Level I CORPORATE ISSUERS

of the CORPORATE STRUCTURES AND OWNERSHIP

CFA® Program
Learning Outcome Statements

LOS : Compare business structures and describe key features of corporate

issuers.
LOS : Compare public and private companies.
LOS : Compare the financial claims and motivations of lenders.
LOS: Compare business structures and describe key features of corporate issuers.

Business Structures

Describes how a business is organized, influencing day-to-day operations.

Determined by four factors:
Legal identity: The legal relationship between the owner(s) and the
business.
Business liability: The level of liability an individual assumes due to a
business's actions or debts. The levels of liability can be described as
limited or unlimited.
Owner-operator relationship: The relationship between the business's
owners and the management.
Taxation: Tax regime applicable to a business structure.
LOS: Compare business structures and describe key features of corporate issuers.

Types of Business Structures

1 Sole Proprietorship (Sole Trader)

Owner raises the business capital and fully controls the business operations.
Features:
The owner operates it.
Do not have a legal identity – considered as an extension of the owner.
The owner keeps all the financial returns and bears all risks.
Profits generated are taxed as personal income.
Simple and flexible to operate.
Financing is solely from the owner.
Business growth depends on the financial ability and risk appetite of
the owner.
LOS: Compare business structures and describe key features of corporate issuers.

2 General Partnership
Have at least two owners (partners) whose roles and responsibilities are stated in
the partnership agreement.
Features:
Operated by the partners.
Has no legal identity – ownership is set in the partnership agreement.
Business risks and business liability are shared by the partners.
Business returns are shared by the partners, and profits are taxed like
personal income.
Capital and expertise are contributed by the partners.
Business growth depends on the ability of the partners to finance and the
level of their risk appetite.
Have two types of partners:
a) The general partner(s) (GP) has (have) unlimited liability and is (are)
responsible for managing the business.
b) Limited partners (LPs) have limited liability.
LOS: Compare business structures and describe key features of corporate issuers.

2 General Partnership
LPs earn a lower share of profit than the general partners, given the managerial
position of GP in the business.
Examples: Private equity funds and hedge funds.
Features:
Capital contributions and expertise are provided by the partners.
GP manages the business and has unlimited liability.
LPs do not have business control and have limited liability.
All partners are entitled to a share in returns, where profits are taxed as
personal income.
Business growth depends on the financial capabilities of the GPs and LPs,
risk appetite, and the competence and integrity of the GP(s).
No legal identity – the partnership agreement regulates ownership.
LOS: Compare business structures and describe key features of corporate issuers.

3 General Partnership (Limited Liability)

An advanced type of limited partnership.
Owners have limited liability.
Corporation has higher access to capital and expertise, which facilitates quick growth.
A corporation has different names depending on the jurisdiction:
UK: Limited company.
US: Limited liability company (LLC).
Examples: Regional stock exchanges and national or multinational conglomerates.
Features:
A corporation is a separate legal entity.
Dividends (distributions) paid to the owners are taxed as personal income.
Corporations have unlimited opportunities to access capital, hence unlimited capital
potential.
Owner-operator separation allows for higher and diverse resourcing with significant
risk control.
In some countries, shareholders are tax disadvantaged due to double taxation of
corporate profits and dividends.
Business risk is shared across multiple owners.
LOS: Compare business structures and describe key features of corporate issuers.

Types of Corporations

1. Nonprofits

Established with a purpose, such as promoting public health, religious

benefits, or charitable missions, are usually not driven by profits.
Similar to for-profits: They have a board of directors and can have paid
employees.
In contrast to for-profits: They lack shareholders and do not pay dividends.
Moreover, nonprofits do not pay taxes.
Can generate profits when they are managed well, which are reinvested
back into the mission of the corporation.
Examples: Harvard University and Asian Development Bank.
LOS: Compare business structures and describe key features of corporate issuers.

2. Public and Private For-Profits

Engages in legal business to make profits for the owners.

Can be private or public, depending on the number of shareholders (in
some countries), whether the corporation is listed on a stock exchange, and
other factors.
For example, the stocks of for-profit are listed on an exchange; in
contrast, private for-profit companies do not trade on exchange but
through buyer-seller agreements.

More on Corporations
A corporation is formed by filing articles of incorporation
to a regulatory authority.
Legal Identity of Hence considered a legal entity separate and unique
a Corporation from the owners.
Being separate legal identity implies that a corporation
has the rights and responsibilities of an individual.
LOS: Compare business structures and describe key features of corporate issuers.

The business owners and managers are separated.

Business owners are excluded from the company’s
day-to-day operations.
Owners elect a board of directors to run the business;
then, the board hires the CEO and other senior leaders to
oversee the day-to-day operations of the corporation.
Owner-Operator
Separation of a Board of directors should conduct business that
Corporation aligns with the owner's interest and consider the
interests of other stakeholders such as employees
and creditors.
Owner-operator separation of a corporation allows the
corporations to access capital financing easily.
Owners can leverage greater resources to run the
business since capital is the only requirement for
someone to become one of the owners.
LOS: Compare business structures and describe key features of corporate issuers.

Risks in a corporation are shared across all owners, but

owners have limited liability.
Maximum loss owners can incur is their investment
amount into the business.
Business Returns are shared by the owners through equity
Liability of a claims proportional to their respective shares.
Corporation No contractual obligation for the repayment of the
ownership claim.
Owners have a residual claim on the corporation’s
cash flows and assets after liabilities have been
settled.
LOS: Compare business structures and describe key features of corporate issuers.

Corporations access capital financing from capital providers –

individuals and entities willing to finance the company in return
for the company's issued securities.
Two types of Capital financing:
Capital Financing
of a Corporation I. Ownership capital (equity): Money invested by the
and Types of owners of the corporation in return for the ownership of
the company (they become shareholders).
Capital Providers
II. Borrowed capital (debt): Money borrowed from the
lenders (bondholders).
Examples of capital providers: Corporations, individuals, and
governments.
Corporations are subject to the tax authority and tax codes
outlining the issuer's tax reporting, payment, and status.
Tax regimes on corporations vary with country.
Taxation of a Majority of the countries: Corporations experience double
Corporation taxation of corporate profits (corporations are taxed
directly on their profits, and shareholders taxed on their
dividends).
Some countries: Shareholders are not taxed if the
corporations had initially paid taxes on the dividends
distributed.
 LOS: Compare public and private companies

Public and Private Corporations

A corporation can be regarded as private or public, determined by the following factors:
1. Issuance of shares

Public Companies
Issue additional shares in the capital markets to raise huge amounts of capital
from investors who then trade among themselves in the secondary market.

Private Companies
Invite investors to purchase the company's shares through a private placement
memorandum (PPM) (also called offering memorandum).
Document that describes the business, the terms of the offering, and the risks
involved in investing in the company.
Private securities are typically unregulated.
Accredited investors may only be invited to purchase the shares.
Accredited investors are sophisticated investors with a high-risk appetite to the
extent that regulatory oversight and protection are unnecessary – they must
have a particular level of income or a certain level of professional experience.
 LOS: Compare public and private companies

2. Exchange Listing and Share Ownership Transfer

Public Companies
Shares are listed and traded on an exchange.
Allows owners of the company to be easily transferred since buyers
and sellers transact directly with each other in the secondary market.
Each transaction between a buyer and seller causes a change in share
price hence the value of companies over time.
Effect of significant news about the company or the overall economy
can affect the value of the shares.
Value of equity (market capitalization) of a listed public company:
𝐌𝐚𝐫𝐤𝐞𝐭 c𝐚𝐩𝐢𝐭𝐚𝐥𝐢𝐳𝐚𝐭𝐢𝐨𝐧 = 𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬
= 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐬𝐭𝐨𝐜𝐤 𝐩𝐫𝐢𝐜𝐞 × 𝐓𝐨𝐭𝐚𝐥 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠
Market capitalization is the theoretical amount an investor would pay to
own the entire company.
 LOS: Compare public and private companies

2. Exchange Listing and Share Ownership Transfer

Premium may be added over market capitalization to woo the shareholders

into acquisition.
Investors are also interested in the enterprise value of a public company.
Enterprise value.
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐯𝐚𝐥𝐮𝐞 = 𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬 + 𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 d𝐞𝐛𝐭
− 𝐂𝐚𝐬𝐡
Enterprise value gives a better value of cost to own a company that is free and
clear of all debt.
Private Companies
Shares are not listed on an exchange.
No noticeable valuation or price transparency, making it difficult to buy and
sell the shares.
If the owner of the private company wants to sell the shares, they will have to
find a willing buyer and then agree on the price.
 LOS: Compare public and private companies

3. Registration and Disclosure Requirements

Public Companies
Obligated to register with a regulatory authority.
Subject to greater compliance and reporting requirements. For instance, the
Securities and Exchange Commission (SEC) regulates US public companies.
Must disclose certain information, such as a stock transaction made by
directors.
Disclosed documents are made public for investors and analysts to gauge the
risks that might affect the company's business strategy and profit generation
or meeting its financial obligations.

Private Companies
Not subject to the same level of regulatory authority as public companies.
However, some pertinent rules such as filing tax returns and prohibitions
against fraud are still applicable.
Have no obligation to disclose particular information to the public BUT can
disclose important information directly to their investors
LOS: Compare public and private companies

Going from Private to Public Company

A private company can go public in three ways:

1. Initial Public Offering (IPO)

1.A private company that meets certain listing requirements

required by the exchange completes an IPO.
An IPO involves an investment bank that underwrites the
sale of new or existing shares.
If it goes through, the company is public, and thus its shares
are traded on an exchange.
Proceeds from an IPO go to the issuing company, which can then
use the fundd to capitalize on other investments.
LOS: Compare public and private companies

2. Direct Listing (DL)

Unlike an IPO, it does not involve an underwriter, and no new capital

is raised.
A company is listed on an exchange where the existing
shareholders sell the shares.
Beneficial in that it is fast and cost-effective.

3. Acquisition

A private company may go public when acquired by a large public

company.
Another way is through a special purpose acquisition company
(SPAC) – a public company that specializes in acquiring an
unspecified company in the future ("blank check" company).
 LOS: Compare public and private companies

How do SPACs operate?

SPACs raise capital through an IPO, where proceeds are put in a trust account.
Money in the trust account can only be distributed to complete the
acquisition or can be returned to the investors after a finite time has
elapsed.
Investors in SPACs do not know what the SPAC will buy, but they can speculate
from the backgrounds of the SPAC's executives or comments on social media.
When the SPAC finalizes the purchase of the private company, the company goes
public.

Life Cycle of Corporations

Whether a company is public or private can be determined by identifying the stage

of its life cycle.
The typical life of a company goes from start-up to growth, to maturity, then to
decline.
LOS: Compare public and private companies

Start-up

The company is nothing less than an idea and a business plan initially funded
by the founders, and if there is a need for more capital, family and friends may
buy ownership or provide loans.
Business risk is extremely high (hence financing is difficult).
The company lacks revenues, and cash flows are negative.
More capital may be required as the company grows.
Founders may seek help from an investment banker to raise capital from
venture capitalists (series A investors), usually private equity or debt
investors.
LOS: Compare public and private companies

Growth
More capital is required, and the revenue and cash flows may be increasing,
with moderate business risk.
The company is not yet profitable and thus cannot rely on internally generated
income to facilitate growth.
Might seek capital from the series B and series C capital providers or
consider going public via an IPO if it meets the requirements and the
owners are willing to let go of the ownership.
LOS: Compare public and private companies

Maturity
The need for external funding decreases, and the business risk is less.
The company is profitable with positive and predictable revenues and cash
flows.
Can internally fund its growth using retained earnings.
The company has a high potential to borrow money at favorable terms from
the private or public market
Cash flows are more predictable, and the operations are "business-as-
usual" (BAU).
LOS: Compare public and private companies

Decline
The need for external financing is decreasing.
The company may be trying to salvage itself by developing new lines of
business or acquiring companies that are growing significantly.
Business risk is increasing.
Financing difficulty is increasing.
As the company is trying to reinvent itself, it may need additional capital,
but the costs might be higher, given the declining cash flows.
LOS: Compare public and private companies

Going from Public Company to Private Company

Occurs when investors (or group of investors) purchase all company shares and
then delist it from the exchange.
This can happen through two methods: leveraged buyout (LBO) or managed
buyout (MBO).
Both LBO and MBO involve borrowing capital to finance the acquisition.
The difference between LBO and MBO comes with the relationship between the
investors buying the company and the acquired company.
In an LBO, the investors are not affiliated with the company.
In an MBO, the buying investors are part of the management of the
acquired company.
Privatization typically occurs when the investors feel the company shares are
undervalued in the public market and that the financing costs of the acquisition
is significantly low and attractive.
LOS: Compare public and private companies

Trends in Public and Private Companies

Emerging economies: The number of public companies is increasing because

there are higher growth rates and the transition from closed to open market
structures.
Developed economies: The number of private companies is increasing (and
intuitively decreasing public companies) due to:
I. Significantly due to mergers and acquisitions.
II. Many private companies prefer to be private for easy accessibility of
capital from the private market.
Avoid regulatory hampers and associated costs.
III. Discourage the short-term focus most investors in public companies
have.
Privatization offers flexibility and fruitful decision-making to
business leadership.
LOS: Compare the financial claims and motivations of lenders

Lenders and Owners of a Company

Lenders (debt financiers) and owners (equity financiers) have different binding
contracts with a company.

Debtholders must be fully paid before distributions are made to the

owners (equity holders).

Equity holders are residual claimants to the company.

All other stakeholders, such as employees and suppliers, must be paid

before the equity holders.
LOS: Compare the financial claims and motivations of lenders

Equity and Debt Risk-Return Profiles

Investor Perspective: Equity holders

The maximum loss that equity holders can incur is capped at their investment
amount in the company.
Gain if the share prices increase in futures.
No limit on the gains to an equity holder if the company succeeds.
Gains in terms of distributions from the company and residual claim after a
profitable corporation settles its obligations
Risks: Investment risk is higher for the equity holders than bondholders.
Stocks are riskier for investors since no contractual obligation is set to
distribute to the shareholders or repay the capital investment.
Equity holders may lose entire investments if the company goes bankrupt.
 LOS: Compare the financial claims and motivations of lenders

Risk-Return Profile of an Equity Holder

Equity Investment Gain/Loss

Equity holders are
interested in the
Unlimited continuous
upside maximization of
the company's net
value.
0
Lose Translates
equity directly to their
investment shareholder
share values.
Future
value
Value of Value of issued of firm
issued debt debt + equity
LOS: Compare the financial claims and motivations of lenders

Investor Perspective: Bondholders

Have fixed priority claims on a company through contractually promised

interest payments and return of the principal amount.
Do not receive more than promised interest payments when a company
becomes profitable.
Upside gains: Capped at the interest payments plus the principal.
Downside losses: If a company falls below the book value of the debt.
Risks: Investment risk is lower for bondholders than equity holders.
When a company is financially healthy, bondholders are assured of their
returns since the company can easily service the loan or has sufficient
assets that serve as collateral.
 LOS: Compare the financial claims and motivations of lenders

Risk-Return Profile of a Bondholder In contrast to equity

holders, bondholders have
Debt investment recourse opportunities
when a company is in
gain/loss
financial distress.
Use the contractual
agreement to force
the issuer to liquidate
assets to repay their
Limited debt.
Limited upside
downside to Note: Bondholders
0 debt could lose their
entire investment
Lose Future too.
debt value Bondholders are keener on
investment Value of Value of of firm the default risk of the
issued issued debt company and its ability to
debt + equity meet debt obligations.
LOS: Compare the financial claims and motivations of lenders

Debt soundness of a company is determined by:

I. Issuer's creditworthiness and willingness to repay debt.
II. Issuer's cash flow and quality of collateral.
III. Issuer’s probability of default and amount of loss given default.

Risk-Return Profile: Issuer Perspective

Corporations prefer debt capital over equity capital.

Cost of debt is lower than that of equity capital, and the return to the
lenders is capped.
Equity capital dilutes ownership and is only appropriate when the
issuer's cash flows are absent or unpredictable.
Bonds are riskier than shares since it involves contractual agreements which
must be honored.
Bondholders elevate the risk to the corporation by increasing leverage.
LOS: Compare the financial claims and motivations of lenders

Conflicts of Interest between Bondholders and Equity Holders

Since shareholders' loss is capped at their respective initial investment amount and
return potential is unlimited.
Shareholders refer a company's management to invest in areas with high
calculated risks and potential returns.
Potential return for the bondholders is limited to the face value of the bond and the
coupon payments, and they do not receive any benefits from the risky investment
decisions of the company.
Bondholders prefer a company to invest in less risky projects with certain cash
flows, however small, to secure timely interest and principal repayments.
Bondholders cannot control a company's investment decisions, but they can use
covenants.
Learning Outcome Statements

LOS : Compare business structures and describe key features of corporate

issuers.
LOS : Compare public and private companies.
LOS : Compare the financial claims and motivations of lenders.