2.3  The Capital of the AG	53

Collective Minority Rights of Stockholders

Collective minority rights are ‘rights’ in the sense that they confer a legal position which grants an option on action to the minority stockholder(s), and ‘collective’in the sense that they do not arise from holding a single stock but require a certain participation threshold. A stockholder who wishes to exercise such a ‘collective’ right must, therefore, fulfill the respective participation quota by heror himself, i.e. hold enough stocks, or act in concert with other stockholders to fulfill the quota. Some collective minority rights are listed in Table 2.1.76

2.3  The Capital of the AG

2.3.1  Equity and Capital Structure

Corporate growth requires capital and this is true in particular for theAG, as it is the typical business vehicle for large enterprises. With regard to the origin of financial funds, two sources of capital can be distinguished: internal and external financing.

2.3.1.1  Internal Financing

The company may use its profits as a source of capital for new investments instead of distributing the profits to the stockholder. This so-called internal financing of the company may include various measures, inter alia amortization, the building of reserves (e.g. pension reserves), the retention of earnings or the sale of tangible corporate assets. Internal financing has several advantages, such as being a quick way to raise funds while avoiding control procedures required by banks, and saving interest rates. However, internal financing is typically limited in volume.77 Furthermore, an emphasis on internal financing may lead to conflicts with certain interest groups, e.g. a decision on the retention of profits may collide with the interest of the stockholders to receive dividends. In any case, internal financing often lacks sufficient flexibility both in time and volume to match market circumstances and, last but not least, may also have negative tax effects.78

2.3.1.2  External Financing

As an alternative to internal financing, the AG may obtain ‘fresh money’, i.e. raise funds from sources outside of the company (so-called external financing). With regard to external financing one may distinguish between debt financing, equity financing and mezzanine financing:

76  For a comprehensive table see Wirth et al. 2010, pp. 161 et seq.

77  Of course, external financing is limited as well—both in theory and in practice. It is, however, safe to assume that there is more money available outside the company than within it.

78  While, e.g., interest on debt capital constitutes business expenditures and may be deducted from taxable income (see Secs. 4, 4a Income Taxation Act, EStG), the income resulting from a sale of tangible assets may be subject to taxation itself.

54	2  Stock Corporation (AG)

Debt financing basically means borrowing money. In return for granting a loan, the creditor receives the promise that the principal and interest on the debt will be repaid. The interest rate to be paid typically includes the so-called ‘market rate of interest’ plus a risk premium depending—inter alia—on the following factors: the borrower (start-up vs. well-established company), certain collaterals used to secure the debt (secured vs. unsecured debt), the maturity of the loan (short-term vs. longterm) and the volume of the loan (low volume vs. high volume).Apart from specific loan agreements (such as bilateral or syndicated loans), common types of debt financing are bonds, mortgages and promissory notes.

When making use of equity financing, the company tries to raise capital from its stockholders.79 This can be achieved either by additional share capital contributions of its existing stockholders or by admitting new, additional stockholders to the company, which will then have to pay their share capital contributions.

The so-called mezzanine financing refers to specific financial instruments which are a hybrid of debt and equity financing.80 Mezzanine financing comprises subordinated debts or preferred equity instruments which represent a claim on a company’s assets only senior to that of the common shares. Because mezzanine capital is subordinated to debt provided by senior lenders it is treated like equity on the company’s balance sheet, making it easier to obtain further debt financing. On the other hand, mezzanine debt holders will ask for higher rates of return (approximately 14–30% above the ordinary interest rate) in order to be compensated for the additional risk. Because of these higher costs mezzanine instruments are used primarily for temporarily filling in financial gaps, especially when financing M&A transactions.

2.3.1.3  Determining the Right Capital Structure

In planning and designing the capital structure of a company, i.e. the combination of various tools of internal and external financing and, in particular, those of equity instruments and debt and mezzanine instruments, many aspects are to be considered.81 Debt financing, for example, can be a powerful and flexible tool to finance the company’s assets. Debt obligations are limited to the loan repayment period, after which the lender has no further claims. Furthermore, by repaying the debt on time the company may improve its credit rating, thereby enhancing its chances for future fundraising. Furthermore, since interest on debt can be deducted from taxable income, debt financing my also create some tax benefits. The primary advantage of debt financing, however, is that it allows the shareholders to fully retain their

79  In finance the term ‘equity’ refers to the subjective value of an ownership interest in property, i.e. the amount of money someone is willing to pay for a property minus any attached liability.

80  The financial term “mezzanine” derives from the architectural term ‘mezzanine’ (from ital. ‘mezzo’for ‘half’) for an intermediate floor between two main floors of a building.

81  Economic research suggests that given an ideal market, the source of financing employed by a company will have no influence on its corporate value (so-called Modigliani-Miller theorem). Reality, however, is not a perfect market but suffers heavily from information asymmetries, agency costs, bankruptcy costs and—of course—taxes.