?
Does the state offer any kind of protection against takeovers?
Several questions must be addressed in selecting a state for incorporation, including: How much flexibility does the state grant to corporate management? What rights do state statutes give to shareholders? What restrictions does the state place on the distribution of dividends, and does the state offer any kind of protection against takeovers?

15. Legal Process of Incorporation
Selection of corporation name
Drafting and filing articles of incorporation
First organizational meeting held
The legal process of incorporation involves selection of a corporate name, the drafting and filing of articles of incorporation, and the convening of the first organizational meeting.

16. Remedies for Defective Incorporation
De jure corporation: Lawful corporation that has met the substantial elements of incorporation process
De facto corporation: Corporation that has not met the requirements of state incorporation statute, but courts recognize it as a corporation for most purposes to avoid unfairness to third parties who reasonably believed it was properly incorporated
Corporation by estoppel: Corporation prevented by court from denying its corporate status
Piercing corporate veil: Shareholders personally liable when they have used corporation to engage in illegal/wrongful acts
A de jure corporation is a lawful corporation that has met the substantial elements of the incorporation process. A de facto corporation is a corporation that has not met the requirements for state-sanctioned incorporation, but that courts nevertheless recognize as a corporation for most purposes, in order to avoid unfairness to third parties who reasonably believed it was properly incorporated. Through corporation by estoppel, a corporation is prevented by the court from denying its corporate status. In piercing the corporate veil, a court holds shareholders personally liable when they have used the corporation to engage in illegal or wrongful acts.

17. Situations When Courts May Pierce Corporate Veil
Corporation lacked adequate capital when initially formed
Corporation did not follow statutory mandates regarding corporate business
Shareholders' personal interests and corporate interests are commingled (corporation has no separate identity)
Shareholders attempt to commit fraud through corporation
Courts are likely to pierce the corporate veil when a corporation lacked adequate capital when it was initially formed, the corporation did not follow statutory mandates regarding corporate business, shareholders' personal interests and corporate interests are commingled (in other words, the corporation has no separate identity), and shareholders attempt to commit fraud through the corporation.

18. Debt Securities versus Equity Securities
Debt securities: Bonds (representing loans to corporation from another party)
Equity securities: Stock
Debt securities are bonds, representing loans to a corporation from another party, while equity securities constitute stock.

19. Types of Bond Debt Securities
Unsecured bond (debenture): No assets support corporation's obligation to repay face value of bond
Secured bond (mortgage bond): Specific property supports corporation's obligation to repay; creditor can seize secured interest if bond not repaid
Income bond: Corporation pays interest on bond in proportion to earnings
Convertible bond: Allows shareholders to exchange bond for shares of company stock
Callable bond: Allows corporation to call in and repay bond at specific times
Unsecured bonds (also known as debentures), secured bonds (also known as mortgage bonds), income bonds, convertible bonds, and callable bonds are types of debt securities. With an unsecured bond, no assets support a corporation's obligation to repay the face value of bond; through a secured bond, specific property supports the corporation's obligation to repay, and a creditor can seize the secured interest if the bond is not repaid. With an income bond, a corporation pays interest on the bond in proportion to its earnings, while a convertible bond allows shareholders to exchange the bond for shares of company stock. Finally, a callable bond allows a corporation to call in and repay the bond at specified times.

20. Equity Securities: Preferred versus Common Stock
Preferred stock: Stockholder enjoys preferences regarding assets and dividends
Common stock: Stockholder owns portion of corporation, but no preferences regarding assets and dividends
With preferred stock, stockholders enjoy preferences regarding the distribution of assets and dividends. With common stock, stockholders own a portion of the corporation but are not entitled to preferential treatment regarding the distribution of assets and dividends.

21. Chapter 38 Hypothetical Case 3
Since 2006, Clyde Monett has operated an art restoration business specializing in the refurbishment of portraits and paintings. He operated the enterprise as a sole proprietorship called Monett's Art Restoration Services until 2012, when he attended a business structures, licenses, and permits workshop at a local community college.
The presenting attorney at the workshop suggested Monett convert his business to a corporation in order to shield his personal property and real estate from liability for his business's financial obligations (Monett's personal net worth is approximately $150,000).
Following the incorporation process, the only change to the business's name was the addition of the word "Incorporated." Monett was the only incorporator of the business. He serves as the president, vice president, and treasurer of the corporation; his sister, Rachel Monett, is the secretary.
Chapter 38 Hypothetical Case 3: Since 2006, Clyde Monett has operated an art restoration business specializing in the refurbishment of portraits and paintings. He operated the enterprise as a sole proprietorship called Monett's Art Restoration Services until 2012, when he attended a business structures, licenses, and permits workshop at a local community college.
The presenting attorney at the workshop suggested Monett convert his business to a corporation in order to shield his personal property and real estate from liability for his business's financial obligations (Monett's personal net worth is approximately $150,000).
Following the incorporation process, the only change to the business's name was the addition of the word "Incorporated." Monett was the only incorporator of the business. He serves as the president, vice president, and treasurer of the corporation; his sister, Rachel Monett, is the secretary.
[Instructor: See Potential Problems with Formation of the Corporation in Chapter 38]

22. Chapter 38 Hypothetical Case 3 (cont'd)
Since the corporation's formation in 2012, the siblings have convened only one official corporate meeting; the meeting lasted approximately one hour, and the two shared family gossip for 45 minutes of that hour. Monett's Art Restoration Services, Incorporated has maintained an average daily balance of $45.22 in the corporate checking account at Homeland National Bank.
Last week, Monett inadvertently purchased the wrong art refurbishment materials (the cleaning solution was too acidic), and the oversight resulted in irreparable damage to a painting conservatively valued at $75,000. The owner of the painting, Svetlana Poe, demands $75,000 in damages from Monett. Monett apologizes, offers two free coupons for future restoration services, and refuses to pay the $75,000. The current corporate checking account balance is $52.84.
Is Clyde Monett personally liable for the $75,000 damage claim? Is he ethically obligated to pay Poe $75,000?
Chapter 38 Hypothetical Case 3 (cont'd): Since the corporation's formation in 2012, the siblings have convened only one official corporate meeting; the meeting lasted approximately one hour, and the two shared family gossip for 45 minutes of that hour. Monett's Art Restoration Services, Incorporated has maintained an average daily balance of $45.22 in the corporate checking account at Homeland National Bank.
Last week, Monett inadvertently purchased the wrong art refurbishment materials (the cleaning solution was too acidic), and the oversight resulted in irreparable damage to a painting conservatively valued at $75,000. The owner of the painting, Svetlana Poe, demands $75,000 in damages from Monett. Monett apologizes, offers two free coupons for future restoration services, and refuses to pay the $75,000. The current corporate checking account balance is $52.84.
Is Clyde Monett personally liable for the $75,000 damage claim? Is he ethically obligated to pay Poe $75,000?
[Instructor: See Potential Problems with Formation of the Corporation in Chapter 38]

23. Chapter 38 Hypothetical Case 4
Nathalie Sawyer is the founder, president, and CEO of Can-Do Fabricators, a Connecticut-based corporation that fabricates granite, marble, and quartz countertops. Can-Do is a closely held corporation with 20 stockholders other than Sawyer. All of the other stockholders are Sawyer's family members or personal friends. Sawyer herself owns 60 percent of the shares of Can-Do; the remaining stockholders each own 2 percent of the shares.
Sawyer has plans to expand the company into New York; in order to do so, she needs a significant influx of capital—$4 million. Sawyer's present facility is valued at $5 million.
Sawyer decides to issue corporate bonds in order to raise the capital she needs. She is considering issuing unsecured, secured, or convertible bonds. If she chooses unsecured bonds, Can-Do will end up paying much more interest on the bonds than either of the other two choices.
What are the potential downsides (other than higher interest) and benefits of choosing each of the types of bonds? Explain your answer.
Chapter 38 Hypothetical Case 4: Nathalie Sawyer is the founder, president, and CEO of Can-Do Fabricators, a Connecticut-based corporation that fabricates granite, marble, and quartz countertops. Can-Do is a closely held corporation with 20 stockholders other than Sawyer. All of the other stockholders are Sawyer's family members or personal friends. Sawyer herself owns 60 percent of the shares of Can-Do; the remaining stockholders each own 2 percent of the shares.
Sawyer has plans to expand the company into New York; in order to do so, she needs a significant influx of capital—$4 million. Sawyer's present facility is valued at $5 million.
Sawyer decides to issue corporate bonds in order to raise the capital she needs. She is considering issuing unsecured, secured, or convertible bonds. If she chooses unsecured bonds, Can-Do will end up paying much more interest on the bonds than either of the other two choices.
What are the potential downsides (other than higher interest) and benefits of choosing each of the types of bonds? Explain your answer.
[Instructor: See Corporate Financing in Chapter 38]