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Open versus Closed – Ownership of the Corporation

Terms:

Close Corporation:
A close corporation is a corporation whose ownership interests, i.e.the shares of the corporation, are not available for exchange on any public market. Shares of a close corporation may still be exchanged in private transactions, if such transactions are allowed. While the corporation may thus change hands, there is not much liquidity in the corporation. In close companies, the directors, officers, and majority shareholders are obliged to proceed with complete fairness in any transaction that affects the other shareholders. A privately held company is called a “close” company because its shares are “closely held”. In other words, they are held under the total control of the shareholder, without the ease of exchange provided by a public market.

Open Corporation:
An open corporation is a corporation whose ownership shares are available for exchange on a public market. The market on which the shares are traded may be an organized market such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), or the NASDAQ electronic marketplace (which is technically not an exchange, but serves a similar function). Alternatively, the shares might be exchanged in private, so-called “over-the-counter” (OTC) transactions. These transactions involve the shares of companies that are not listed on an exchange, but whose shares are still available for public trading.

Liquidity:
Liquidity can be thought of as the ease by which shareholders are able to exchange their interests in the company. A high liquidity means that the shares (or bonds, notes, etc.) can be easily sold and converted into cash. Conversely, low liquidity means that it is difficult to sell the holding. Typically, the most “liquid” companies are those that are public and traded on organized exchanges. Close companies with a small number of shareholders are considered to be highly illiquid investments.

Ownership of the Corporate Form

When working with a corporate client, you must be aware of the nature of the ownership of the corporation. This issue is fundamental for several reasons. While laws regarding the management and operation of both close and open corporations are generally the same, the treatment of the two forms of corporations by the courts can often be quite different.

What, then, is the difference between an open and a close corporation? The difference lies primarily in the way that ownership, by way of shares, is distributed. In a close corporation, shares of the corporation are generally held by only a small number of people and are not available for sale or purchase in the public markets. Conversely, an open (i.e. public) company is one where ownership of the corporation’s shares is widely distributed and those shares, more often than not, are also traded on some form of organized securities market (such as the New York Stock Exchange (NYSE) or via the Nasdaq electronic marketplace). We will be talking more about the nature and mechanisms of the securities markets later in Chapter VI.

EXAMPLE: After several years of successful operations, XYZ Corp. decides to sell its shares on the public markets. XYZ Corp. gets its finances in order and registers with the NYSE to sell its securities. After a successful first issue, and wide sale of its shares on the market, XYZ is now an open and publicly traded company.

At this point, we need to take a slightly closer look at how a company would choose whether to stay closed or to become “open” by publicly offering its shares. Additionally, we will consider how the courts and shareholders view these two variants of the corporate form.

The Open / Public Corporation

Virtually every major company that you are familiar with, be it Microsoft or Ford Motors, is a public company. That means that each one of those huge corporations has gone through a process whereby it has taken the ownership of the company, which was initially held by just a few people, such as those who worked for or financed the company, and allowed anyone with a few dollars to invest in that company. The process by which a company “goes public” (i.e. offers it shares for sale) is an arduous process which can include years of preparation and millions of dollars in expense. Why would these companies go through such a process?

The primary answer is a simple one…Money.

EXAMPLE: The Big Corp. decides that it would like to enter the cement manufacturing business. As its current lenders (banks) have already committed all their available funds for the year to other clients, Big Corp. decides to sell shares of its stock to individual investors in order to raise funds for the new business line. Upon the sale of those shares to a large number of people or over a public exchange, Big Corp. becomes a public company.

This reason can also be stated in terms slightly less brash:

“As a company grows and matures, it will eventually reach a point in its lifecycle whereby it will be forced to enter the markets either as an acquirer or a target. If the acquisitive path is chosen, then the company will require sufficient capital reserves to manage current operating overhead, continue to invest in internal research and development, and to enter transactions for the purpose of purchasing other assets and entering new markets.”

Either way that you state it, the result is the same. As a company gets bigger, its business operations and its chances of success are tied both to the current products and services it offers, and to reaching out to buy new companies or ideas that broaden the scope of the company’s offerings. The problem is that the company may not have sufficient funds on hand to operate the business it has at the same time that it buys the businesses it wants for its future. In such a case, many companies turn to the public securities markets as a means of raising the money (also known as “capital”) that they require to continue to expand. In essence, what the company is doing is selling investors a piece of the company as it is now, and the promise of the company as it will be once it carries out its plans of expansion and growth.

EXAMPLE: As an investor, Larry likes to invest in companies that have had steady earnings for at least five years and solid prospects for future growth. Larry notices that Uber Corp. is planning on issuing a new series of shares in order to finance its entry into the lucrative CD clock radio market. Larry sees that Uber has a strong track record and he likes the way the company is planning on selling its new radios. He buys shares in Uber on the basis of these past earnings and the potential for the company’s future.

Besides raising financing for future growth, placing shares in hands of the public also gives the corporation several other benefits. First, it is a “risk spreading” mechanism, meaning that as the shares of the company are sold into the market, those who originally owned the shares now have the ability to sell the shares that they own into that market. Thus, the people who work for the company and who might own some percentage of the company can, themselves, sell their shares on the market for cash. This feature of going public, known as adding liquidity to the company’s ownership, is a key consideration for entering the process.

On the other hand, there are some factors that weigh against going public. Perhaps the primary drawback to going public is that as members of the general public come to own part of the corporation, the directors and officers who run the corporation are now accountable to those public shareholders. Such accountability comes in many forms, but most important are the facts that 1) the company now must continue to make money on a recurring basis or explain why it has failed to do so and 2) the directors and officers now owe duties of care and loyalty – their fiduciary duties – to many more people. This, of course, increases their potential risk of exposure if they fail to act in the manner prescribed by law.

EXAMPLE: Teddy runs a midsized hat factory that has been experiencing stellar growth over the last 5 years due to the public’s desire for every new hat that Teddy produces. A group of bankers suggest that Teddy take the company public to capitalize on all the good will the market is likely to show him because of his success. Teddy, however, likes running the company without a lot of oversight from others. Because he likes to have full creative and business control, he decides to turn down the bankers’ advice.

The Close Corporation

The close, or privately held corporation is one where ownership of the corporation is held by a limited number of individuals or, on occasion, by other companies. See 8 Del. C. § 342. The shares of the company are not available to the general public for sale or exchange. As you might have guessed, the vast majority of corporations adopt and maintain the private form as it is not worth the time, effort, and expense for them to enter the public securities markets. In many cases, these corporations do not require the vast sums of capital that are necessary for the large scale acquisitions typical of public companies. Often, when capital is needed in the close corporation, it can be raised through bank loans, loans from individual investors, or other, similar, small-scale funding avenues.

For many companies, the close corporation is the ideal form because of the fact that it does concentrate ownership in the hands of a few individuals. In a close company, the holders of the corporation’s shares are often the actual employees or managers of the company itself, or people who are closely related (by family relation or financial interest) to those who run the company. As such, authority to make decisions regarding the management and operation of the private company is vested in only a few people, making it possible to make fast decisions about corporate strategy without having to respect the interests of a multitude of shareholders, as would be the case in a public company.

At the same time, the close corporation has a variety of disadvantages that result from the concentration of ownership in the hands of a few. First, while the company is more maneuverable, because of the fact that only a few people own the company, if those people happen to disagree with each other, the result may spell trouble for the company’s future. As there is no public market for the company’s stock, and the stock itself often contains restrictions and covenants on the transferability of ownership rights, a person trying to disentangle his or her interests from a close company will often face a difficult situation.

EXAMPLE: Shannon is thinking about investing in one of two companies that make video games for a new console that is coming out. One of the companies is a huge firm that has been around for years and is publicly traded on the Nasdaq. The other company is a start-up with no public shares but big potential. Shannon is a friend of the owner of the small company. He invites her personally to invest in the company. Shannon sees big potential for the small firm, but she is also worried that she will need to have cash on hand for when she goes back to school to get her master’s degree in video game design. As such, she decides to invest in the public firm to be sure that she can sell her shares when she needs the money back.

For a discussion of the laws applicable to close corporations, see George J. Seidel, Close Corporation Law: Michigan, Delaware and the Model Act, 11 Del. J. Corp. L. 383 (1987).

©2003 – 2015 National Paralegal College / National Juris University

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The C-corporation is the standard corporation, while the S-corporation has elected a special tax status with the IRS.

C-corporation, under United States federal income tax law, refers to any corporation that is taxed separately from its owners. A C corporation is distinguished from an S-corporation, which generally is not taxed separately.

The S-corporation is a corporation that has elected a special tax status with the IRS. It gets its name because it is defined in Subchapter S of the Internal Revenue Code.

A C corporation, under United States federal income tax law, refers to any corporation that is taxed separately from its owners. A C corporation is distinguished from an S-corporation, which generally is not taxed separately.