Nature of a Private Limited Company
Creative Pty Ltd is a private limited company with a maximum number of five directors who are tasked with the administration and management of the company. The company has in the past been performing well and thus making huge profits (Brigham, Ehrhardt, Nason & Gessaroli, 2016). However, the directors of the company would want to see the company continuing to operate indefinitely. They are therefore contemplating on obtaining some finance help in securing the enterprise. Such an action is attributed to the fact that, if the firm does not get adequate money in the next few months, the directors will be unable to pay a variety of costs such as equipment, rent, and other primary research facilities.
During the formation of such a company, there are certain rules which must be adhered to. For instance, the minimum required a number of shareholders are two while the maximum is up to 200. Also, there is the minimum number of directors required, and according to the companies act, the minimum number of directors required should be two. However, the maximum can be seven who will be appointed by the first two directors who initiated the company (Means, 2017). Additionally, there is typically no limit to the minimum amount of capital which is to be contributed by each of the pioneers of the company. Apart from that, the shares in the private company cannot be easily transferred without seeking the opinion of the other shareholders of the company. It, therefore, means that the shares cannot be sold to the public by the shareholders in a bid to raise capital (Brigham et al., 2016).
According to Light (2015), the other rule is on the liability of the members of the company such that the shareholders have limited liability. When the company is faced with any loss due to an occurrence of any particular event, then each of the shareholders is liable hence they are forced to sell their assets to pay for the loss. However, the individual assets of the shareholders are usually to sell to pay off the loss. Such liability is based on the amount of shares held by each of the shareholders. Another rule is on the minimum subscription, where the shares of a private limited company can be traded and hence allotted to the public before such a minimum subscription has been received. Additionally, all the private companies must use the word private limited after its name and failure to which such a company may be deregistered.
Rules for Private Limited Companies
A private company can issue stock except that the shares cannot be traded in the public. Also, the shares cannot, therefore, be issued via an initial public offering, and this is because they are less liquid thus difficult to value. Creative Pty Ltd, therefore, can issue its shares though it cannot be traded in the public arena. There are key advantages and disadvantages associated with the withholding of shares in a company, and this is as discussed below;
The rate of inflation is considered as the rate at which the prices of particular items are increasing the economy. Typically the purchasing power decreases when the inflation rate is above the returns earned on investment and savings (Marra, 2016). When shares are held by a company, the amount of money grows faster compared to inflation and this results in an increase in the purchasing power of individuals in the economy.
The holding of shares by a company usually lead to large returns. The period of holding shares by a particular company provides the time to take advantage of the long-term stock trends. It also gives shareholders the time to check for the periods of poor stock performance (Pyles, 2014).
According to Marra (2016), holding of stock for long-term leads to low returns on interest including the regular income and this is in comparison with the taxes on returns on stock investments. When shares are held, the short-term capital gains tax rate will not be paid, and hence the company will typically evade paying for such a tax.
When a dividend paying share is held, it results in a stream of income, and this is primarily when the share will be issued, and it performs well in the market. Also, the dividend paying share can be used to purchase certain additional shares of stock to the company.
The holding of shares has a variety of limitations. For instance, it results in a risk of price decline in the shares which leads to loss of value and an entire loss to a particular company. The other disadvantage is that there is likely to be high costs associated with the holding of the shares by the company, for instance, the purchase cost and carrying cost (Pyles, 2014). Further, the holding of shares in a company typically leads to the risk of obsolescence such that the shares will lose value in the market and hence they will be charged at a price which is below their fair value. It also results in low profits being obtained by a company since they may be issued in the market at a time when there is inflation, and this reduces their fair value in the long run.
Issuing Shares for a Private Limited Company
There are a variety of rules which apply to a variety of forms of financing. The two types of financing, that is, debt and equity have different rules pertaining to each of them. For debt financing, the business support infrastructure and bankruptcy regulation which will typically enhance a company’s ability to obtain loans. Further, there are rules relating to the elimination of bias aimed at getting finance through debt. The rules are categorized into two that is the anti-abuse rule and reclassification rule.
Reclassification Rule
Nas (2016), argues that the reclassification rule is usually used in the reclassification of various financial instruments and this is based on the economic substance and substance over form principles. Such rules help in the identification of whether a particular financial instrument is a debt or equity form of financing.
Anti-bias Rule
Under the anti-bias rule, the rate of interest should be paid together with the loans offered to a particular company or even individual, and this has to be at an arm’s length (Nas, 2016). However the rate of interest is not at an arm’s length, it is non-deductible.
Earnings Stripping Rules
The earnings stripping rule entails the limitation of the interest to be deducted on the finance, and this is usually in reference to the amount of earnings of the borrower (Buchanan, 2014). The rule, therefore, deducts interests on the basis of earnings before interest, taxes, and amortization.
Thin Capitalization Rule
Under the rule, a maximum debt to equity ratio is developed. When the interest on the debt is above the maximum ratio, it is not deducted when computing amount of tax to be paid by the borrower of the finance (Means, 2017). However at times the amount of debt to equity ratio allowable varies depending on the prevailing economic situation.
The rule is typically applied in circumstances in which a specific transaction in a capital structure has been used to replace an outstanding equity instrument usually with a debt instrument. There is usually an excessive interest deduction on loan issued to the borrower.
There are certain requirements for debt financing, for instance, there has to be collateral attached to obtain the capital (Niskanen, 2017). Various financial institutions often look at a variety of elements such as the use of proceeds, capitalization table, business plan and projected and historical finances. Based on the above rules, Harry should get the approval of the other directors on the type of financing it should select. The type of finance should be such that it will enable the operations of the company to continue indefinitely.
Advantages of Holding Shares
According to Pyles (2014), the directors of a company have various duties and responsibilities according to the law. They should, therefore, take the necessary measures to ensure that the creditors do not suffer any financial losses in case of a company’s insolvency. A situation of insolvency is critical for any company, and hence the directors are expected to be aware of the existing financial situation of the company. There are a variety of risks that the directors are exposed in case of insolvency. For instance, there will be compulsory liquidation of the company leading to the disqualification of the directors in charge (Lam, 2014). The disqualification could be when it is identified that there were events of antecedent transactions such as the sale of assets at less price and awarding of high salary even though a company is in financial problem. The other risk is that the directors will be held personally responsible and hence their personal property will be used to pay for the amount lost. Such a situation may leave them bankrupt.
The directors will also be faced with the risk of reversal of asset disposal. The above situation arises when the court of law requires that the asset disposed of is void and hence it has to be restored back to the company. When the asset is restored to the company, it will be sold for the benefit of the creditors (Knechel & Salterio, 2016). When the directors become bankrupt, and the bank realizes that they have become insolvent after providing security for a loan, they will consider it as a breach of the covenant. Such a breach of covenant allows the bank to seize the assets provided as collateral. The suppliers may place certain terms and conditions which entail the transfer of ownership clause (Gitman, Juchau & Flanagan, 2015). Such a clause allows them to remain with the ownership of the goods before full payment has been made. Additionally, the directors will lose control of the administration of the company once it has been liquidated.
According to Brigham et al., (2016), the director of a company can also be subjected to criminal charges and sometimes end up being imprisoned in the event of dishonesty by the director. According to the provisions in the corporations’ act, a director can be exposed to the risk of civil penalties and such penalties may be up to $100,000.The other key insolvency risk to the directors can be the compensation proceedings laid against them, and this should be in regards to the exact amount lost by the creditors. Such a compensation proceeding may be initiated by the creditor or the liquidator. The compensation to be paid can result in the personal bankruptcy of a particular director.
Disadvantages of Holding Shares
The key steps that Harry and his fellow directors should take to protect themselves against the insolvent trading liability entail the use of safe harbor. The safe harbor according to Australia’s insolvency law enables the directors to be only liable for debts which were incurred during the insolvency of the company (Stout & Blair, 2017). Also, according to the law, the course of action taken by directors must be assessed to determine whether it would have resulted in the better outcome rather than an immediate liquidation. Harry and his fellow directors can therefore still have control of the company irrespective of the financial problem and take the right steps to revive the company.
According to Williams (2015), the other key step which the directors can take would entail seeking of legal advice from an independent solicitor in relation to the insolvency on certain key issues such as, creditors meeting protocols, public examinations, directors and officers’ insurance rights and personal guarantee obligations. Further, the directors should obtain independent legal advice from an independent lawyer for confidential advice on the matter. The advice, however, should not be in conflict with the key objectives of the company. Lastly, Harry and his fellow directors can use the directors’ defenses which are based on the Insolvency Law Reform Act 2016 (Kraakman & Armour, 2017). For instance, they may defend themselves that they undertook every necessary step to prevent the company from being insolvent.
The other defense is that they have a reasonable reason to suspect that the company is solvent and will be solvent for a particular period of time (Du Plessis & Rühmkorf, 2015). Another defense is that the directors took a course of action which would result in better performance of the company. The directors who are found to be liable for the insolvent adding can also be relieved from the liability if they can display that they relied on information relating the company’s financial position and affairs provided to them by another competent individual such as an advisor or even another director.
Another way they can be relieved occurs when they can prove that they had every reason to believe that the firm would still continue with its operations irrespective of the debt which had been borrowed.Additionally,the directors can protect themselves from the insolvency trading liability by showing that they had prevented the debt from being incurred after insolvency by taking the necessary steps (Huggins, Simnett & Hargovan, 2015).Lastly, the directors can be defended from the insolvency trading liability by indicating that they were never involved in the management and administration of the firm during the time which the debt was incurred by providing good reasons such as ill health.
References
Brigham, E. F., Ehrhardt, M. C., Nason, R. R., & Gessaroli, J. (2016). Financial Managment: Theory And Practice, Canadian Edition. Nelson Education.
Buchanan, J. M. (2014). Public finance in democratic process: Fiscal institutions and individual choice. UNC Press Books.
Du Plessis, J., & Rühmkorf, A. (2015). New trends regarding sustainability and integrated reporting for companies: what protection do directors have?.
Gitman, L. J., Juchau, R., & Flanagan, J. (2015). Principles of managerial finance. Pearson Higher Education AU.
Huggins, A., Simnett, R., & Hargovan, A. (2015). Integrated reporting and directors’ concerns about personal liability exposure: Law reform options. Company and Securities Law Journal, 33, 176-195.
Knechel, W. R., & Salterio, S. E. (2016). Auditing: Assurance and risk. Routledge.
Kraakman, R., & Armour, J. (2017). The anatomy of corporate law: A comparative and functional approach. Oxford University Press.
Lam, J. (2014). Enterprise risk management: from incentives to controls. John Wiley & Sons.
Light, R. S. (Ed.). (2015). Structuring venture capital, private equity, and entrepreneurial transactions. Wolters Kluwer Law & Business.
Marra, A. (2016). The Pros and Cons of Fair Value Accounting in a Globalized Economy: A Never Ending Debate. Journal of Accounting, Auditing & Finance, 31(4), 582-591.
Means, G. (2017). The modern corporation and private property. Routledge.
Nas, T. F. (2016). Cost-benefit analysis: Theory and application. Lexington Books.
Niskanen, J. (2017). Bureaucracy and representative government. Routledge.
Pyles, M. K. (2014). Capital Structure: Sell It Off!. In Applied Corporate Finance (pp. 159-190). Springer, New York, NY.
Stout, L. A., & Blair, M. M. (2017). A team production theory of corporate law. In Corporate Governance (pp. 169-250). Gower.
Williams, R. (2015). What Can We Expect to Gain from Reforming the Insolvent Trading Remedy?. The Modern Law Review, 78(1), 55-84.
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