Why is learning the language of your clients critical in getting the answers you want?

 Three basic forms of commercial activities:

o proprietorships,
o partnerships,
o corporations
o common variations: limited partnerships and limited liability companies.

 Eight questions to help define which legal form is most appropriate:

o What kind of a business?
 NOT whether it’s selling cars or phones
 Rather asking: what legal form of business?
1. How is the business formed (state action?)
a. All by yourself, or whether some sort of state action necessary (e.g., paper, approval)
2. How can the business raise money?
a. Borrow?
b. Bring in equity investors?
i. Ownership interest; last in line to be paid, possible unlimited upside if all goes well
3. How is it controlled?
4. Who is liable for the business’s debt? (limited liability?)
a. Aka is it just the business? Or are people involved in being liable?
5. Are assets locked in? (who can take money out of the business, esp if it is doing well?)
a. E.g., corporations; asset lock-in frequent
6. How is the business terminated?
a. Perpetual life?
7. Is the business itself taxed?
8. Can equity investors sell [their interests to other investors easily]?

 Proprietorships
o What is a proprietorship? An individual doing business as an individual
o Oldest kind of biz org
o Can be formed easily w/o state action
o Can borrow money from bank or friends
o Cannot take in equity investors; one and only one owner
o Often dubbed “Sole proprietorship”
o Who can control? Proprietor has complete control
o Problem: a sole proprietor is personally liable for the debts of the proprietorship.
 E.g., lease, personal liability, etc.
 (no “limited liability” for a proprietorship)
o proprietor can easily withdraw money from business profits
o  b/c proprietorship has no asset lock-in
o a proprietorship lasts as long as the proprietor wants it to last + as long as the proprietor lasts
 e.g., if he wishes to stop, or dies, the proprietorship biz dies
o does the proprietorship pay taxes? NO.
 IRS acts as if the biz does not exist independently from the proprietor
 Proprietor is taxed for income taxes
 Called pass-through taxation: taking biz profits and passing them through to individual
o Can the proprietor sell their equity interest to another investor?
 No. Can’t sell biz itself.
 Can sell biz assets (equipment, inventory, biz name [DBA-Doing business as], etc.)
 Partnerships
o How is it formed?
 Multiple partners; each partner mutually agrees with all other partners to form the
partnership.
 Can be written down (and common to), but need not be.
 Can be oral agreement, or even implied.
 No state action req. (Can, but not req.)
 Can borrow money, or can take in equity investors.
 Take in $, and in return, give a share of profits
o Who controls a partnership?
 All partners share control
 Sometimes a partner may act as a representative agent for other partners
 E.g., be empowered to act on behalf of another
 The more significant the decision, the more you need to make sure that other
partners are a part of the decision
 Majority/unanimous agreements
o Who is liable for the biz debt?
 No LLC; partnership debt/injury=individual partners have to chip in
o How does a partner get $ out of the partnership?
 Any partner at any time can get their $ by withdrawing from the partnership.
 AKA no asset lock-in
o How long does a partnership last?
 Till partner withdraws or dies—even if others are around and want to continue doing biz.
 If one exits, you have to re-create partnerships
 (often in partnership agreements, partners agree to re-enter new agreement)
o Tax?
 Pass-through tax treatment [all profits are attributed to the individual partners]
 Partnerships CAN opt to be treated as a biz org whose profits are taxed, but this is
uncommon because it’s doubly-taxed (as a partnership and as an individual)
o Can partners sell equity interests to someone else?
 No. who the partner is is important.
 Yes to the right of income in partnership [since this is only the economic right and not
political].

 Corporations and LLCs

o LLC is an alternative kind of corp
o Have only been around ~1000 years.
o How is a corp. created?
 Requires state involvement: must file a charter [basic rules/constitution of corp];
fundamental doc. [AKA articles of incorporation, certificate of corporation]
 Charter must be filed with applicable state gov’t
 Filing a document? Electronically done
 State of incorporation?
 Strategy required
 Delaware is popular (easy, clear laws), but mostly in the state they’re doing biz in
o How can corps raise money?
 Borrow
 Bring in equity investors [“Shareholders” or “stockholders”]; they get share/stock
certificates
 A corporation is a legal entity. It has rights much like individuals have. Shareholders
cannot own this right. They also own their own assets (through asset lock-in).
 o Who controls a corp?
 Board of directors
 In Non-profits, directors elect themselves
 In most profits, shareholders elect directors [indirect control of corp’s decisions]
 Two categories
 Private/closely-held corporations: Few shareholders/one shareholder that has
more than 50%  typically controls board of directors
 Pubic corp (typical): makes shares available on stock exchange; consequently,
may have millions of SHs. True control by Board of directors because small SHs
have no control.
o Who is liable for debt?
 Status of corp as legal person is important: only the corp is liable for the corp’s debts.
The human beings [SHs, board, execs, etc.] are limited in liability (and are not personally
responsible for what the corp does)
  key characteristic of corp.; makes corp form desirable.
 Downside: assets belong to the corporate entity and not to the entrepreneur/owners.
 ASSET LOCK-IN  b/c When they bought shares, their money becomes corp’s
money.
 Why buy? Dividends or if they hang on to stock, sell later at higher price (share price
appreciation).
o How long can a corporation last? What brings them to a close?
 Corporations can last in perpetuity (e.g., Hudsons Bay Co., 1670)
 So corps can pursue vast projects that individuals could not
 Downside: must be taxed as entities; dividends are taxed again as individual incomes to
shareholders
o Can SHs sell their interests in the corp?
 Yes. They then become SHs in the company.
 Primary marketsecondary market (stock market)—company doesn’t make additional
money that way.
 Corps: Directors
o 5-15 or more people.
o Meet 4-12 times a year and run the business (make highest-level decisions) e.g., merging, selling
assets, etc.
o Two categories
 Inside directors: board + closer connection (such as working for it, e.g., CEO)
 Outside directors: independent of company, no economic connection other than sitting on
the board (don’t work, don’t do business with)
 Corps: officers
o Formal position with legal obligations. Actually run the business
o Most significant officer: Corp secretary
 Official memory/voice of the corp; minutes are kept by corp sec
 Must make sure procedures are followed
o Beyond corp secretary, multiple executives… (“C-level execs”)
 CEO, chief executive officer. Top employee. Reports directly to the board.
 COO, chief operating officer. Helps CEO run company. Often in line of succession to
CEO.
 CFO, chief financial officer. Ensures funds are used well.
 CAO, chief accounting officer (AKA Comptroller), ensures financial records are accurate
 CLO, chief legal officer (AKA general counsel)
 CHRO (HR), CTO (tech), etc.
 Directors, presidents, vice presidents, etc. exist; vary from company to company
 Corps: shareholders
o Typically have voting rights (e.g., elect, remove directors, or mergers, etc.)
o Two categories
 Individual shareholders (mom & pop shareholders), buy shares thru broker dealer etc.
 Institutional shareholders, are in the business of representing investors thru portfolio
(e.g., mutual funds, and companies, like vanguard, black rock, etc.) they today hold 25-
30% shares out there
 E.g. Pension fund, hedge fund (similar to mutual fund, but mutual funds are
heavily regulated by the SEC and thus can sell shares to general public. Hedge
funds are less regulated, more dangerous, and so only people who are
sophisticated and wealthy can invest with hedge funds)
 E.g., insurance companies, sovereign wealth funds…
 Institutional investors > individual investors, but the latter are still significant

 Variation 1: Limited Partnership

o Hybrid between general partnership and a corp.
o Two kinds of partners: limited partner + general partner
o General partner is just a partnership partner
o Limited partner: Limited Liability but does not control org (similar to a shareholder)
o To create:
 Need state action
o Can borrow like biz forms, but can sell equity interest through limited partnership interest
o Is controlled by general partner
o Limited partners are entitled to pass-thru taxation! (no double taxation)
o Can last till general partnerships’ death or withdrawal, but most are set up for a fixed term.
o May list limited partnerships in market and make it transferrable.
o Customization 가능 to make it more corp like or more partnership like

 Variation 2: LLC
o Recentest biz form (~30 or 40 yrs)
o Is a biz org that gives you flexibility to pick elements of corporate and partnership law
o How is it created?
 Filing with relevant state req. called “Membership Agreement” but otherwise very similar
to corporation charter.
 Delaware not nec. so popular
o Can borrow money
o Can sell membership interests (equity shares)
o If run like a partnership, “member-managed LLC”
o If run like a corporation (hiring managers, much like corp’s board), “manager-managed LLC”
o Only the LLC is liable for LLC’s debts (like corp.)
o Withdrawal of assets:
 케바케
o duration: in the past, thirty years  can now exist in perpetuity
o tax treatment: can choose to be taxed as an entity [then dividend-like payments are doubly taxed]
OR it’s not taxed as an entity as a pass-through taxation

 Variation 3: LLPs and LLLPs (esp with malpractice as an issue)

o Forms of partnerships where liability rules are changed to recognize the fact that doctors and
lawyers that form partnerships; all partners are liable for Ks as a practice, but not for malpractice.
o LLP—partners are liable equally for partnership’s contract debts but not co-partners’ negligence
 o Limited LLP LLLP— LLP that takes in limited partners. AKA, limited partners have no personal
liability; even among general partners, they are not liable for co-partners’ negligence.

 S corp, C corp – tax treatment differences.

o Professional corporations, S corps, C Corps…
o Reference to IRS rules for how orgs are taxed
o C corp: classic corp, double-taxation. Taxable entity.
o Prof corp/S corp: limited; somewhat restrictive rules (e.g., cant have too many shareholders)—if
corp is small enough, it is taxed as a partnership (pass-through tax treatment)

T0
SP -- As a sole proprietorship, I would be worried about potential lawsuits re: the quality or temperature of my
coffee (what if someone spilled it and it resulted in personal injury?). I would have to get insurance.

As the owner, I could not sell CC to another investor if the business did well. I would be limited to selling the
name (goodwill) of the business.

LLC-- A partnership would probably work (especially with the programmer). The biggest concern would be
that the programmer would then be able to withdraw at any point, so you could address the issue in the
charter and not allow free withdrawal of funds from the LLC.

Double-taxation would be an issue with a standard corporation, but as an LLC, you could allow for pass-
through taxation and avoid the issue.

LLC/Corp-- A large amount of money is required, so it's useful to be able to both borrow money and take in
equity investors.

A plant is a long-term investment; a corporation would be able to last for as long as necessary to continue a
potentially successful, and therefore long-term, business, for it may last in perpetuity.

You'd also need a diverse set of experts to run such a large-scale venture, so a set of officers, in addition to
directors and shareholders, would likely assist in running the business.

Agency Relationship
Agency: asking someone to do something on your behalf.
Principal (hirer) – agent (hiree) – 3dp (sbd the agent is dealing with on principal’s behalf)
- Principal’s duty to 3dP (aka, when is the principal held responsible for the agent’s acts?)
- AKA did the agent have authority to bind the principal?

Duties of principals and agents

- What does the principal owe the agent?
o Compensation that was promised
o Indemnification of agents’ costs that they incur when they are doing the principal’s business
 E.g., “cab fare” or legal costs
- What does the agent owe the principal?
 o Duty of Obedience: when principal tells you to do something, you do it. (e.g., employment)
o Duty of Care: when doing something on behalf of principal, do it with care
o Duty of Loyalty: obligation to act first and foremost on behalf of principal; no extraction of
benefit for yourself.

- (Board of) Directors’ fiduciary duties: loyalty, care, and business judgment
o BoDs represent fictional entities so they’re not classic agents being directed by a principal
o They instead have fiduciary duties (directors are fiduciaries (≠ agents))
o Duty of loyalty: can’t use their corporate positions to make themselves better off
 Courts enforce this rigorously
o Duty of care: duty not to be negligent
 Business judgment rule: toothless, courts do not enforce this as rigorously
 Why? The court will only look at the process (were directors informed? Did they look at
the options and ask appropriate Qs?) and not second-guess the decision made, even if it is
made poorly or foolishly.

T1
1 raise funds by borrowing
2 limited partnership
3 board of directors
4 longest one: not taxed at level of org
5 “both a and b”
6 general partners
7 corp sec
8 corp
9 pub corp
10 both A and B
11 pass thru LL
12 proprietorship
Chapter Two. Debt and Equity Financing
Risks and benefits; why managers use a mix of both; economic and political rights to debt/equity investors

Equity: “ownership interest” v. Debt: borrowing

(common stock) ---------------------(bonds and debentures)

The more equity-like your financing is, the more political power (control) you’ll have.
So one end, common stock, most rights
Debt: fewest rights

Economic right is the opposite, kinda.

Debt holders have seniority when it comes to being paid.

One other classic difference: where are my rights?

Equity (esp common stock holders) – articles, corporate charter
Debtholders – contract that created the debt in the first place

Common stock ownership rights:

1. Economic right: Are paid dividends (sometimes)
Dividends are declared only when BoD wants to dish em out. Also, common SHs’ rights to payment is junior to
debt financers and preferred SHs. But by this point, whatever remains is theirs (good if company is doing well!)
 dividends can be CASH STOCK or even Corporate property.
2. Liquidated assets
Received only after senior creditors get back what they are entitled to receive. Could even be nothing.

Common stockholders have limited control: only certain matters!

- Who sits on board of directors?
- Approve or veto certain corporate transactions (“fundamental changes”) if/when they are proposed by
board of directors, such as merger, liquidation of company, change in certificate of incorporation, or sale
of all/substantially all of the corp’s assets
Typically: one-share one-vote (so if you have majority # shares, then you’ll be very influential)
Variations: classified voting / classes of shares  some classes are given more votes (e.g., class A shares, 1
vote per share / class B shares, 10 votes per share)
Variation 2: cumulative voting—accumulate points for every share you have and vote them collectively. This
gives minority shareholders greater power; may even vote in a BoD member.

Also, common SHs are given legal standing to sue BoD on behalf of corp for (alleged) breach of fiduciary duty
(“derivative suit”).

Voting Dilution
Common SHs are given voting rights  gives rise to a concern of voting dilution
How? The corp may issue more voting shares, which would dilute the majority holder

Equity dilution (imp. In the context of startups or IPOs)

If corp issues additional shares  equity dilution (if against you) or equity concentration (if for you)
(New equity comes in that trumps existing equity)
e.g., A and B own 1 share, $10 each. C comes in and is sold 1 share for $40. The corp now worth $60 total. If
liquidated, then each A, B, and C would get $20 each. A and B = concentration; C = dilution
cf) IPOs are popular b/c original/existing shareholders enjoy a huge equity concentration 

Equity in Articles: Par Value and Max # of shares

Where do you find the equity structure of a corporation?  the articles of incorporation
MAX # OF SHARES the corp is authorized to issue
 illegal for BoD to issue any more shares than this limit
PAR VALUE (most companies have this) the min price the corp HAS to charge any new buyer
 illegal for BoD to issue shares for less than Par value
 old fashioned but many corps still have this (And DEL corp code has it)
Originally included to protect against voting dilution (max # shares) and economic dilution (par value).

Equity in Articles 2
Any departures from 1 share 1 vote must be described in articles of corp
Any issuance of shares must be approved by BoD; lower level employees may not decide
Accounting: balance sheet will describe, at the bottom (equity portion), how much stock the company sold,
repurchased (‘treasury shares’ – no voting power btw), par value, etc.

Debt
Simplest form of financing a business
Can borrow from individuals, banks (‘loan’), or by selling debt to debt investors (‘debt issuance’-an IOU) called
bonds or debentures.
Debt investors have senior economic rights: 1. Right to regular payment of interest (may be FIXED—5% of
principal or VARIABLE/FLOATING. This is pre-determined by the K) – regardless of whether the company is
making money! 2. Right to repayment of principal, upon some designated maturity date.

Weaker control rights/political rights

 no right to vote, no right to participate in biz decisions unless designated in debt K.
 no right to fiduciary duty lawsuit on behalf of corp unless designated in debt K.

Where is all this information located? NOT in the articles, but in the K that creates the debt
They are called “trust indenture” or “debt covenant” etc.
Debt investors can bargain for a lot of stuff, aka lots of different kinds of debt…

Types of debt
Short term v. long term
Long term = more risk = “debentures” or “bonds”  >1 yr maturity date (3, 5, 10 yrs or longer)
Short term = less risk = “notes” or “commercial paper” (3, 6, 12 months)
Why short term loans? Corps intend to roll over short-term debt by taking out additional debt
Secured v. unsecured
Secured = lender is entitled to have debt repaid out of the asset before any other creditor
Always better to be secured creditor because you get first cut at the asset that secured your loan
Senior v. junior
Senior = senior debtholders are entitled to first repayment in the event of liquidation
 during loan negotiation, can negotiate terms like “future loans will be subordinated”
junior debt = subordinated debt
 junk bonds, junk debt = most junior, most subordinated debt

ratings agencies
Some debt riskier than others
measuring risk
- How healthy is the business? Is debt secure? Junior or senior? Short term or long term?
 look to see if a rating agency rated the debt.
e.g., S&P, Moody’s, Fitch
Give independent grades to different kinds of corp debt issuances
Triple A – double A – single A  Triple B (pretty risky) – double B – single B (junk bond territory) – C

Preferred stock
Hybrid of debt and equity
Elements of equity
- Get dividends, but fixed-size (there is a maximum) (common stock is not fixed)
- After getting dividend maximum, can’t get anything more that year
Elements of debt
- Preferred stock dividends are SENIOR TO common stock dividends
- (once preferred stock dividends are paid out, then common stock dividends are too)
Directors need not declare preferred stock dividend  might pay no dividends to Preferred Stockholders for a
few years, then pile up 5 years later. The dividends are cumulative thus preferred stockholders would be paid
5x their cap.

Liquidation preference (fixed $)

 if the company is ever liquidated, preferred stock SHs get the set amount back before any common stock
SHs get anything.
BUT just as preferred SH’s econ rights get stronger, their control rights get weaker: typically don’t have a vote,
or if they do, limited vote (e.g., only if company does not pay dividends for several years) + no right to sue
company for breach of fiduciary duty.

Preferred rights 
BOTH articles of incorporation AND the K
# of preferred shares, par value, voting rights  articles of incorporation
other details (esp: dividend the preferred stock pays)  K under which preferred shares are issued
this is possible according to articles of incorporation (“blank check preferred stock” provision) – because
preferred stock competes with debt for investors, some flexibility required so they can make preferred stock a
competitive investment.

Corporate finance strategy: how to raise money? Internal financing thru selling goods/services? External
financing thru Debt/Equity?
 Between debt and equity…:
debt-equity ratio: high / low debt-equity ratio
levered business /has a lot of leverage.

How to choose btw debt/ and equity? Three considerations:

1. tax consequences
a. are significant: discriminates against equity
b. payments the corps make to equity holders (dividends or profits) are not treated as deductible biz
expenses
c. interest on debt is tax deductible
d. tax deductible? Tax bill smaller
e. e.g. of tax advantages of financing with more debt, less equity
i. hypo1
ii. You have $5000; need $10,000.
iii. Your Equity : 5 shares of common stock at $1000/share  $5000
iv. Debt: 5 bonds at $1000 each  $5000
1. Bonds pay interest ($100/bond; $500/year)
v. What happens if biz is successful and you begin to make $1000/yr? (assume 40%
marginal rate of corporate profits for tax)
1. Pay $500 to bondholders for interest  $500 left – your taxable profit (interest
paid to bondholders is deducted)
2. IRS gets 40% ($200)
3. $300 left as shareholder (6% ROI)

i. hypo 2
ii. need $10000 and have $5000.
iii. you buy bonds: you leverage your company
iv. 5 bonds: outside investors ($5000)
v. 4 bonds: YOURSELF (shareholder)
vi. 1 share of common stock ($1000)
vii. 9 to 1 debt-equity ratio
viii. the company makes $1000
 a. pays $900 in bonds interest: $500 to outside investors and $400 to biz owner for
owning 4 bonds
b. Company gets tax deduction of $900
c. IRS taxes 40% of $100, or $40.
d. $60 can be paid to biz owner on top of the $400.
e. You get more money! By decreasing tax bill by financing more with debt than
equity
2. liquidation consequences / bankruptcy consequences
a. WHAT IS BANKRUPTCY
i. Can’t pay back the money they borrowed (principal, or even interest)
ii. Two ways to go to bankruptcy court:
1. Voluntary bankruptcy: debtor himself goes and requests relief or change terms
2. Involuntary bankruptcy: Creditors don’t believe you can pay back
b. Types of bankruptcy
i. “chapter 7”: classic. Available to individuals and biz. Court divides remaining assets and
divides to creditors and then all debts are forgiven.
ii. “chapter 11”: reorganization. Applies to businesses. Come up with plan under which
debtor tries to pay back as much as possible.
iii. “chapter 13”: reorganization. Applies to individuals.
iv. Note: bankruptcy court has been changed so individuals aren’t as easily excused under
chapter 7 and courts encourage chapter 13 reorg. (Esp student loans)
c. What happens in a chapter 7 bankruptcy?
i. Assets are divvied up according to seniority
ii. Senior creditors get debts repaid in full, then junior, then whatever is leftover goes back
to owner or shareholders of business.
iii. Variation 1: creditor’s loan may be secured (e.g., on a car)  in court, said creditor has
first “Crack” at the asset.
iv. Implication for corporate finance strategy: as a biz owner, you contribute some $ in
DEBT and secure said debt with a particular piece of corporate property to get first crack
of corporate property.
d. Hypo. 4500 debt.
i. Bondowners are senior to equity.
ii. If biz owner wants to maximize return for a potentially failed biz…:
1. 1 share of common stock ($1000/share) + 9 bonds ($1000/bond) of which FOUR
she buys, 5 is outside investors.  $10,000.
2. If biz fails and only $4500 are left… 9 bonds… each entitled to $1000 but only
$4500 remains. /9 하면 개당 $500. So for her 4 bonds, she gets 4*$500 and
outside investors get $2500.
3. She gets some $ back AND she gets better tax treatment.
3. advantages of leverage in terms of increasing the return
a. Debt looks good: reduces tax bill and makes it easier to claim assets in the event of liquidation.
b. Additionally, it allows biz founder to bring leverage into play:
c. How does leverage work? HYPO.
d. 50% debt (bonds) /50% equity (common stock)  $10,000 raised.
e. Earn $1,000  $500 interest for bond holders and $500 dividends. Biz owner invested $5000
thru common stock and got $500 back (10% ROE)
f. Earn $1500  $500 interest for bond holders and $1000 dividends. Biz owner invested $5000
thru common stock and got $1000 back (20% ROE)
g. As biz does well, benefits go to the equity holder; regardless of how well the biz does,
bondholder’s $ is the same
h. HYPO. Biz owner invests only $1000 (1 common stock) and gets $9000 thru bonds (outside
investors)
i. If biz earns $1000, $900 interest distributed to bondholders  $100 left in dividends. Invested
$1000 and gets $100, so 10% ROE
j. If biz earns $1500, $900 interested distributed to bondholders  $600 left in dividends. Invested
$1000 and gets $600, so 60% ROE
k. By using the power of leverage, by financing mostly debt and little equity, ROE goes higher.
l. UPSIDES: less tax, protection (get more back in case of liquidation), power of leverage
m. DOWNSIDE of using too much debt  more debt / less equity, the more likely that if biz hits a
rough patch, the biz will fail.
n. Hypo. Biz owner invests only $1000 (1 common stock) and gets $9000 thru bonds (outside
investors)
o. Suppose biz does not earn $1000 but makes only $500 in profits. Not enough to pay $900 in
interest.
p. Legal & contractual limitations on too much debt exist:
i. contracts themselves: may limit loans from other sources or pay out too much dividends
ii. tax authorities may limit what biz owner dubs “bond” (debt) and re-categorize it as
“stock” (equity) and not give it tax deductible status
iii. “Piercing the corporate veil” – should biz owner be allowed to escape liability for
corporate debt, or should it not be (vis a vis the court’s piercing the corporate veil)?
Consider whether biz owner has contributed their investment in the form of debt, or in
some other form where it seemed the biz was financed NOT through equity?
iv.  Court can say the biz was kept undercapitalized and hold biz owner responsible
v. “equitable subordination” – biz founder must get in line behind outside creditors in the
case of liquidation and not be able to take seniority by buying bonds and not providing
equity.