6.1 Stockholders’ Equity: Understanding Capital Accounts

So far, we’ve explored the basics of the balance sheet including  asset,  liability and owners’ equity accounts, along with components of the income statement like revenues and expenses.. Our main objective was to calculate net income using journal entries and T-accounts. In this chapter, we’ll get more specific and break equity down into multiple capital accounts, a term that represents ownership in an entity.

Capital accounts track how much of the business belongs to each owner. The total of all capital accounts always equals total assets minus total liabilities (remember the accounting equation, Assets = Liabilities + Owners’ Equity). This amount reflects what is referred to as residual interest of the owners if the entity were to liquidate, receive full value for its assets and pay off all liabilities. The residual interest would then be distributed to its owners based on a pro rata basis of ownership.

Capital accounts typically fall into three categories:

1. Contributed capital (i.e., Common Stock and Additional Paid-in Capital):  funds directly invested by owners.
2. Earned capital (i.e., Retained Earnings):  profits generated over time.
3. Other comprehensive income: equity changes from certain transactions that don’t flow through net income.

How these capital accounts are structured depends on the type of business entity: corporations, partnerships, sole proprietorships, or LLCs. In this section, we focus predominantly on corporations.

Contributed Capital and Distributions

When shareholders invest money in a corporation, the investment is recorded on the books. If shareholders pay cash, the corporation increases its cash (a debit), and simultaneously increases common stock (a credit) to show the ownership claim. If any of that money is later returned to the investor, the entries are reversed accordingly.

What if, in the meantime, the corporation took out loans, and the lender considered the original capital invested as part of their decision? This concern led to the creation of a concept known as the legal capital regime, a system developed by state legislatures to protect creditors.

Under this old system, each share of stock was assigned a par value (i.e., an arbitrary figure, maybe a penny or a dollar). When a shareholder invested in the company, their payment was split into two parts:

• Legal (or stated) capital, equal to the par value of the shares.
• Additional paid-in capital, which was the rest of their payment.

Crucially, corporations couldn’t sell shares below par value, nor could they return legal capital to shareholders. The idea was that creditors could count on that legal capital always being there.

Over time, though, people realized this framework was flawed. Par value had no real meaning given that it was whatever the corporation decided. And creditors don’t care how much was invested years ago; they care about whether the company can generate enough earnings and cash flow today.

Because of these problems, most states have scaled back or abandoned the legal capital rules. The Model Business Corporation Act (MBCA) was adopted in over 40 states which modernized the system, letting companies decide for themselves how to account for contributed capital. Still, a few states like Delaware hold on to parts of the old system, so it’s important to understand the basics.

Why Legal Capital Still Matters

Despite its decline, the legal capital regime still has legal implications in a few key areas:

1. Minimum Issuance Price: A corporation cannot legally issue stock for less than its par value. If it does, the resulting stock creates potential liability for shareholders—they might be on the hook to creditors for the shortfall, even though shareholders usually have limited liability.
2. Dividend Restrictions: Boards of directors can’t pay dividends or make certain shareholder distributions if doing so would reduce legal capital. This rule comes from the belief that legal capital serves as a buffer for creditors.
3. Acceptable Consideration for Shares: Traditional legal capital rules limited what could be accepted in exchange for shares—typically just cash or physical property. Promises to pay in the future or to perform services were often excluded. This stemmed from outdated views about what counts as “real” value.

Model Business Corporation Act: § 6.21 – Issuance of Shares

The Model Business Corporation Act, § 6.21 Issuance of Shares, states the following:

(a) The authority granted in this section to the board of directors may, if stated in the articles of incorporation, be reserved to the shareholders.

(b) The board of directors may approve the issuance of shares in exchange for any form of consideration, tangible or intangible, that benefits the corporation. This may include cash, promissory notes, services already performed, contracts for future services, or the corporation’s own securities.

(c) Prior to issuing shares, the board must determine that the consideration received or to be received is adequate. Once made, the board’s determination is conclusive with respect to whether the shares are validly issued, fully paid, and non-assessable.

(d) Once the corporation receives the authorized consideration, the corresponding shares are deemed fully paid and non-assessable.

Consideration

Specific to consideration, Section 6.21 does not require shares to have a par value so there is no set minimum issuance price. The section expressly allows shares to be issued in exchange for any form of tangible or intangible property or benefit to the corporation. This includes promissory notes, contracts for future services, and other non-cash assets.

The term “benefit” is broadly interpreted to include items like debt forgiveness, claim releases, or other intangible advantages. It is up to the board of directors to exercise sound business judgment in deciding what forms of consideration are appropriate. As long as the decision is made in good faith and with due care, it should not be second-guessed based on rigid or arbitrary criteria.

Board’s Role in Determination of Adequacy

The board’s responsibility to ensure that the corporation receives adequate consideration for issued shares is safeguarded by their general fiduciary duties. Often, the value of the property or benefit received may not be easily measurable. However, if the board reasonably concludes that issuing shares in exchange for such consideration is appropriate, that determination satisfies the requirements of Section 6.21.

A formal resolution specifically declaring the adequacy of consideration is not required. The board’s authorization of the issuance itself is sufficient to imply this determination. Additionally, the board is not obligated to assign a precise accounting value to the consideration received.

Section 6.21(c) establishes that the board’s judgment regarding the adequacy of consideration is conclusive for determining whether the shares are legally issued, fully paid, and non-assessable.

It is important to note, however, that valid issuance still depends on compliance with corporate procedures such as staying within authorized share limits and following proper notice and quorum requirements for board meetings.

Model Business Corporation Act: § 6.40 – Distributions to Shareholders

The Model Business Corporation Act, § 6.40 Issuance of Shares, states the following:

(a) A board of directors may authorize and the corporation may make distributions to its shareholders subject to restriction by the articles of incorporation and the limitation in subsection (c).

(c) No distribution may be made if, after giving it effect:

(1 ) the corporation would not be able to pay its debts as they become due in the usual course of business; or

(2) the corporation’s total assets would be less than the sum of its total liabilities plus (unless the articles of incorporation permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution.

 (d) The board of directors may base a determination that a distribution is not prohibited under subsection (c) either on financial statements prepared on the basis of accounting practices and principles that are reasonable in the circumstances or on a fair valuation or other method that is reasonable in the circumstances.

Overview

Section 6.40 establishes a single, consistent standard for evaluating all corporate distributions. Under the Model Act, “distributions” are broadly defined to include transfers of cash or other assets (excluding the corporation’s own shares) made to shareholders based on their ownership of shares. Common examples include cash or property dividends, share repurchases by the corporation, and distributions of promissory notes or debt. Although the Act does not rely on the traditional concept of “surplus,” it imposes limits on distributions using both an equity insolvency test and a balance sheet test.

Equity Insolvency Test

In the majority of cases where a corporation is operating normally as a going concern, it will generally be clear from available financial information that no special evaluation of the equity insolvency test under Section 6.40(c)(1) is necessary. While balance sheets and income statements alone are not determinative under this test, the presence of substantial shareholders’ equity and routine business operations typically indicate that no issues arise under the standard. For corporations with regularly audited financial statements, the absence of a “going concern” qualification in the latest auditor’s report along with no significant adverse developments since, will usually be sufficient evidence of compliance.

However, when there are signs of financial difficulty or uncertainty about the corporation’s liquidity or ongoing operations, the board of directors,  officers or advisors on whom they rely, may need to assess the situation more closely. Because the equity insolvency test involves a broader judgment about financial health, no strict, objective rule is provided. 

 If the corporation faces known or potential contingent liabilities, it is appropriate to make reasonable estimates regarding the likelihood, timing, and magnitude of any recovery against the corporation taking into account available insurance or other protections. In some situations, conducting a cash flow analysis based on a forward-looking business plan and budget may help determine whether the corporation can reasonably meet its obligations as they mature.

In making these determinations, directors may rely on reports, statements, opinions, and analyses prepared by others. Generally, they are not expected to engage directly in the underlying technical details, market data, or economic projections relevant to such assessments.

Balance Sheet Test

The balance sheet test under the Model Business Corporation Act (MBCA), Section 6.40(c)(2), is a legal standard used by a corporation’s board of directors to determine whether a proposed distribution (like dividends, share buybacks, or other payments to shareholders) is financially permissible. The purpose of this test is to protect creditors and the financial integrity of the corporation by ensuring that the corporation remains solvent after the distribution.

Under Section 6.40(c)(2), a distribution may not be made if, after the distribution, the corporation’s total assets would be less than the sum of its:

1. 1. Total liabilities, and
   2. The amount needed to satisfy preferential rights of shareholders (if the corporation were liquidated) whose rights are superior to those receiving the distribution.

The balance sheet test requires that, after a distribution, the corporation’s assets must be greater than its liabilities plus any liquidation preferences. The board has broad discretion to use reasonable valuation methods suited to the situation and can rely on internal and external support to justify their determination.

Summary

Even though most states no longer rely on traditional legal capital rules, the core ideas behind them still matter. Rules about not selling shares below par value, limiting certain payouts to shareholders, and making sure shares are paid for with real value continue to shape how corporations operate. The Model Business Corporation Act gives boards more flexibility to decide what counts as fair payment for shares and when it’s safe to make distributions. Still, boards must act responsibly and follow proper procedures. Understanding the history and purpose of legal capital helps ensure good decision-making and protects both creditors and shareholders.

Homework 6.1: Legal Capital & MBCA Applications