CORPORATE STRUCTURES AND FUNDING

1. There are a variety of structures through which a business can trade. The most common of these are a sole trader, partnership and a company limited by shares. The key distinctions in trading by these means are as follows:-

1.2 Sole Trader

1.1.1 A sole trader is in fact the business and is personally liable for all of its debts.

1.1.2 A sole trader cannot dispose of any ownership of the business or have the business itself generate new cash.

1.1.3 There is no requirement to be audited or file accounts at Companies House.

1.2 Partnership

1.2.1 In many respects very similar to a sole trader except that two or more persons are in business together for a common purpose.

1.2.2 No formal partnership deed has to be drawn up but this is usually desirable so that the parties can regulate their affairs. If this is not done the Partnership Act 1890 (which provides a specimen set of rules) will automatically apply.

1.2.3 The management of the firm's business is regarded as a matter for all of the partners together. They are free to agree how the affairs of the partnership will be governed as a matter of contract.

1.2.4 In Scot's Law a partnership has a degree of "legal personality" which means that the partnership can sue and be sued in its own right.

1.2.5 Where a partnership exists each and every partner is jointly and severally liable for the whole debts of the firm. This means that any external creditor can sue an individual partner for the full amount of any debt or obligation owed to him by the firm leaving it for the individual partners to recover any contribution which may be due from the other partners. This follows from the underlying principle that each partner is deemed to be an agent of the firm for any transaction undertaken by him on behalf of the firm.

1.2.6 There is no formal liquidation of partnership and the individual partners are treated as sole traders in as much that they are subject to the law or bankruptcy if they cannot meet the firm's obligations out of the firm's assets.

1.2.7 Like a sole trader a partnership can only raise money by borrowing with the individual partners themselves are liable for all of the firm's debts.

1.2.8 There can also be difficulties with succession issues if the partners have not agreed for a continuation if a partner leaves.

1.2.9 Again there is no requirement for audit or the filing of accounts.

1.3 Company Limited by Shares

A company limited by shares is incorporated by registration under the Companies Acts and is regarded as a separate legal person. As a distinct legal entity many of the difficulties of unincorporated structures are overcome in as much that the company trades on its own account, money can be raised by issuing shares (ie., granting ownership rights in the company) and the company itself can grant security over its own assets. The directors of the company would only be personally liable to the extent to which they had signed any collateral guarantees.

The key features of a company limited by shares are as follows:-

1.3.1 As a company limited by shares the liability of shareholders is only to contribute the amount of any unpaid share capital even if the company goes into insolvent liquidation.

1.3.2 In a limited company ownership and control can be separated which allows for ownership to be given to parties who are not involved in the business.

1.3.3 The affairs of the company are largely directed by company legislation although issues relating to corporate responsibility and the rights and duties of directors, management issues and shareholders rights must always be considered in the light of the precise formal structure of the company which can be tailored as appropriate.

1.3.4 Companies can be private or public and only public shares can be quoted on the stock market. The vast majority of companies are private and there are special provisions which will apply under the Companies Act if a company wants to even call itself a public company. The shares of a publicly quoted company are freely transferrable without restriction and for the most part only established companies looking to raise substantial amounts of money would seek a stock market or AIM (Alternative Investment Market) listing.

2. Creating a Company Limited by Shares

2.1 A company comes into legal existence on the issue of a Certificate of Incorporation which is obtained when the company files a Memorandum and Articles of Association, completes a statement of the first directors and secretary and first registered office and a statutory declaration is lodged in relation to the formalities of creation of the company.

2.2 The Memorandum and Articles of Association sets out what the company is allowed to do and its constitution. The day to day regulations governing the management of the company, the operation of the powers of the company and the regulation of shareholders' rights between themselves are set out in the Articles of Association. This is in effect a contract between the members and the company and consideration should be given to the structure which is created at the outset. In particular thought should be given to how a quorum for shareholders and directors meetings has been established, restrictions on transfer of shares, the allotment of new shares and all other matters which determine the balance power and the ongoing relationship between the directors and the shareholders and the protection of minorities. Other salient points which should be given consideration are as follows:-

2.2.1 In the same way that the Partnership Act will apply for partners who do not contract to the contrary, Table A of the Companies Act provides a specimen set of rules which will automatically apply to any company save to the extent they are expressly dis-applied in the Articles of Association which the company adopts. Consideration should always be given to the provisions of Table A to see precisely what modification may be required. An obvious example of this is that under Table A the chairman of the company has a second or casting vote on a deadlock of votes at directors and shareholders meetings. In a 50/50 company it may not be appropriate for either party to have control and in the absence of any changes to these provisions in Table A control could be gifted by one party to the other.

2.3 There must be at least one director and a separate secretary and there is now only a requirement for one member of a company. Effectively a company can be and is often used as a vehicle for a "one man" operation in order to secure the advantages of limited liability for debts and also the ability to be able to raise new money through share issues and borrowing against the assets of the business.

2.4 A limited company has a requirement to file and publish audited accounts but tax on a company's profits is levied on the company itself. In a partnership the individual partners are responsible for their own tax.

3. Control Issues

3.1 In terms of Table A the company in general meeting (which in theory is the forum for ultimate control of the company) delegates day to day authority to manage the companies' affairs to its board of directors. In the absence of a Shareholders Agreement any party who is not on the Board of Directors may find themselves greatly removed from the company's operations. In order to allow a party who is merely a shareholder - or indeed a party who may also be on the board but does not have a level of shareholding which gives him actual power - to maintain control or involvement the participants in a new company will often enter into a Shareholders Agreement. This is a contract between the members themselves (and usually the company) in terms of which it is agreed that certain key decisions cannot be made without generally the unanimity of the parties involved regardless of who owns the most shares or any voting pacts which could be formed. These restrictions tend to be more focussed towards activities which are outwith the ordinary course of the company's trade. If the provisions for the Shareholders Agreement are breached then one member can sue the other member(s) as an individual for any loss which he has suffered. The ability to sue the other parties in the venture is a significant improvement on general company law where actions by members against the company are notoriously difficult and expensive to enforce. In addition a well drafted Shareholders Agreement will have reporting structures and allow the participants to receive regular financial information regardless of whether they have been appointed to the company's Board of Directors.

4. Shares

4.1 A company raises cash by issuing shares. A company has an authorised share capital which is created from time to time and this is the number of shares which the directors can be authorised to issue. While shares are normally issued for cash they can be issued for other forms of consideration provided that they are not issued for less than their nominal value (usually £1 although the shares could be divided into any denomination). Sometimes a greater amount is paid than the nominal value of shares to establish a share premium account.

4.2 New shares in a company are usually issued with reference to rights of pre-emption. These are special rules set out in the Articles of Association in terms of which the existing members of the company have a prior to right to subscribe for new shares before they are offered to third parties. This works by members being entitled to apply for shares pro rata to their existing shares in the capital of the company. Consideration will be given to special characteristics which can be given to shares when we turn to look at funding issues.

5. Powers of Directors

Subject always to matters which require the internal agreement of the parties themselves, to the outside world the directors are able to carry out powers which the company enjoys under its "objects clause" in its Memorandum of Association. This clause sets out a list of objects and powers with which the company was constituted. Any activity undertaken by directors outwith these powers is regarded as being "ultra vires" (beyond its powers) and any such contract would be void and could not be enforced against the company even if all of the shareholders had sought to ratify it. However a completed transaction will have absolute protection from the ultra vires rule and will be valid in respect of third parties involved in the transaction.

6. Key Features of Rights and Liabilities of Shareholders in a Company

6.1 Subject always to matters of contractual agreement and any shareholders agreement the rights of a shareholder are dependent on the sort of shares which he holds.

6.2 Certain shares carry the right to attend and vote at general meetings, certain shares can ignore such rights to vote and certain shares may or may not give specific rights to income. Very often these special rights are given to shares where they are issued as part of a funding exercise and it is appropriate for different categories of shares to exist for different types of participants in the company (ie., ordinary shares can be issued to those actively involved on a day to day basis and preference shares could be issued to an investor who is merely looking for a financial return over a given period).

6.3 It should be noted that 51% of voting shares carries a majority in general meeting (an ordinary resolution) and ultimately all key matters can be delegated to the company in general meeting. As a matter of law some important company decisions require a 75% majority (a special resolution). An example of this would be any subsequent change to the Company's Memorandum and Articles of Association. Importantly the right to appoint and remove a director is carried by a simple majority - which at least as a matter of company law between the members and the company cannot be contracted out of - albeit parties can contract between themselves that they will not exercise these powers

6.4 The most common other rights of shareholders are:-

6.4.1 To attend and vote at general meetings of the company one of which must be held at least every 15 months;

6.4.2 To receive a copy of the accounts of the company;

6.4.3 In many cases to vote for the re-election or the election of directors;

6.4.4 To receive a dividend (income) paid by the company on the shares. Payments of dividends require to be approved by the company's directors and are subject to the company having made "profits available for distribution". It is not automatic that the company can merely pay cash out and the company will have to be making a profit before an income return can be made to members. The division between ownership and control in terms of which owners receive a financial return regardless of their actual participation is one of the key distinctions of the limited liability structure.

7. Issue of Shares

7.1 It is common to obtain finance of a company's business by a further issue of shares which can either be issued to existing shareholders or to third parties (private investors and/or institutions) which is likely to be dependent upon first obtaining the consent of the existing shareholders. In a company's life the initial capital is usually provided by the participants themselves. There comes a point in the company's development in which it may have to look for external finance and may approach either a private investor or institutions or a combination of both to take new shares in its capital to fund the business as it goes forward.

7.2 Under the company's constitution there will be a structure in terms of which the directors are empowered to issue new shares and under which the issue of new shares will be regulated. This will usually be by reference to pre-emption rights in terms of which the existing shareholders are entitled to apply for new shares pro rata to their level of existing holdings of shares in the company before shares which are not taken up can be offered to a third party. As the company evolves the structure may have to be changed to create new classes of shares which will allow investors a suitable level of financial return and control but also leaves the running of the business to the parties holding the original equity stake as far as possible. It is the equity share capital of the company which has significant value on a sale or a listing.

8. Preference Shares

8.1 In attracting investment funding a company can create what are called "preference shares" to raise new capital. These are actually a hybrid of shares and debt and will require to be "created" under the company's Articles of Association with special rights attaching to both the income return which is expected and other controls which are required. Preference shares will usually carry a fixed rate of return in the same way that a bank will look for return on capital. This return is still linked to the company's ability to pay a dividend and can only be paid if the company is in profit. This return of income takes precedence over any dividend payable to the holders or ordinary shares and preference shares will have a prior right to the return of capital on any winding up. If this is not achievable it is common to find that the dividend becomes "cumulative" so that once the company does make profit then any past dividends which could not be met are made before any dividends are paid to the holders of ordinary shares. In addition to this interest is likely to accrue on dividends which are unpaid.

8.2 Preference shares can also be created as being redeemable which in effect sees a return on the capital investment being made after a period of time and the shares ceasing to exist on redemption. Shares can be redeemable at once or over a period of time and can be redeemed at a premium or at their par value. The ability for the funder to exit can be desirable from the company's point of view as preference shares are regarded as borrowings and impact adversely on a company's balance sheet. Investors may also look for a proportion of the equity share capital in addition to a preference share so that they also benefit from any uplift in the company's value.

8.3 Preference shares can be created with a great deal of flexibility and can include rights to participate in the profits of the company as well as or instead of a fixed dividend ie., as a percentage of the profits which the company makes. All dividends and redemptions payable in respect of preference shares (including arrears of dividend) will invariably rank prior to any payments and the ordinary shareholders who will receive nothing if there is not enough cash to go around.

9. Class Rights and Other Investor Protections

9.1 Investors in a company will invariably want to introduce restrictions which protect their investment and ensure that they are kept informed of material matters outwith the ordinary course of trade. This is usually achieved by two means. The first is a Subscription Agreement which is a contract detailing the precise terms on which the investment is being made. This document will include warranties to be given by the directors in relation to the trading performance and other operational matters of the company. In tandem with this new Articles of Association will invariably be adopted on the issue of preference shares. These "investee articles" will not only set out the financial returns attaching to new investment type shares but will also create what are called "class rights".

9.2 Class rights are separate consents which are required from each class of shareholder (or a majority of shares in that class - usually 75%) in relation to key constitutional and trading matters which will be specified in the Articles. Without these consents having been obtained from the holders of the class rights the company and its directors will not be legally permitted to carry out these matters. Class rights can be required in relation to the issue of new shares, the material disposal of the company's assets, the grant of share options for service contracts and any other restriction or matter requiring approval which the investors consider desirable.

10. Company Borrowings and Securities

10.1 A company is as we have seen either financed by monies subscribed for its share capital or by loans secured by their assets or otherwise or a combination of the two. All companies are invariably incorporated with the power to borrow money and grant security over their assets to secure borrowings.

10.2 Securities can be either fixed or floating the simplest being a fixed charge on heritable property. In England a fixed security can also be created over moveable assets ie., plant and equipment but under Scots Law this is not possible. In Scots Law security over land is taken by way of a Standard Security and this can be granted by any business which owns property whether incorporated or not. Any failure by the borrower to repay the loan or the interest on it may require a property which is charged to be sold and the proceeds applied exclusively for the settlement of this claim in priority to any other debts or obligations which rank after it.

10.3 The precedence of ranking between competing lenders is established either by the date of registration of the security (with the prior date of security taking preference) or more usually by a formal agreement between the various lenders to the company regulating this procedure which is called a Ranking Agreement. Under a Ranking Agreement the company's bankers will invariably look for prior ranking for their indebtedness before others are repaid. It should also be noted that where directors are owed money by the company they will usually be asked to sign letters of postponement by commercial lenders. The effect of this is that they cannot take the money back out of the company without the bank's permission or until such time as the bank has been paid off.

10.4 The ability of a limited company to grant a Floating Charge is one of the key characteristics which gives it an advantage over other trading structures. The principal characteristics of a Floating Charge are as follows:-

10.4.1 It is a charge on a class of assets or income both now and in the future;

10.4.2 Until such time as steps are taken by or on behalf of the chargeholder to enforce security the company is allowed to carry on its business in the ordinary course and dispose of all or any of its assets in the ordinary course of business without interruption.

10.4.3 When an action is taken by creditors to enforce a charge it is said to "crystallise" and whatever property is in ownership of the company at that time will fall under the charge subject to prior fixed charges and any prior ranking of Floating Charges. A Floating Charge is created by a formal deed being signed and registered at Companies House.

11. Off Balance Sheet Funding

11.1 As an alternative to raising finance by borrowings or issuing new share capital a company can look to advance by a strategic collaboration. This could involve a joint venture with an established business in terms of which by a combination of the ideas and expertise of the company and the presence in a desirable market of the existing player that a low cost means of expansion can be achieved.

11.2 The affairs of any joint venture are regulated by a special Joint Venture Agreement and a new limited company can be formed for the enterprise through which each participant will be involved in the venture and will realise a return in their investment or other form of individual.

11.3 Invariably the joint venture vehicle itself will require funding which can either be obtained from a bank or from the more established operator. Great care should be taken by the minority participant in a joint venture that the party "bank-rolling" the operation does not effectively take control by the back door through the advance of debt. In this circumstance from the minority participants point of view debt should be postponed behind the company's bank and should not be repayable on demand. Any security given in connection with the debt by the joint venture company to a participant would effectively give the party providing finance control by the back door. From their point of view they might argue that this is appropriate and that they want to keep control over their investment. As with all things this is simply a matter for negotiation in each case to see what is fair and/or achievable!