Corporate Finance: Stock, Securities, Dividends, and Distributions

Equity and Debt Securities; Authorized, Issued, and Outstanding Shares

A corporation raises capital by issuing securities, which fall into two broad categories. Equity securities (stock) represent ownership interests and give the holder a residual claim on the corporation's assets and earnings. Debt securities — bonds (secured), debentures (unsecured), and notes — represent creditor claims: the holder is owed a fixed sum with interest and ranks ahead of shareholders in liquidation but has no ownership or voting rights.

The fundamental distinction matters for priority (creditors are paid before shareholders), for tax (interest is deductible to the corporation; dividends are not), and for control (debt holders ordinarily do not vote).

Within equity, common stock is the baseline ownership unit: common shareholders generally have voting rights, the right to dividends when declared, and the residual right to assets on dissolution after creditors and preferred shareholders are paid. Preferred stock carries a preference — typically a fixed dividend preference (paid before common dividends) and/or a liquidation preference (paid before common on dissolution). Preferred dividends may be cumulative (unpaid preferred dividends accumulate as arrearages that must be paid before any common dividend) or noncumulative.

Stock can also be participating (sharing again with common after the preference), convertible (into common), or redeemable. The corporation's share structure is tracked through three terms: authorized shares (the maximum number the articles permit the corporation to issue), issued shares (those actually sold or distributed), and outstanding shares (issued shares currently held by shareholders, excluding treasury shares the corporation has reacquired). Only outstanding shares vote and receive dividends. To issue more shares than authorized, the corporation must amend its articles.

Issuance of Stock and Lawful Consideration

When a corporation issues stock, it sells previously unissued (or treasury) shares, typically pursuant to a subscription agreement — a promise to buy shares. A pre-incorporation subscription is, under many statutes including California's, irrevocable for a period (often six months) unless the agreement provides otherwise or all subscribers consent, reflecting the corporation's reliance in forming. Once the board accepts subscriptions and issues shares, the subscriber becomes a shareholder.

The central rule is that shares must be issued for valid consideration. Historically, statutes restricted consideration to money, tangible property, and services already performed, barring promissory notes and future services as consideration because those gave the corporation no present value. Modern statutes have liberalized this.

California Corporations Code §409 permits consideration to consist of any tangible or intangible property or benefit to the corporation, including money paid, labor done, services actually rendered, debts or securities cancelled, and tangible or intangible property actually received — and California, following the modern view, allows even promissory notes and contracts for future services in defined circumstances, though such shares may be placed in escrow until performance.

When shares are issued for valid consideration of at least the par value (where par exists), they are fully paid and nonassessable, meaning the corporation cannot later demand more from the holder. Par value is a nominal minimum issue price stated in the articles; issuing par stock for less than par creates watered stock, and the shareholder (and sometimes a knowing director) is liable to the corporation or its creditors for the water — the difference between par and the consideration actually paid.

Most modern corporations issue no-par stock to avoid watered-stock liability, with the board setting the consideration. The board's good-faith determination of the value of non-cash consideration is generally conclusive absent fraud.

Preemptive Rights and Protection Against Dilution

When a corporation issues new shares, existing shareholders face dilution — their proportional ownership and voting power shrink as the total number of shares grows. Preemptive rights address this by giving existing shareholders the right of first refusal to purchase a proportional part of any new issuance, allowing them to maintain their percentage ownership before the shares are offered to outsiders. For example, a shareholder owning 10% of the outstanding stock would have the right to buy 10% of a new issuance.

The critical modern rule is that preemptive rights do not exist by default. Under the modern approach reflected in California Corporations Code provisions and the Model Business Corporation Act, preemptive rights exist only if expressly granted in the articles of incorporation ("opt-in"). This reverses the older common-law presumption that preemptive rights existed automatically.

Even where granted, preemptive rights are subject to important exceptions: they typically do not apply to shares issued for non-cash consideration (such as property or services), shares issued as compensation to directors, officers, or employees, shares issued within a short period after incorporation (the initial capitalization), shares issued to satisfy conversion or option rights, or treasury shares being reissued — because in those situations the purpose of maintaining proportional cash-investment parity does not apply or applying the right would frustrate a legitimate corporate transaction.

A shareholder who wishes to preserve voting control in a close corporation should therefore insist that preemptive rights be written into the articles, since the statutory default will not supply them. Where preemptive rights are wrongfully denied, the shareholder may seek an injunction against the issuance or damages for the dilution suffered.

Dividends, Distributions, and Directors' Liability

A distribution is any transfer of cash or property by the corporation to its shareholders with respect to their shares — most commonly a dividend, but also a repurchase or redemption of shares. The decision whether to declare a dividend rests in the board's discretion and is protected by the business judgment rule; courts will not compel a dividend absent bad faith or abuse of discretion (the rare case where directors withhold dividends to oppress minority shareholders or for an improper personal motive).

Once lawfully declared, a cash dividend becomes a debt of the corporation that shareholders can enforce.

The board's discretion is bounded by statutory solvency limits designed to protect creditors from having corporate assets distributed away.

California Corporations Code §500 sets a distinctive two-track test: a distribution to shareholders is permitted only if either (1) the amount of retained earnings immediately before the distribution equals or exceeds the amount of the proposed distribution (the retained earnings test);

or (2) immediately after the distribution, the corporation's total assets would be at least equal to a specified multiple of its total liabilities (historically 1¼ times liabilities, excluding certain items) and its current assets would at least equal its current liabilities (the balance-sheet/liquidity test).

In all events, under §501 a distribution is prohibited if the corporation is or would thereby be rendered unable to pay its debts as they become due (the equity insolvency test). Directors who vote for or assent to an unlawful distribution are personally liable to the corporation for the unlawful amount (with contribution among them), and shareholders who receive a distribution knowing it was unlawful — or received when the corporation was insolvent — may be compelled to return it.

Dividends are paid out of the legally available funds; preferred dividend preferences and any cumulative arrearages must be honored before common dividends.