14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock

Incorporation and Issuance of Stock

Incorporating a business and issuing stock are the foundational steps a company takes to raise capital and establish itself as a formal legal entity. This process moves from filing paperwork with the state, to selling shares to investors, to potentially going public through an IPO. For Financial Accounting I, you need to understand both the mechanics of this process and the journal entries that follow from it.

Steps for Incorporating and Issuing Stock

1. File articles of incorporation with the state. This creates the corporation as a separate legal entity, distinct from its owners. The articles spell out key details: the company's name, its purpose, the number of shares it's authorized to issue, and its governance structure.

2. Sell stock to initial investors. Founders and early investors purchase shares directly from the company in what's called a private placement. This establishes the corporation's initial capitalization, giving it funds to begin operations.

3. Conduct an initial public offering (IPO) to raise additional capital. An investment bank underwrites the offering and sells shares to the public on the primary market (exchanges like the NYSE or NASDAQ). Once issued, those shares trade on the secondary market among investors, which provides liquidity. The corporation only receives cash from the primary market sale, not from secondary market trades between investors.

4. Comply with securities laws and regulations. The company must register with the Securities and Exchange Commission (SEC) and file periodic reports. Ongoing financial disclosures keep shareholders informed and ensure transparency.

Financing Alternatives for Corporations

Corporations can raise money through debt (borrowing) or equity (selling ownership). Most companies use a mix of both to balance cost, risk, and control. The choice between them has real accounting and tax consequences you should understand.

Debt vs. Equity Financing Comparison

Debt Financing

• Advantages:
  • Interest expense is tax deductible, which lowers the effective cost of borrowing
  • Creditors don't receive ownership or voting rights, so existing owners keep full control
  • Leverage can amplify returns for shareholders when profits exceed interest costs
• Disadvantages:
  • Requires regular interest payments and principal repayment on a fixed schedule, regardless of how the business is performing
  • Increases financial risk; if the company can't make payments, it may face bankruptcy
  • Loan agreements often include debt covenants (restrictions on things like additional borrowing or dividend payments) that limit operational flexibility

Equity Financing

• Advantages:
  • No required repayment of capital, so funds can be used indefinitely
  • Dividends are discretionary and can be reduced or suspended to conserve cash
  • Bringing in equity investors can signal confidence in the company's long-term growth
• Disadvantages:
  • Dilutes ownership for existing shareholders, who now hold a smaller percentage of the company
  • Dividends paid to shareholders are not tax deductible for the corporation (unlike interest on debt)
  • Profits must be shared with new shareholders, which reduces earnings per share

Classes and Characteristics of Stock

Common Stock

Common stock represents basic ownership in a corporation. Common shareholders have a residual claim, meaning they receive what's left of assets and earnings after all other obligations are met. Key features:

• Entitled to dividends if and when declared by the board of directors (dividends are not guaranteed)
• Carries voting rights to elect the board of directors and approve major corporate actions like mergers
• Has the lowest priority claim on assets in liquidation, behind creditors and preferred shareholders

Preferred Stock

Preferred stock sits between debt and common stock in terms of risk and priority. It typically pays a fixed dividend rate, and those dividends must be paid before any common dividends can be issued. Key features:

• Higher priority claim on assets than common stock in liquidation, but still lower than debt holders
• Usually does not carry voting rights, except in special circumstances defined in the stock's prospectus
• May be callable (the company can repurchase shares at a stated price) or convertible (shareholders can exchange preferred shares for common shares)

Other Key Stock Terms

• Par value: An arbitrary face value assigned per share, often set at a minimal amount like $0.01. Par value has no connection to market value, but it matters in accounting because stock issuances are recorded relative to par.
• Authorized shares: The maximum number of shares the corporation is allowed to issue, as stated in the articles of incorporation.
• Issued shares: The number of authorized shares that have actually been sold to investors. This can be less than or equal to authorized shares, but never more.
• Outstanding shares: The number of issued shares currently held by investors. Outstanding shares equal issued shares minus any treasury stock.
• Treasury stock: Previously issued shares the corporation has bought back. These shares are no longer outstanding, don't receive dividends, and don't carry voting rights.
• Market capitalization: The total market value of a company's outstanding shares, calculated as $\text{Market Cap} = \text{Share Price} \times \text{Outstanding Shares}$.

Corporate Governance and Shareholder Rights

Corporate governance is the system of rules, practices, and processes that direct and control a company. For shareholders, governance determines how much say they have in the company's direction.

Shareholders hold several important rights:

• Voting on major corporate decisions and electing board members
• Receiving dividends when declared by the board
• Accessing the company's financial statements and other disclosures

Companies often list their shares on a stock exchange (NYSE, NASDAQ) to provide liquidity for shareholders and increase the company's visibility to potential investors.