Author: TheLawStudent

Types of market

TheLawStudent

When you are trying to understand the status quo of a business, a key factor is the nature of the market in which it operates, in particular, you will be interested in the number of competitors and therefore the level of competition it can expect.

Some common classifications are set out below.

Monopoly

A market form in which there is only one business undertaking, meaning that there are no competitors. Within the UK, the Competition and Markets Authority tries to guard against abuses of monopolies.

Oligopoly

A market in which there are only a few (perhaps three of four) major competitors, which control the vast majority of the market. The small number of sellers makes it easier for any particular business to be more aware of what the other players in the market are doing. Price fixing is often seen in this type of market. This is where key players collude to set prices. They can set prices high, because there is nowhere else where consumers can then go to get a lower price. Alternatively, perhaps two providers will collude together to set prices low in order to push out other players and then raise their prices to recoup their losses. This is known as predatory pricing.

Monopolistic Competition

In this scenario, there are many competing businesses and consumers in the market and, because products are differentiated between businesses, there is more than just a price consideration between products. In the short run, firms may have a monopoly on their products but in the longer run, because there are usually low barriers to entry, other providers may step in to their market.

Oligopsony

This is quite a specific type of market form but one which you are likely to come across if you work within the farming sector, where there are many suppliers, such as cocoa, tobacco or cattle farmers but they have only a few possible buyers to which that they can sell. In the case of cocoa, there are only three major buyers which sell the cocoa beans on to chocolate makers.

When you are trying to understand a business, it is very useful to understand the market form that it operates within as it will provide you with an idea of how competitive its sector is and therefore what conditions it operates within.

SWOT analysis

TheLawStudent

Another way of examining a business’ ‘status quo’ is to look at its internal and external risks and opportunities as they currently stand. A classic yet simple way of doing this is through a SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis, which provides a systematic way of doing so.

As an example of the SWOT analysis approach, we will consider Walmart, the multinational supermarket chain.

Strengths

A business’ strengths are those factors which make it somehow ‘better’ or potentially better than the competition. These may also be labelled ‘competitive advantages‘. Walmart’s strengths include:

  • exceptional buying power, due to its size relative to the competition;
  • considered to be a very good employer, helping with recruitment and retention of top quality staff; and
  • strong reputation based on a wide range of products at affordable prices.

Weaknesses

A business’ weaknesses are those factors which somehow place the business at a disadvantage relative to other companies operating in the same market. Walmart’s weaknesses include:

  • it may be a global company but its business is focused in particular countries, such as the UK and US, meaning that it does not have market domination in many of the rapidly growing countries such as China and India;
  • it has a very bad reputation for corporate social responsibility, despite considerable efforts in this field. Documentaries such as ‘Walmart: The High Cost of Low Price’ mean that it is seen as an unethical trader, reducing its brand value; and
  • it is so big that it may be difficult to react quickly to rapid changes in the market, leaving it exposed.

Opportunities

Opportunities exist external to the business and are chances to increase sales or profits within the wider environment. Walmart’s opportunities include:

  • mergers or acquisitions with companies in areas such as China or India to increase market share quickly; and
  • the trend for smaller, local branches of supermarkets in the US and UK is something which Walmart has not yet exploited but where there is a potential for money to be made.

Threats

Threats also exist external to the business and are things which could cause problems. These may also be labelled as ‘competitive disadvantages’. For Walmart, these include:

  • continuing bad reputation for corporate social responsibility means that Walmart needs to be very careful not to expose itself to bad publicity with regard to this;
  • intense price competition between Walmart and other supermarkets or suppliers could reduce Walmart’s profit margins significantly; and
  • the growing costs of food which are being experienced across the world may also reduce Walmart’s profit margins.

Once a business has undertaken a SWOT analysis, those involved will have a much better idea of its current status. This analysis will feed into the process of creating strategic options, allowing the business to capitalise on opportunities and competitive advantages and mitigate where possible the weaknesses and threats.

The Business Life Cycle

TheLawStudent

Every business is likely to go through a whole life cycle, from set-up to shutdown. Understanding what stage a business is at in this life cycle will help you to know what their opportunities and challenges may be.

Stages in the business life cycle

Incorporation

All new business ventures start with an idea. An entrepreneur might have an idea about starting a brand new business in order to launch a new product or service. Examples of this would be James Dyson’s idea of a new type of vacuum cleaner or the launch of Facebook by Harvard students. Alternatively, an idea may come from a pre-existing business that wants to head in a new direction, bringing something fresh to the market. Whenever a business begins its life the people with the ideas for that business must decide which business medium to use i.e. sole trader, partnership, limited liability partnership or company. If it is decided that the new business should be operated through a company then the first stage will be to incorporate that company.

Raising Money

If a business chooses to incorporate, it can begin to trade as a company once it has been incorporated. Early in the growth cycle the business will need to raise money to begin its life because it will need to buy the resources needed in order to start to sell its products or services. For some businesses, set-up costs will be low, for example setting up a recruitment consultancy requires very little to get started. For others, for example beginning a brand new chain of restaurants, there will be very high set-up costs associated with recruiting staff, fitting out restaurants and marketing the restaurants to ensure that people come to eat there.

There are two main ways in which a company can raise money, firstly through the issue of shares known as equity finance. This is where the company issues shares in exchange for cash. The shareholders will therefore own a stake in the company and will expect to receive dividends (income) on their shares and a capital return (i.e. a gain over and above what they originally paid for the shares) if and when they sell their shares. Shares could be offered publicly, to friends or colleagues, or even sold to venture capitalists such as 3i. Venture capitalists tend to invest in high-risk start-ups which they believe will offer a high return on investment if they are successful.

The second way a company can raise capital is through debt finance. This is where a company borrows money and in return promises to repay that loan plus interest. A lender, such as a bank, will usually insist on taking some form of security over assets from the company which, through security enforcement processes, will help it to receive back as much of its money as possible if the company defaults on the loan payment or if the company breaches the loan agreement.

Expansion

Successful businesses often want to grow. A business can do this organically, by increasing sales and profit through natural growth of its own business. Expanding the range of products or services or widening the target market can both be effective strategies for natural or organic growth.

A business can also grow acquisitively. If the company buys a competitor, perhaps to gain its customer list and therefore its market share, this is known as horizontal integration. In the 2000s, there were a significant number of horizontal integrations in the pharmaceutical sector, for example between Glaxo Wellcome Plc. and Smithkline Beecham Plc., which subsequently became GlaxoSmithKline Plc. Alternatively the successful business might acquire a business which is part of its supply chain; either a supplier or a distributor. This process can be referred to as vertical integration, an example of which is the takeover by the wholesaler Booker of Budgens and Londis grocery chains.

Insolvency

Finally, if things do not go to plan, the last stage in a company’s life cycle may be insolvency. This is where an insolvency process is commenced in circumstances where the company is not able to pay its debts. Over the past few years there have been a number of high profile insolvencies in the travel and retail sectors, such as Thomas Cook in September 2019, Debenhams, which went into administration in April 2020 and Arcadia Group (owners of brands such as Topshop, Dorothy Perkins, Burton and Miss Selfridge) in November 2020.

Why does this matter to a lawyer?

If you can understand where in the business life cycle the business you are working with is positioned, you will have a better understanding of the types of opportunities and threats they are facing. For example, a company that is teetering on the brink of insolvency will have a very different range of concerns to one which has just been offered a £10 million equity investment by a venture capitalist to develop a new business idea.

Business Law and Practice

TheLawStudent

Introduction to business law and practice

Over the next few posts, I am going to focus on the LPC module on Business Law and Practice (BLP). The BLP module covers a number of areas of legislation, the primary of which is the CA 2006. The CA 2006 represented the biggest overhaul of UK company law since the Companies Act 1985.

The Government’s aim was to simplify, and to introduce more flexibility into, the law. The CA 2006 is intended to make it easier to set up and run a private company. In addition, the Government intended that the CA 2006 should “promote shareholder engagement and a long-term investment culture”.

The key areas of reform in the CA 2006 include:

  • statutory statement of directors’ duties;
  • statutory control of directors;
  • widening of shareholder remedies;
  • simplification of shareholder meetings and resolutions;
  • greater use of electronic communications; and
  • simplification of the rules concerning share capital and its maintenance.

Another key area of reform was company constitution, by which I mean the company’s rule book. CA 2006 sets out the minimum rules and the constitution of a company can then apply more rigid or detailed systems of management. An integral part of a company’s constitution is its Articles of Association (‘Articles’). The Articles form a contract between the company and the shareholders (and, to an extent, between the shareholders themselves). The Articles govern the rules of their relationship and determine the company’s internal management. Essentially, the Articles set out how the company must be run. The CA 2006 provides a precedent set of Articles called the Model Articles (the CA 1985 equivalent was called Table A). A company can choose its Articles but a company incorporated under the CA 2006 will automatically have the Model Articles unless it chooses otherwise.

Company Procedure

Decisions are made on behalf of a company by its directors (board resolutions taken at board meetings) and shareholders (ordinary or special resolutions taken by shareholders at general meetings or passed by written resolution). Company procedure is a fundamental part of the BLP module and an area that we will focus on the law relating to.

Consolidated accounts

TheLawStudent

Companies with one or more subsidiaries are required to publish accounts for the group of companies as a whole as well as their own annual accounts (s.399 CA 2006). This is because (subject to certain exemptions) shareholders of the parent company should have access to some information regarding the subsidiary company. In principle, every subsidiary in the group also has a duty to prepare its own individual accounts, but exemptions are widely available so it is likely to be rare in practice for subsidiaries to do so (ss.394A and 479A CA 2006).

In this post, I discuss the concept of consolidated accounts at a high level, without considering the rules in any detail.

The consolidated Profit and Loss Account

In consolidated accounts, the Profit and Loss Account of the parent company and its subsidiaries are brought together (see the third column in the example below).

The Profit and Loss Account of the parent company (column 1 above) will include dividends paid to it by the subsidiary but not the subsidiary’s profits. Such dividends and any intra group trading that has taken place between the subsidiary and the parent company are excluded from the consolidated Profit and Loss Account (column 3 above).

There is one further factor to consider if the subsidiary is not wholly owned (i.e. if there is a third-party minority interest in the subsidiary). In this scenario, the entire profit for the parent company and its subsidiaries will be shown in the group accounts – then the minority interest’s share is deducted.

The consolidated Balance Sheet

The Balance Sheets of each company in the group will be amalgamated and the only issued share capital represented on the consolidated Balance Sheet (column 3) will be that of the parent company.

The Balance Sheet of the parent company will include the share capital of the subsidiary as a long-term investment, at cost. The subsidiary in this example has no subsidiary of its own and so shows no long term investment in its Balance Sheet (Column 2).

The assets of the subsidiary must however be added to the assets of the parent and represented in the consolidated Balance Sheet accordingly. After a subsidiary has been acquired, its profits are included in the consolidated Profit and Loss Account.

What if the subsidiary is not wholly owned? The total assets and liabilities of the companies in the group are shown, along with the minority interest’s share in those assets and liabilities as a deduction.

Company owned investments

TheLawStudent

Companies can own investments in exactly the same way as a natural person would, for example, a company may have subsidiaries or own a portfolio of shares in other companies. These are assets.

  1. If investments are held for the long term, they should be shown in the Balance Sheet as a non-current asset.
  2. If investments are held only for the short term, with the intention of selling them in the fairly near future, they should be shown in the Balance Sheet as a current asset.

Income from investments (i.e. dividends received by a company) is shown in the Profit and Loss Account.

‘Writing down’ investments

Investments are usually shown at cost (without impairment). If their value falls, however, they should be ‘written down’ to their new, lower value. This will involve the following adjustments to the accounts:

  1. reduction in the value of the asset in the Balance Sheet by the amount of the decrease in value; and
  2. reduction in value to be treated as an expense in the Profit and Loss Account (‘impairment of investments’).

These adjustments have the following effect:

  • the increase in the expenses reduces the profit for the year at the bottom of the Profit and Loss Account to the same extent; and
  • the reduction in size of the ‘Profit for the year’ figure which is carried across to the SoCiE causes a similar reduction in the size of Retained Earnings (profit and loss carried forward) in the Balance Sheet, thus maintaining the balance.

Bonus issue of shares

TheLawStudent

A ‘bonus issue’ of shares is also known as a ‘capitalisation issue’ or ‘scrip
issue’.

A company may decide to convert some of its reserves into share capital by issuing fully paid shares to existing shareholders on a pro rata basis for no consideration; in other words, shareholders do not have to pay for the bonus shares. ‘Pro rata’ means that the proportion of shares held by each shareholder pre- and post-bonus issue will not change, and therefore the proportions of voting rights will also remain the same.

Shares that are issued pro rata are often expressed by way of a ratio, i.e. x:y, where x is the amount of shares issued to the shareholder for every amount of shares (y) they currently hold.

This process does not raise any money for the company, but rather the company will use its reserves to fund the issue. A company may use its retained earnings or its share premium account to fund a bonus issue (s.610(3) CA 2006).

The assets and liabilities of the company are unchanged after the bonus issue.

Revenue reserves and dividends

TheLawStudent

Retained Earnings

‘Retained earnings’ is the reserve account for retained profits.

The retained earnings represent profits after tax earned by the company over its history and not distributed by way of dividend or appropriated to another reserve. It generally increases from year to year as most companies do not distribute all of their profits.

Statement of Changes in Equity

For company accounts, profit for the year is not carried over directly from the Profit and Loss Account to the bottom half of the Balance Sheet. Instead, it is carried over into a separate calculation, the Statement of Changes in Equity (the ‘SoCiE’).

Dividends

Dividends are paid or payable out of profits generated in the current or previous accounting periods. Any company can make a distribution (e.g. a dividend) provided that it has ‘profits available for the purpose’ (s.830(1) CA 2006). It is only after the financial statements have been completed that the profits generated in a given accounting period can finally be determined.

In ALCIE terminology, dividends are recorded in a capital account as they are transactions between the business and its owner(s). For this reason, dividends do not belong on a Profit and Loss account. When a company declares a dividend, this will show up in the SoCiE.

Ordinary Shares

There are two types of dividend that can be paid on ordinary shares; a final or an interim dividend. Both are calculated in exactly the same way, the only difference between the two being that:

  1. the final dividend is declared after the year end and paid some time thereafter; and
  2. the interim dividend is paid during, and in respect of, the current accounting period.

Final dividend

The size of the final dividend is declared by the company’s directors in the Directors’ Report, and approved by the company’s shareholders by ordinary resolution, typically passed at the Annual General Meeting (AGM) if the company has one.

If the directors have recommended a final dividend, but the shareholders have not yet approved it, the dividend is called a proposed dividend. A proposed dividend does not constitute a debt enforceable by the relevant shareholders until it is approved i.e. declared by an ordinary resolution of the shareholders. Therefore, any final dividend which is proposed but which has not been approved will not appear in the accounts of that accounting period.

Example:

A company with an accounting period of a year ending on 31 December 2020 wishes to pay a final dividend in respect of that accounting period. The directors of the company tell you that the final dividend will be approved by an ordinary resolution of the shareholders at a general meeting which is due to take place in March 2021. If the final dividend is declared by ordinary resolution at the general meeting, it will appear in the accounts for the period ending 31 December 2021.

A final dividend that has been approved by the shareholders is called a declared dividend. A declared dividend constitutes a debt of the company enforceable by the relevant shareholders. A declared dividend will be taken into account in the SoCiE, as a deduction in calculating the Retained Earnings (profit and loss carried forward) which will appear in the bottom half of the Balance Sheet.

If the declared dividend has not yet been paid to shareholders by the time the accounts for that year have been prepared, it will appear in the Balance Sheet at the end of the year in which it was declared (as part of ‘current liabilities’). It will also be taken into account in the SoCiE at that year-end.

A declared dividend which has been paid to shareholders before that year end will only be taken into account in the SoCiE.

Interim dividend

The articles of a company normally give the directors the power to decide to pay interim dividends. Interim dividends can therefore be paid without the need for an ordinary resolution of the shareholders. Any board resolution to pay an interim dividend may be rescinded before the interim dividend is paid, so an unpaid interim dividend is not a debt that the shareholders are legally entitled to sue upon.

For this reason, the accounting treatment of interim dividends is different to the treatment of final dividends. Interim dividends will only be reflected in a company’s accounts if they have actually been paid. When an interim dividend has been paid in any year the amount of the dividend will have been deducted from the assets, i.e. cash and cash equivalents, and will be shown as an item on the trial balance. A dividend is an allocation of profit and not an expense of the company so it will not be shown in the Profit and Loss Account. The interim dividend will be taken into account in the SoCiE (in this respect, interim dividends are treated the same as declared (and paid) dividends).

Any profits after tax not paid to shareholders as dividends are retained in the company.

Preference shares

Preference dividends are usually paid in two instalments each year. Because of the nature of preference shares, the amount of the dividend will already be known each year.

Example:

A company which has issued 200,000 non-redeemable non-cumulative 6% preference shares of £1 each pays an annual dividend of 6 pence on each preference share (subject to there being sufficient profits to do so). If part of that dividend has already been paid to preference shareholders as an interim dividend in any year, that part will not appear on the top half of the company’s Balance Sheet for the relevant year. However, it will appear as a deduction in the SoCiE to calculate the Retained Earnings in the bottom half of the Balance Sheet. The remainder of the preference dividend is declared by the shareholders, and though paid after the year end, will appear in the SoCiE to calculate retained earnings and be shown as a Current liability in the top half of the Balance Sheet.

Legal treatment of dividends for ordinary shares

It is important to understand the differences between the legal and accounting treatment of dividends, based on the type of dividend and its status. These are summarised in the table below

  Legal treatment Accounting treatment
Final dividend – proposed Not a legal debt, cannot be enforced by shareholders. Dividend does not appear in the company accounts.
Final dividend – declared, but not paid Legal debt enforceable by shareholders. Dividend will be taken into account in the SoCiE at the end of the accounting period in which it is declared. In the unlikely event that the dividend has been declared but not paid as at the date of the Balance Sheet, it will also appear in the Balance Sheet as part of ‘Current liabilities’.
Final dividend – declared and paid Legal debt enforceable by shareholders. The assets of the company will have been reduced by the amount of the dividend and the dividend will feature as an item in the trial balance. The dividend will be taken into account in the SoCiE at the end of the accounting period in which it is declared and will impact on the Retained Earnings (profit and loss carried forward) in the Balance Sheet.
Interim dividend – declared and paid The interim dividend becomes a legal debt once it has been paid to the shareholders. The assets of the company will have been reduced by the amount of the dividend and the dividend will feature as an item in the trial balance. The dividend will be taken into account in the SoCiE at the end of the accounting period in which it is paid and will impact on the Retained Earnings (profit and loss carried forward) in the Balance Sheet.

 

Share capital and reserves

TheLawStudent

Called up share capital

The share capital account tells the reader the aggregate amount that has been ‘called up’ (i.e. the amount of the nominal value of its shares that the company has required its shareholders to pay) on each class of issued shares, not including any premium. This called up value may, or may not, be the same as the aggregate of the nominal value of the issued shares, for example, if they are not fully paid. It is relatively rare to encounter shares which are not fully paid up.

Example:

A newly-incorporated company has issued 300,000 ordinary shares of £1, and has called up 75p per share. The value of the called up share capital in the company’s Balance Sheet will therefore be £225,000.

Reserves

Reserves can be described as the capital of the company in excess of the called up value of the issued share capital. Reserves can be split into two categories:

  • capital reserves (e.g. share premium account, revaluation reserve, capital redemption reserve), which I will discuss below; and
  • revenue reserves (e.g. retained earnings), which I will discuss in a future post.

Broadly speaking, assets representing the capital reserves cannot be distributed by way of dividend or other payment to shareholders. However, revenue reserves are distributable reserves and therefore, assets representing such reserves can be distributed to shareholders in the form of dividends.

Share premium account

The share premium account represents the difference between the nominal value of the shares and the amount that the shareholders actually paid for the shares i.e. the subscription price (if greater). N.B. The market price of the shares, once they have been issued, has no bearing at all on the company’s accounts and so, if their market price goes up or down, the share premium account will remain unaltered.

The share premium account is a capital reserve. Assets representing it therefore cannot be distributed to shareholders, except in exceptional circumstances such as a bonus issue or on a buyback of shares.

Revaluation reserve

A revaluation reserve is created when a company’s directors, as a matter of accounting policy, wish to show more up to date values of non-current assets in the accounts. For example, the value of its real property portfolio may have increased, and so the company re-values the assets in question to their current value.

The increase in the value of the asset in the Balance Sheet causes the figure for Net Assets to rise correspondingly i.e. in simple terms, the top half of the Balance Sheet has increased. It is therefore necessary to make a corresponding change to the bottom half of the Balance Sheet. This is achieved by creating or increasing an existing revaluation reserve by the same value.

The revaluation reserve represents a notional profit to the company from the rise in value of the asset. This profit is, however, unrealised until the asset is sold, and as such it is a capital reserve and is not distributable as a dividend until the company sells the asset and realises the profit (s.830(2) CA 2006).

Any subsequent reduction in a re-valued asset’s value can be set off against the revaluation reserve.

Capital redemption reserve

A capital redemption reserve can only be created as a consequence of a transaction between the company and its shareholders under detailed provisions of the Companies Act 2006 such as, for example, a buyback of shares out of a company’s capital. Such transactions are relatively unusual and do not form part of the course of everyday business for any company.