What is a corporation?

Formally speaking, a corporation is nothing but an abstraction to which we assign rights and duties. It exists independently of humans in the sense that it has indefinite life, and its assets and obligations are legally separate from those of any humans involved in its founding or administration. Today in the United States, anyone—a single individual, group, or another corporation or other entity—can create a corporation in a day for a couple hundred dollars in registration fees (e.g., using incorporate.com).

The corporate abstraction is an extraordinarily useful and widely used device for organizing relationships between various people and different assets. Most importantly, a group of people can pool their assets by transferring them to a corporation that will act as a single contracting interface with third parties (and with the owners among themselves, for that matter). Or a single person can set up multiple corporations to hold different assets and to enter into contracts relating to those assets. You can and should, therefore, also think of the corporation as a contracting technology. It facilitates contracting by partitioning and pooling assets.

Of course, being an abstraction rather than a real person, the corporation cannot exercise its rights, discharge its duties, or consume its profits by itself. Human beings must act on its behalf and ultimately consume its profits, if any. Humans can be involved directly, or through a chain of corporations (e.g., corporation A’s sole shareholder is corporation B, whose shareholders are human beings). The basic default governance is simple: (common) shareholders elect the board of directors (cf. DGCL 211(b)), which formally manages the corporation (DGCL 141(a)), mostly by appointing the chief executive officer and other top management (cf. DGCL 142(a)), who in turn act on behalf of the corporation in day-to-day matters. As to consuming the profits, the board may decide to distribute available funds to shareholders—or not (cf. DGCL 170(a)). By default, each share confers one vote and the right to equal distributions per share (cf. DGCL 212(a) – the more shares you own, the more votes you have and the more of any distribution you get. Corporate law fills in the details: what if the board is unfaithful to shareholder interest? What if shareholders have divergent interests? Are there any other interests to be taken into account?

Technically, the corporation is not the only abstraction available for asset pooling and partitioning. There are variants such as the limited liability company (LLC) that have all or most of the features discussed here, and are subject to very similar rules. From the perspective of this introductory course, the differences are minor, and hence not covered.

What the corporation is not

The corporation is not a person like a human being. To be sure, we sometimes refer to corporations as “legal persons” (cf. 1 U.S.C. §1). But you should realize that this is just legalistic shorthand to emphasize the fact that a corporation can be the object and subject of legal claims. It does not mean that a corporation is a person in the sense that it has the same rights and obligations as human beings. Or have you ever heard of a corporation being drafted into military service? Or invoking a human right not to be tortured? As Chief Justice Roberts quipped in an opinion denying that AT&T could suffer “an unwarranted invasion of personal privacy” (FCC v. AT&T, 131 S.Ct. 1177, 1185 (2011)): “We trust that AT&T will not take it personally.”

The corporation is also not the same as a business. A corporation may “own” a business, but they are not the same thing. A business is a collection of assets and a set of real world activities. A corporation is an abstract legal reference point to which we assign those assets. (Another formal note: In most jurisdictions, one technically cannot own a “business.” Rather, one owns the assets that form the business, which include not only chattel and real property but also contracts, intellectual property, etc.)

Example 1: Olivia's Pizza

To make this more concrete, think of your local pizza store. Perhaps it is called “Olivia's Pizza,” and Olivia indeed runs the place. You might think that Olivia is the “owner” of the store. In all likelihood, however, the formal “owner” of the pizza place — or rather the contracting party on the relevant contracts — is actually a corporation. The corporation might be called “Olivia's Pizza Place Inc.,” or “XYZ Corp.” for that matter. XYZCorp. might be (a) the lessee under any lease contract for the store building or other leased items, (b) the employer of any employees, (c) the owner of any real estate or chattel such as the pizza oven or the store sign, and (d) the contracting party with the payment system operator (so your payment for the pizza might show up under “XYZ Corp.” on your credit card statement).

Of course, Olivia might be XYZ Corp.’s sole shareholder, director, and chief executive officer (CEO). As shareholder, Olivia would elect the board (here a single director), which in turn appoints the CEO. As CEO and director, Olivia would then have plenary power to administer the business. And as shareholder, she might receive any profits as dividend. For many practical purposes, it is thus irrelevant if Olivia owns the store outright or through a corporation. So what’s the point of incorporating?

One benefit of incorporating can be convenience in contracting in certain transactions. If Olivia ever wanted to sell the pizza place after incorporating, she would just sell the corporation — a single asset (or to be more precise, all her shares in the corporation, still just one collection of a uniform asset). By contrast, as a single owner, she would have to transfer all the assets individually.

Another convenience is that incorporating changes the default rule from unlimited liability to limited liability. The default rule for corporations is that shareholders, directors, and corporate officers are not liable for corporate debts (but they do stand to lose any assets they invested in the corporation as shareholders: hence the expression “limited liability” rather than “no liability”). By contrast, the default rule for single owners is the same as that for any other individual debt: full liability except for protection under the bankruptcy code. It is extremely important that you realize these are only default rules. Contracts can and often do transform limited liability into unlimited liability and vice versa. For example, a no-recourse mortgage contractually limits the borrower’s liability to the value of the underlying real estate. Most importantly for present purposes, controlling shareholders such as Olivia often contractually guarantee particular corporate debts such as bank loans (i.e., they contractually promise to pay the corporate debt if the corporation does not). In contractual relationships, the legal concept of “limited liability” is thus neither necessary nor sufficient to provide actual limited liability for shareholders; it merely facilitates it. The situation is different (and controversial) for most tort liability, as most tort creditors never consented, even implicitly, to the limited liability arrangement.

(Question: Did you, as a customer of Olivia's Pizza, consent to Olivia's limited liability? Does it matter, legally or as a policy matter? What if Olivia herself negligently dropped a piece of glass onto your pizza — is she still protected by limited liability? Should she be?)

Another benefit is entity shielding. Entity shielding refers to a liability barrier in the opposite direction: Olivia's personal creditors cannot demand payment or seize any assets from XYZ Corp. The personal creditors can only seize Olivia's shares in XYZ Corp. Entity shielding is extremely useful because it allows those interacting with XYZ Corp. to focus their attention on the pizza store’s assets and financial prospects, and not worry about Olivia's other businesses. Imagine for example that Olivia also runs a construction business in a different city. Without entity shielding, creditors from the construction business might seize assets of the pizza store, and vice versa. As a consequence, the two businesses’ financial health could not be assessed independently of each other. By contrast, with entity shielding, a bank making a loan to develop the pizza store need only assess the financial prospects of the pizza store, i.e., XYZ Corp. And if the construction business does fail, XYZ Corp. can nevertheless continue business as usual. Entity shielding is more than a mere convenience in that it cannot be accomplished by contracting in the technical sense of the term (i.e., as opposed to the broader set of voluntary arrangements discussed below, which include corporate charters). That being said, the law also provides entity shielding to other entities such as partnerships.

One can neatly summarize limited liability and entity shielding with the simple legal construction of the corporation as a separate “legal person.” “Naturally,” one might say, separate persons are not liable for each other’s debts. Importantly, however, the legal construction is only a convenient summary of policy choices that must be grounded elsewhere. For there is nothing natural about declaring the corporation a separate legal person in the first place (nor, for that matter, would there be anything natural about the opposite arrangement, in particular holding investors liable for all debts of the business). It is a convenient fiction, and the law does not adhere to it strictly. We will encounter exceptions in corporate law (notably “piercing the veil”), and there are many more in tax, antitrust, etc. See generally Felix Cohen, Transcendental Nonsense and the Functional Approach, 35 Colum. L. Rev. 809 (1935).

Example 2: Apple Inc.

We have just argued that the corporation can be useful for small, single-owner-manager businesses such as Olivia's Pizza. But the corporation’s full advantages only come into play in larger businesses with multiple shareholder-investors, many or most of whom have no direct involvement in management – i.e., there is separation of ownership and control. Almost all large firms are organized as corporations. And the majority of economic activity is bundled in large firms.

Think of Apple Inc. When its legendary co-founder and CEO Steve Jobs died, from a legal perspective all that happened was that the board of Apple Inc. had to appoint a new CEO. By contrast, if Steve Jobs had been the single owner of Apple, the entire business would have been part of his estate, presumably with deleterious consequences. Similarly, if the board of Apple Inc. decides to replace the CEO, it does so by simple resolution — it does not need to expropriate the old CEO.

Even more important than independence from its managers, Apple is independent from its shareholders, and the shareholders are excluded from management. Think of Apple Inc.’s millions of shareholders. Imagine the mayhem if any one of them could demand participation in Apple’s management, or liquidation and distribution of Apple’s assets. Or if the creditors of any one shareholder could demand payment from Apple, even just for a limited amount, and seize Apple’s assets to the extent the payment is not forthcoming. And of course it would be impossible for Apple to enter into a contract or file a suit if this required the signatures of all its shareholders, just as no plaintiff could sue “Apple” if it required naming every single shareholder as a defendant. In other words, Apple Inc. as we know it could not exist without the convenience of a single fictitious “legal person,” restricting shareholder involvement in management, and entity shielding.

Many think that Apple Inc. and other large corporations also could not exist without limited liability. The argument is that shareholder liability would deter wealthy investors (who are the ones most likely to be sued), would make the corporation’s credit-worthiness dependent on its fluctuating shareholder base, and would interfere with diversification (the strategy to invest in many different assets so as to not put all eggs into one basket). There is reason to doubt this common wisdom, however. Limited liability distorts shareholders’ incentives because they (fully) benefit from the upside but do not (fully) bear the downside of risky investments. And the problems of unlimited shareholder liability may be minor if liability is proportional to the number of shares held. Empirically, California provided for proportional shareholder liability until 1931, and American Express was organized with unlimited shareholder liability until 1965. It appears that shareholders largely viewed the shift to limited liability with indifference both in California and in American Express.

Back to indefinite life, and the inability of individual shareholders to demand liquidation. If an Apple shareholder wants to cash out, he or she can simply sell the shares. The default rule is that shares are freely transferable. This default rule complements indefinite life. It reconciles the corporation’s need for continuity with individual shareholders’ need for liquidity, i.e., the ability to convert their investment to cash. In smaller corporations, particularly family firms, however, the charter or shareholder agreements sometimes restrict transferability of shares. And even if sale is not restricted, there is often no market for a small corporation’s shares at a price that fully reflects the corporation’s value. In these cases, liquidity can be a major source of disagreement between shareholders.

In general, multi-member organizations also have governance problems that Olivia's Pizza does not have. (We write “organizations” because the problems are not specific to corporations.) When the only shareholder (Olivia) is also the only director, the only manager, and the only employee, there are no conflicts to resolve. But when there are millions of shareholders or more generally investors, a multi-member board, dozens of managers, and thousands of employees, conflicts abound. Millions are not necessary for conflicts to arise, however. The conflicts can be even more acrimonious when there are only two shareholders. Mitigating these conflicts is the main preoccupation of corporate law and of this course.

The broader picture

Before embarking on our study of conflict mitigation, here are a couple more basic facts to round out the corporate picture.

Holdings and subsidiaries

Large businesses are usually not one but many corporations. Usually, a so-called “holding company” sits at the top of a pyramid of several layers of fully-owned subsidiary corporations. That is, the holding company owns 100% of the shares of several direct subsidiaries. These direct subsidiaries in turn own 100% of the shares of some other, indirect subsidiaries. And so on. This is a further illustration of the point that a corporation and a business are not the same thing.

Some advantages of the subsidiary structure are similar to the advantages of incorporating Olivia's Pizza. Others include tax considerations and regulatory requirements. For example, Apple Inc. became infamous for its use of Irish subsidiaries to “manage” its corporate tax liability. And yet, the relevant part of its corporate structure (see here and here [p. 20]) appeared simple compared to the full network of subsidiaries of, e.g., JP Morgan, which comprises hundreds of subsidiaries.

In this course, we usually focus on the top level holding company because that is where the governance problems arise.

Partnerships and other entity types

You may wonder what would happen if a multi-person firm did not incorporate. The answer is that “the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership,” unless the association was specifically formed under a separate statute such as the DGCL (which will generally require at least a registration). See section 202 of the Uniform Partnership Act of 1997; cf. section 6(1) of the Uniform Partnership Act of 1914.

This is a very dangerous default rule. Absent agreement to the contrary, (1) all partners have unlimited liability for partnership debt, (2) all partners have equal rights to participate in management, (3) any partner may be able to demand dissolution at any time, and (4) partnership interests are not transferable. It is a recipe for disaster.

You might now wonder how businesses could even operate before incorporation became generally available in the 19th century. There are three answers: First, some were lucky or corrupt enough to procure a special corporate charter from the queen/king or legislature (by “special act” or “private law”). Second, some businesses may indeed not have commenced or grown beyond a certain point because the corporate form was not available. Third, and most importantly, the partnership rules described above are merely the default rules. They can and usually are heavily tailored in the partnership agreement, provided that the partners are aware that they are forming a partnership.

For example, the partnership agreements of contemporary law firm partnerships reserve management to a committee, and provide for a regulated cash-out without dissolution if a partner wants to exit the partnership. The one thing that the partnership agreement cannot exclude in a traditional partnership is unlimited liability. To limit liability in a practical way, the law firm must choose a different entity type, as most large firms have done by now. In the past, before incorporation became freely available in England in the middle of the 19^th century, English solicitors tailored trusts to approximate a corporation with limited liability.

Contractual freedom

There is a more general theme here. Almost everything in U.S. corporate law can be modified by contract, at least if we understand contract in a broader sense to include charters and bylaws. For example, the charter can create separate classes of stock with different voting and distribution rights (DGCL 151(a), 212(a)). Even if a rule is mandatory on its face, like unlimited liability for partners in general partnerships, one can usually circumvent it by choosing an economically equivalent but legally different transaction or entity type, such as the limited liability partnership (LLP). See generally Bernard Black, Is Corporate Law Trivial?, 84 Nw. U. L. Rev. 542 (1990).

We will discuss the normative sense or nonsense of this state of affairs towards the end of the course. Until then, it is important to keep in mind that any judicial or legislative decision we read is contingent on the particular contractual arrangements chosen by the individuals involved. More to the point, as a budding corporate lawyer, you should always be thinking: what clause or arrangement could have avoided this problem?

Questions:

1. Some large law firms choose to remain general partnerships. Can you guess why? (Do you know an example of a firm that’s a general partnership?)

2. Which of the elements of the corporation could not have been provided by a simple contract between the participants (shareholders, managers, etc.)? In other words, if there were no corporate, partnership, or other organizational law but merely contract law, what would be missing?

We take a brief detour into agency law. One of agency law’s two components is the legal attribution of the actions of one person (the “agent”) to another (the “principal”) in relationship to third parties. This explains why agency law is often taught alongside corporate law. Being an abstraction, a corporation needs someone else to act on its behalf, i.e., as its agent. Corporate officers—e.g., the CEO—are legally agents of the corporation, as are the many other people acting for the corporation. Agency law provides the legal basis why actions of the CEO or a store clerk can establish liability between the corporation and some third party, both in contract and in tort. Agency law’s second component is rules for the “internal” relationship between agent and principal, which is relevant for a corporation’s relationships with its employees etc. and refined into special corporate law rules for corporate officers and directors covered extensively later in the book.

Agency law is state law, but the leading source of agency law is actually the Restatement of Agency (Third), a summary of the various state laws published by the American Law Institute. The Restatement is not binding law but it is highly influential in practice.

Formally, agency is the fiduciary relationship that arises when one person (the principal) agrees with another person (the agent) that the agent shall act on the principal’s behalf and subject to the principal’s control (Restatement (Third) of Agency § 1). The agency relationship therefore exists by consent: both principal and agent must consent to create it, and if either wishes to terminate the agency relationship, then the relationship is terminated. In addition, if the parties have agreed to what is in substance an agency relationship, a court will treat it as such, even if the parties do not recognize that they have created an agency relationship, or even if they wish to avoid doing so.

The formal definition also notes a core feature of agency: it is a “fiduciary relationship” in which the agent owes the principal fiduciary duties. The concept of fiduciary duties is one of the most fundamental in corporate law, because a corporation’s officers and directors owe the corporation special fiduciary duties that pervasively regulate their conduct. In general, fiduciary duties mean that the fiduciary (here the agent) must act loyally to serve the interests of the recipient of the fiduciary duty (here the principal). Agents owe specific fiduciary duties of care, loyalty, and obedience. The duty of care requires agents to act with the competence that a reasonable person would exercise in similar circumstances. The duty of loyalty requires agents to serve the principal’s interests rather than their own. The duty of obedience requires agents to act in accordance with the instructions of the principal.

The law also holds a principal responsible to third parties for various acts of the agent. Here, we will discuss the principal’s liability for contracts the agent enters into and torts the agent commits. Whether a principal is obligated by a contract an agent enters depends on the extent to which the agent was acting with authority. There are two main forms of authority. First, actual authority exists when the agent reasonably believes, based on the principal’s conduct, that the principal wants the agent to so act. Practically speaking, this is by far the most common form of authority in real life: In most agency relationships, agents understand and follow the wishes of their principal. They will enter contracts if, and only if, the principal wants them to contract. These agents act with actual authority. Second, apparent authority exists when a third party reasonably believes the agent to possess authority to enter a contract based on the third party’s perception of the principal’s conduct. Even if an agent enters into a contract without authority, a principal can still be liable for it when the principal later approves of the contract (called “ratification”), or if the principal is aware a third party entered a contract because he or she believed the principal was bound by it and the principal caused such belief or did not take reasonable steps to notify the third party of the actual facts (called “estoppel”).

The principal is always liable for an agent’s torts if the principal specifically instructed the agent to perform the tortious act (though this is not the typical scenario). Otherwise, the principal’s liability in tort depends mostly on the type of agent. A principal is generally not liable for torts committed by an independent contractor, unless the principal was negligent in selecting the contractor. A principal is liable for the torts committed by an employee when the employee is acting within the scope of his or her employment. Whether an agent is an independent contractor or an employee depends on the principal’s level of control over the agent’s performance of the task. If the principal exercises considerable control, then the agent is generally an employee. Otherwise, the agent is an independent contractor. A current controversy is whether Uber drivers are independent contractors or employees. The liability for employees is “strict” meaning that the principal is liable for the tort regardless of how much care the principal exercised in trying to avoid torts by an employee, and a tort does not fall outside the scope of employment simply because the employee disregarded instructions. This doctrine of principal liability is called “vicarious liability” or “respondeat superior.”

An agent is also personally liable for any torts the agent commits. However, plaintiffs will generally prefer to sue the principal rather than (or in addition to) the agent, because principals usually have far more money than their agents, especially when the principal is a large corporation. Sometimes, the agent may also be obligated under a contract that the agent enters into for the principal. The agent is not obligated under the contract in the standard case where the third party knows the actual identity of the principal on whose behalf the agent acts (a “disclosed principal”); only the principal and the third party are parties to the contract. However, if the third party knows that there is a principal, but not the actual identity of the principal, then the principal is said to be an “unidentified principal.” In this case, the principal and the third party are again parties to the contract, but the agent is also a party. If the third party does not even know that the person they are contracting with is an agent acting on another’s behalf then the principal is said to be an “undisclosed principal.” For example, if a celebrity wanted to buy a house but did not want her neighbors to know, she might have an agent buy the house for her, so that her neighbors remained unaware that she was the ultimate buyer, i.e., the undisclosed principal. In this case, the third party and the agent are parties to the contract, and the principal is too unless the contract specifically excludes the principal.

Louis comes to you in distress. He tells you the following:

“Kathryn and I have been operating a pizza shop here in Cambridge for years. From a business perspective, we are doing extremely well. Personally, however, things have not been going so well lately. We have been fighting a lot. Today, I received a letter from Kathryn’s attorney ‘demanding and declaring that the business be dissolved and all assets liquidated to pay off the debt.’ I have no idea what that means but I guess it’s serious?

“'All assets’ is a fancy term, too! It is essentially one big pizza oven that we bought a year ago. We lease the store and our three delivery cars. We just renewed the leases a year ago for a five-year term. They all include penalties for early resolution, and they are not assignable. I reckon the penalties would collectively amount to $50,000 if we had to terminate the contracts now! And that oven, there’s a problem there if we have to sell it now, too: it was custom-fit to our location, so I doubt we’d get more than $50,000 for it. But we still have that bank loan for about $100,000 that we used to finance it.

“Is that all? Well, actually, there is another issue that came up right after I received the letter. That guy Steve – he generally buys our veggies and stuff. Goes to the wholesalers every week, they know he works for us. He gets the stuff, they debit our account, and we pay them by check later. Of course, after I got the letter, I told him not to buy anything today – who knows if we’ll ever need it! But he just goes off and buys everything – and then crashes the car on the way back! Apparently he did major damage because now I am getting all these phone calls from various people and their attorneys demanding that I pay some crazy amounts. But I didn’t drive that car, or put in those orders. Why should I pay for them?

“And I sure hope I can keep the shop running. At least I don’t want to be saddled with that bank loan if we do have to close."

Question: Is there anything else you need to know?

Kathy and Louis ask you to set up the legal side of a pizza shop they envision. 

Louis has been working as a baker in a local bakery for many years. He will give up his job to become the pizza shop’s general manager and, for the time being, only full-time employee. Kathy runs a marketing agency that does lots of business with mostly upscale restaurants. She will work on generating demand for the pizza shop in her spare time, while continuing to run her agency.

Kathy and Louis are childhood friends. They still spend a lot of time together. The idea for the pizza shop started at a recent dinner where they were both unhappy with the pizza. They concluded that they could do this better, and that there would be demand for better pizza in Cambridge. Over the next couple weeks, they worked out a business plan. They believe the pizza shop will be quite profitable.

They initially thought that Louis should set up the shop by himself, and that Kathy would just help out with the initial marketing. The problem is, however, that Louis doesn’t have the cash to make the required investments. To be more exact, Louis is totally broke. A bank is willing to lend $100,000 to buy the pizza oven (the single biggest expense), taking a security interest in the oven. But the bank is not willing to lend unsecured for the initial operating expenses (supplies, drivers’ salaries, etc.). Kathy and Louis are confident that the store will be profitable eventually. But they reckon it will take a couple months to get there. In the meantime, expenses will need to be paid, including Louis’s living expenses.

As a solution, Kathy offers to invest some of her retirement savings in the pizza shop. The number they envision – roughly their estimate of six months of expenses – is $60,000. She and Louis also hope that Kathy may eventually join the business full time if things go well – in the long run, they dream of developing a chain.

Questions: 

1. Can you ethically represent both Kathy and Louis in this matter?

2. How would you advise Kathy and Louis to structure their business relationship? What eventualities should they prepare for? To make this more concrete, assume the only reasonable entity choice is a corporation (in reality, they might use an LLC). Which, if any, provisions would you advise they write into the charter or into the bylaws?

Read: Apple charter (Appendix 1); DGCL 102(b)(1), 109, 141(a)/(b), 212, 216, 242, and 275(a)/(b) (for present purposes, it is sufficient to read the simplified versions at simplifiedcodes.com)

Skim:Apple bylaws (Appendix 2).

Optional: take a glance at DGCL 273 (joint venture dissolution) and 341 et seq. (close corporations).

Note: This section matters as much for terminology as for substance. If you have no background in business and finance, you should read it extremely carefully and look up any terms that you do not understand after reading twice.

As already mentioned above, the corporation is the vehicle of choice for pooling the resources of many investors. Before studying this vehicle in detail, it is worth zooming out for a moment to appreciate why these details matter—a lot!

The basic corporate investment relationship

The corporation is at the center of an elaborate system that matches cash-rich investors to cash-poor firms, and thereby enables life as we know it. On one side are savers who invest. For the time being, you can think of such savers as yourself when you start saving for retirement, usually through a tax-deferred plan like a 401(k). Savers invest first and foremost to transfer value through time, from today to the future: you put money into your 401(k) today and get it out when you retire in 40 years or so. On the other side are firms (or, in the beginning, a simple entrepreneur). Firms also wish to transfer value through time, but in the opposite direction, i.e., from the future to today: the firm expects to generate lots of cash in the future and offers to share it in return for financing today, without which it would not be able to generate the future cash in the first place (“Have idea, need money!”).

To be sure, individual savers and entrepreneurs could decide to go it alone and put only their own money into a small-scale self-financed business. But in most industries, the investment required for efficient production far exceeds the wealth of individuals and thus requires pooling resources. For example, Apple has in excess of $300 billion in assets, financed by countless investors. Even if an individual could afford to finance an entire firm, it is generally preferable to spread the individual’s wealth over many firms so as not to put all eggs into one basket, i.e., to reduce risk through diversification.

The importance of large-scale matching of savers and firms cannot be overstated. Without it, life as we know it would be impossible. There would be no personal computers, no smart phones, no cars (electric or not), and no electric skateboards. Nor should we take this matching for granted. In the U.S. and some other developed economies, the system matches savers and firms without much friction (cost): many firms can finance themselves on a grand scale at reasonable rates, and a great number of savers can expect returns not much below the rates paid by the firms. Elsewhere in the world, the spread between what savers get and what firms must pay is large, firms often find it hard to impossible to obtain funding at all, and saving is a treacherous affair. Given the enormous temptations for the recipients of financing not to pay it back, it is easy to see why the system might not work (“Tens of trillions of dollars entrusted to money-driven, focused people by naïve and absent-minded savers – what could go wrong?”). The astonishing thing is that it works so well in some parts of the world – and corporate law has a large part in that.

Investors, intermediaries, and the lifecycle of firms

In fact, the system achieves nothing short of a miracle once you consider that the typical retirement plan saver invests the money for decades and never looks closely at what firms do with the money or even which firms have the money (more on this below). Firms, on the other hand, come and go and mutate all the time, as new ideas are born and old ones adapt or disappear. Throughout this lifecycle of firms, investors have to make important decisions or risk wasting their money on bad firms or being taken to the cleaners by the firms’ managers or other investors. Fortunately, most of these decisions are made by professional investment managers—intermediaries—to whom the ultimate investors like us have entrusted their savings, relying on a well-functioning legal system and other institutions to ensure that we will eventually get our money back, and more.

A thumbnail sketch of a firm’s lifecycle might be: In the beginning, an entrepreneur solicits financing from so-called venture capital funds (VCs) that specialize in early-stage financing. 90% of early stage companies fail. The VCs make their money off of the 10% that do not and reach the next stage: a “trade sale” to another company, or an initial public offering (IPO) of the corporation’s stock to investors at large by means of registration with the S.E.C. and listing on a stock exchange. Depending on how the business develops, the corporation might later offer more stock to the public in a so-called secondary equity offering (SEO), be acquired by another company, acquire other companies, or go bankrupt – or all of the above in various permutations.[1] Along the way, the corporation holds numerous shareholder votes and investor calls, engages in all sorts of financing transactions, and, last but decidedly not least, runs its business. This happens at tens of thousands of firms. Meanwhile, all that the ultimate investors are doing is to put their money into a bank account, annuity contract, retirement plan, etc., wait a couple decades, and leave the rest to financial intermediaries.

Such intermediaries include banks and insurance companies. Banks use funds received as deposits or savings to make loans. Insurance companies offer annuity products by taking savers’ premia and investing them in firms; they also invest premia received from other insurance clients. Prudential regulation generally prohibits banks and insurance companies from investing in stocks, however, and thus they will feature less prominently in this course.

Retail investors’ main way to invest in stocks and bonds (= tradeable debt) is through mutual funds. As the name suggests, mutual funds pool individual investor’ funds and invest them in a pre-specified type of assets (e.g., S&P 500 stocks); each individual investor owns a share of the fund. By size, mutual funds are the big dog among intermediaries, especially in stocks: as of 2017, U.S. mutual funds had almost 20 trillion U.S. dollars under management. However, mutual funds are not the most active participants in corporate governance, nor are they present in all types of firms. This is largely because, in the name of investor protection, the Investment Company Act and the Investment Advisers Act, respectively, impose considerable restrictions on mutual funds and their management companies (like Fidelity or Vanguard). In particular, mutual funds must offer daily redemption at the fund’s then-current net asset value (NAV), which makes it difficult to impossible for mutual funds to invest in illiquid assets, i.e., assets that do not trade in thick markets and hence cannot be sold quickly except at a major discount. Mutual funds therefore mostly invest in public securities, i.e., securities that are registered with the S.E.C. and, usually, admitted to trading on a trading venue such as a stock exchange. Moreover, mutual funds’ diversification requirement and prohibition of performance fees makes it relatively unattractive for mutual fund managers to expend resources on effecting change at individual firms in the fund’s portfolio.

Private funds—funds open only to select investors—are not subject to these restrictions and are thus present in all asset classes. They provide high-powered incentives to their managers for active management, and thus generate a disproportionate amount of trading and engagement. One small but important group of private funds are the aforementioned VCs. A larger group of private funds called private equity (PE) buys mature companies (usually using plenty of additional debt financing), holds and reshapes them for a couple years, and then resells them. Both VCs and private equity funds have investment horizons of at least several years up to a decade and require their own investors to commit their capital for similar periods. All other private funds go by the catch-all name hedge funds. Their investment strategies and horizons differ greatly. Of particular importance for this course, so-called activist hedge funds seek to profit from changing the way a public company conducts its business, having taken a sizeable equity stake in the company that will increase in value if the company improves. Merger arbitrage hedge funds specialize in buying the equity of corporations that have announced to merge.

Investors in private funds include institutional investors such as public and private pension funds (e.g., CalPERS), endowments (e.g., Harvard’s), and sovereign wealth funds (e.g., Saudi Arabia’s). (The teams managing institutional investors are themselves intermediaries for the ultimate beneficiaries, such as employees and retirees.) Other investors in private funds are wealthy individuals, particularly ultra wealthy individuals who often have their own wealth management teams (“family offices”). In this connection, it is worth pointing out that the “savers” that invest their money in firms are not the average Joe: in the U.S., the top 1% own one third of all equity in public firms, and the top 10% own four fifths (these numbers include indirect ownership through pension funds etc.).

Capital structure and corporate governance

As hinted above, there are two broad categories of financial claims that investors acquire in firms, in return for their investment: debt and equity. Debt is an IOU—a fixed claim. It includes loans from banks and others, as well as publicly traded debt securities called bonds. These payment claims can be enforced in court: creditors can sue for payment, and seize the corporation’s assets if payment is not forthcoming. Equity (a/k/a shares, stock), on the other hand, provides no right to payment but usually provides voting rights to elect the corporation’s board, which may determine to pay money to equity holders as a dividend or to buy back their stock.

If the corporation cannot pay its creditors—i.e., if it is insolvent—, unpaid creditors or the corporation itself may petition the bankruptcy court to open a bankruptcy procedure. Bankruptcy does not mean that the business of the corporation is liquidated. Rather, bankruptcy is a collective proceeding to settle various investors’ claims, while preserving the business’s going concern value, if any (potentially simply by selling the business, and then dividing the sale price between existing claimants). The most important tool of bankruptcy law is its automatic stay of individual proceedings, which prevents inefficient liquidation by individual creditors racing to grab the corporation’s assets and explains the expression “filing for bankruptcy protection.” In bankruptcy, claimants are supposed to be paid in order of their seniority (see below). In particular, equity holders are supposed to get paid only after all creditors have been paid in full. Hence equity holders are often referred to as the corporation’s residual claimants.

Debt and equity come in various flavors, including hybrids. This is especially true for debt. Not only do debt claims come in different maturities and with different ancillary rights, such as creditor undertakings to do or not to do something (covenants). Importantly, debt claims also differ in their seniority. Some creditors—so-called juniors—may contractually agree to subordination to certain other creditors—so-called seniors—in bankruptcy, i.e., to receive payment only after the latter have been paid in full. (Bankruptcy law itself also contains some seniority rules for special groups of creditors.) The debtor may grant a security interest in particular assets (e.g., a mortgage) to so-called secured creditors, which enables the secured creditors to obtain satisfaction of their claim from the sale of the asset prior to any other creditors, provided certain formalities, usually including a filing, have been complied with. (Security interests are also called collateral.) The debt contract may provide that the debt is convertible into equity at the election of the creditor and/or the corporation. The debt may also be issued together with options—known as warrants when issued by the corporation—, i.e., rights to purchase stock of the corporation at a pre-specified price (cf. DGCL 157).

Equity tends to be less varied, and most corporations only have one class of common stock. Of late, however, many prominent tech corporations such as Google, Facebook, or Snap have gone public with two or more different classes of stock (“dual class”) to preserve the founders’ control: one high-voting class reserved to the founders, and one low- or even non-voting class for outside investors. Many corporations also issue so-called preferred stock, which tends to have no voting rights but a dividend preference, i.e., the right to receive some specified minimum amount of dividends before any dividends can be paid to common stockholders (cf. DGCL 151(c)/(d)). Anything goes under Delaware corporate law: DGCL 151(a)). Voting and other rights may even be extended to creditors (DGCL 221).

A very important point is that the so-called capital structure formed by the combination of different claims on the corporation is just that: a structure to raise capital and ultimately to divide the returns, if any. There is nothing essential or even permanent about any of the claims or the investors who hold them. The same investors often hold different parts of the capital structure, such as debt and equity, simultaneously or at different points in time. Investors may trade in an out of the corporations’ claims at any time (at least if they are traded in a liquid market). The corporation frequently extinguishes some claims by paying or buying them back and creates others by selling them in return for new investment. For example, the corporation may borrow money to buy back stock (“leveraged recapitalization”), issue stock to pay off debt, repay one loan by taking on another (“refinancing”), or offer to exchange one type of stock for another. (However, sensibly enough, shares owned by the corporation itself—"treasury shares"—do not have voting rights etc., see DGCL 160(c).)

Does capital structure matter? It obviously matters for the pricing of individual claims, as investors only pay for what they get. But what the corporation gives to holders of one claim it cannot give to another, and in light of the previous paragraph, the value of individual claims is hardly of deep interest (except, of course, to those buying or holding those claims!). The real question is whether the total value of all claims that the corporation can sell, and hence the total amount of financing it can raise, depends on the way the claims are delineated by contract, charter, and law? Specifically, does it matter which part of the dollars taken in by the firm (cash flows) go to which investors under which circumstances (cash flow rights), and what rights do those investors have to influence the decisions taken by the firm (control rights)?

Modigliani and Miller’s famous benchmark result in corporate finance is that if the firm’s cash flows were fixed and some other conditions held, it would not matter what sort of financial claims the firm issued – the total value of the claims would always be the same. As Miller once explained this proposition, it does not matter how you slice a pizza – it will always be the same amount of pizza. A corporation, however, is not a pizza: its cash flows depend crucially on how it is managed, which in turn depends on how it is governed, i.e., who has which control rights and how they exercise them. Cash flow rights provide incentives to exercise control rights in a certain manner. These incentives can be more or less aligned with increasing the value of the pie (or size of the pizza, if you will). The division and bundling of cash flow and control rights thus matters a great deal.

Corporate and bankruptcy law have some role in the division and bundling of rights, but most of it is done by contract writ large, including the corporate charter. This is inevitable because businesses differ and hence need different governance terms adjusted to the business. In particular, businesses differ in the amount of debt they can service. Debt offers important advantages. First, it is tax advantaged: interest is tax deductible, while dividends are not. Second, debt is less information-sensitive: creditors only need to assess the corporation's ability to repay the loan rather than the corporation’s full potential. Last but not least, creditors' return expectations are backed up by a hard legal claim and its threat of judicial enforcement and bankruptcy, whereas shareholders are at the mercy of the board. This last feature, however, also makes debt inflexible: it will lead to costly litigation, bankruptcy, or even liquidation whenever the actual cash flows fall short of projected cash flows, or at least give creditors the ability to extract concessions in renegotiating the debt. That is why only stable businesses with predictable cash flows tend to use a lot of debt, while more volatile businesses, particularly startups, rely mostly or exclusively on equity financing. Most of this course will be concerned with the ways in which corporate law seeks to ensure that shareholders will get a return even though they lack a hard claim to repayment.

A final note on capital structure and corporate governance is that every possible arrangement is a compromise, and perfection is impossible. Ex ante, every participant in the business would agree that the goal is to maximize the size of the total pie (or pizza, if you prefer) because that will enable everyone to get a bigger slice (the division can be adjusted by side payments). Once the business gets under way, however, whoever has control over a decision will be tempted to (ab-)use that control to get a bigger slice, even if doing so reduces the size of the total pie. For example, managers may favor growing the business beyond the efficient size if they enjoy the greater power and prestige that comes from running a bigger firm. Creditors may favor inefficient liquidation if continuation, while profitable in expectation, is also risky, such that creditors stand to lose but not much to gain from continuation (remember that creditors' claims are fixed!). Inversely, shareholders may favor inefficient continuation if continuation, while unprofitable in expectation, presents at least the possibility of a positive outcome whereas the liquidation proceeds would go fully or mostly to creditors. The point is that as soon as people pool resources, conflicts of interest are unavoidable. The goal is to mitigate such conflicts; they cannot be eliminated.

Valuation

Note: This subsection is conceptually denser and more algebraic than anything else in this course. You may find it challenging on first reading.

Above, we said tongue-in-cheek that the value of individual claims does not matter in the big scheme of things. Of course, to individual investors, the value of their claim is all that matters. And because of that, understanding how different actions affect the value of individual claims is crucial to understand the incentives of those holding those claims.

To value a claim, one usually starts with the claim’s expected future cash flows. Expected cash flows are the probability-weighted average of the cash flows that the investor will receive in all the conceivable scenarios. For example, if the investment will return either $2 million or nothing with equal probability, the expected cash flows are 50% × $2 million + 50% × 0 = $1 million. In the real world, estimating expected cash flows requires understanding the business and the capital structure, particularly—for debt—the seniority structure and security interests. Usually, such estimates are fraught with very considerable uncertainty, especially for equity (cf. discussion of information-sensitivity above).

The next step is to discount the future cash flows to present value for the time value of money and a risk premium, to name only the most important ones. The time value of money arises from the simple fact that in the world we live in, all investors have the alternative to put their money into other investments that are expected to pay back the same amount of money plus a positive return in the future. In particular, investors have the alternative to invest in U.S. government bonds that will pay back the same amount of money plus interest with certainty. Thus, to persuade investors to give their money to the corporation, the corporation has to offer more than the interest paid by the government. How much more? That depends on the risk of the corporation’s claim. Risk in this context does not mean the probability of non-payment per se: that is already accounted for in the calculation of expected future cash flows. Rather, risk here means the variance or volatility of the expected cash flows. For example, for their retirement, most people would rather have $1 million for sure rather than a 50/50 chance of $2 million or nothing (note that the expected cash flows are the same, namely 50% × $2 million + 50% × 0 = 100% × $1 million). That said, investors can diversify away most risk by investing small amounts in many different assets rather than everything in one asset. By and large, investors thus receive a risk premium only for systematic risk, i.e., risk that is undiversifiable because it is likely to hit all assets at the same time, such as a global recession. (Of course, individual investors would prefer to receive premia for all sorts of things, but in a competitive financial market, investors compete away most other premia – ultimately, the expected return on an investment is set by the supply and demand for capital.)

Let us consider an extremely stylized example. Imagine we knew for certain that a firm will be in operation for only one year, after which it will liquidate all its assets and distribute them to its investors. Imagine further that we magically know that there are only three possible outcomes, all equally likely: after liquidation but before distribution, the firm will hold (1) $0, (2) $100, or (3) $200. What is this firm worth? Start with the expected future cash flows: ⅓×$0+⅓×$100+⅓×$200=$100. To discount those future cash flows to present value, we need to know the time value of money and the firm-specific risk premium. As mentioned above, the time value of money is what you could earn on a government bond of the same duration.[2] Let’s assume the government currently offers 1% on a one year bond. What is the right risk premium? It depends on the firm! The more the success of the firm is correlated with the health of the economy, the higher the risk premium. How high? It depends on what financial markets demand—or equivalently, what investors can get elsewhere—, which in practice we would estimate by looking at similar firms. Imagine we found the right premium to be 10%. In that case, our firm would be worth $100/(1+1%+10%)=$90.09.[3]

Having valued the firm as a whole, let us value individual claims on it. Imagine the firm is organized as a corporation and only has two claimants: a creditor owed $100, and a shareholder.

Let us start with the creditor and observe that the creditor’s claim is not necessarily worth $100—the corporation has promised $100, but whether it will pay that much is an entirely different question, and how to value those payments yet another.[4] Concretely, the corporation will not be able to pay anything to the creditor in case 1 where it ends up holding $0 (perhaps the shareholder would be able to pay, but, because of limited liability, the shareholder will not need to pay and presumably won’t). In the other two cases 2 and 3, the corporation will be able to pay $100 but will not pay more than that (in case 3, it could pay more but it won’t because the creditor only has a fixed claim for $100). Thus, the expected cash flows to the creditor are ⅓×$0+⅓×$100+⅓×$100=$66.67. As to the appropriate discount rate, observe that the creditor’s claim is less volatile than the firm as a whole: in two out of three states, the creditor gets the same amount of money. The appropriate risk premium will thus be lower than for the firm as a whole (which was 10%); assume it is 7%. The time value of money is still 1%. Thus, the creditor’s claim is worth $66.67/(1+1%+7%)=$61.73.

Meanwhile, the shareholder as residual claimant gets whatever is left over after paying the creditor, which is nothing in cases 1 and 2 and $100 in case 3, for an expected cash flow of ⅓×$0+⅓×$0+⅓×$100=$33.33 (alternatively, we could have found this number by subtracting the creditor’s expected cash flows from those of the corporation as a whole). The shareholder’s claim is riskier than the firm as a whole because the shareholder will only be paid in the best possible case; let us assume the appropriate risk premium is 16.5%. Then, the shareholder’s claim is worth $33.33/(1+1%+16.5%)=$28.37.[5]

For obvious reasons, the valuation approach exposited above is called discounted cash-flow analysis (DCF). An alternative to DCF is to use comparables: one calculates some valuation ratio (or “multiple”) for comparable claims, and then assumes that the same ratio will hold for the claim under examination. For example, to value the shares of company A (say, Pepsi), one might look at comparable company B (say, Coca-Cola), calculate the ratio of company B’s stock price to B’s current earnings per share (EPS; roughly, firm profits divided by number of shares outstanding), and then calculate company A’s share value as A’s EPS times B’s share value divided by B’s EPS, on the assumption that A and B should have the same price/EPS multiple. (Thus, if Coca-Cola’s share is worth $150, Coca-Cola’s EPS is $10 per share, and Pepsi’s EPS is $8 per share, then Pepsi’s share is worth $8 × $150/$10 = $120, as valued by EPS multiple.) The advantage of the comparables approach to valuation is that it avoids the difficult task of estimating company A’s expected cash flows. The disadvantage is that one must not only assume that company B is already correctly valued, but also that both companies will develop in parallel from their current starting point. The latter assumption is never exactly true and even the approximation may be very bad. In practice, most valuations triangulate from a combination of DCF and multiple comparable firms.

Finally, knowing a claim’s present value, or PV, is not enough to make an investment decision. At the risk of stating the obvious, the price of the claim also matters. The investment is appealing only if the net present value (NPV), i.e., PV minus price, is positive.

[1] Note in this regard that bankruptcy usually means restructuring or sale rather than liquidation, and firms not only buy but also sell a/k/a “spin off” subsidiaries and other parts of their business. For example, United Airlines was founded as Boeing Air Transport by William Boeing in 1927, merged with his Boeing Airplane Company in 1929, and spun out as United Airlines in 1934; it filed for bankruptcy in 2002, emerged from bankruptcy in 2006, and merged with Continental Airlines in 2013.

[2] Well, actually, the government bond also pays you a compensation for expected inflation. But we’ll assume our business’s outcomes are measured in nominal terms, so including an inflation premium is appropriate.

[3] At the limit, if the success of the firm were purely idiosyncratic—e.g., it depends on whether or not a patent will be upheld in court—, then the appropriate risk premium would be zero, and our firm would be worth $100/(1+1%+0%)=$99.01.

[4] Nor did the creditor necessarily invest $100 – that is merely the face value of the claim, i.e., the promised amount. In fact, given the time value of money, the investor presumably invested less than $100!

[5] In this example, the value of the creditor’s claim and the value of the shareholder’s claim add up to the value of the firm as a whole. This might appear unsurprising because the two claims are the only claims on the firm, and value cannot evaporate or appear from out of nowhere. Notice, however, that the algebraic equivalence depended on the risk premia: it would not hold with different risk premia (e.g., a lower risk premium for equity). Modigliani and Miller, mentioned above, are famous for showing that, under certain conditions, risk premia must be such that the equivalence does hold. As also mentioned above, however, Modigliani-Miller is merely a benchmark result. In reality, risk premia may not obey the equivalence exactly. More importantly, Modigliani-Miller applies to fixed cash flows; if capital structure influences cash flows, then all bets are off. In the example above, an important omission was taxes: the mix of debt and equity generally influences tax burdens, and it would not even make sense to value “the firm” without taking into account its financing and associated expected taxes.

State corporate law is very closely intertwined with federal securities law. The link is so close that it is worth giving you a very brief introduction of some elements that will come up again and again in this course. (In other countries, these elements might be included in “corporate law.” The distinction is artificial.)

Securities are, roughly, tradable investments such as shares and bonds (tradable debt claims). For our purposes, the relevant statutes are the Securities Act of 1933, and the Securities Exchange Act of 1934 (“Exchange Act”). Both grant broad powers to the U.S. Securities and Exchange Commission (SEC). In particular, the SEC has promulgated very detailed rules implementing the securities laws.

The Securities Act is chiefly concerned with the initial disclosure upon a first sale of a security to the public in a so-called registration statement. We will therefore encounter it less often.

The Exchange Act, on the other hand, is ubiquitous. Among other things, it regulates ongoing corporate disclosure, and trading in corporate securities. Most provisions of the Exchange Act apply only to “registered securities,” which include all securities that are publicly traded on a stock exchange or elsewhere. This excludes securities of private companies, i.e., companies whose securities are not marketed to the public, and in particular not traded on a stock exchange. Private companies include not only small firms but also some large ones like Uber (as of December 2017).

In terms of disclosure, the Exchange Act requires, inter alia, the following filings with the SEC, who makes them publicly available on EDGAR:

• Annual disclosure of the corporation’s financial and business situation on form 10-K. This disclosure is quite comprehensive. For example, corporations have to disclose audited financial statements and many details about their executive compensation arrangements.
• Quarterly disclosure on form 10-Q. Less comprehensive than 10-K.
• Ad hoc disclosure of certain specified events such as a merger on form 8-K.
• Proxy statements, i.e., comprehensive disclosure from anyone soliciting shareholder votes, including the corporation itself – see the shareholder voting part of the course.
• Anyone proposing certain important transactions must disclose background, terms, and plans – details when we get there.
• Ownership interests above 5% on Schedule 13D.
• Trades by corporate insiders (directors, officers, and anyone owning 10% or more of a corporation’s stock) (Exchange Act §16(a)).

Since 2000, SEC Regulation FD (for "fair disclosure") additionally provides, in the SEC's own words, that "when an issuer discloses material nonpublic information to certain individuals or entities—generally, securities market professionals, such as stock analysts, or holders of the issuer's securities who may well trade on the basis of the information—the issuer must make public disclosure of that information."

The Securities Laws and the SEC’s rules thereunder also provide private and public remedies for false or misleading statements. The most important provision is SEC rule 10b-5, a broad anti-fraud rule implementing section 10(b) of the Exchange Act. Courts have implied a private right of action under this and similar rules, which sustain an industry of securities class action lawyers. We will deal with rule 10b-5 and others when we cover securities trading in Part IV.

1. Read the Wikipedia excerpts on Alphabet/Google below and look up any terms that you do not know (most were explained in the previous sections!).
2. Find out who Alphabet's major stockholders are, both in terms of (a) voting rights and (b) cash-flow rights.*
   1. What are their stakes worth, approximately, given Alphabet's current stock price?
   2. Beyond their names, who are they, i.e., what is their economic role? To the extent they are businesses, not individuals, what is their business model?
3. As you know from the last question, voting rights and cash flow rights do not go hand in hand in Alphabet. In particular, Class A and Class B shares have equal cash flow rights but unequal voting rights. This is laid down in certain provisions of Alphabet's charter. Which ones? (You can find the Alphabet charter in the SEC database with a little effort, or with no effort on the Alphabet investor relations webpage.)
4. Since 2014, Google/Alphabet's charter also authorizes Class C shares. What voting and cash flow rights do they have? Why do you think Google/Alphabet created this additional class?
5. In 2006, Google bought YouTube for around $1.5 billion. Find out how Google paid the YouTube sellers. (It's ok to Google this one.)

* There are two ways to find out who those major stockholders are. One possibility is to Google them. A more reliable method is to look up Alphabet's proxy statement in the SEC's public database. Go to SEC.gov, select Filings/Company_Filings_Search, search for Alphabet Inc. or its ticker GOOG, and then for its latest form DEF 14A (April 2017), which lists common stock ownership under that heading. One big advantage of this method is that it also works for much less famous public companies.

Google: Excerpt from Wikipedia Entry[1]

Google LLC . . . is an American multinational technology company focusing on artificial intelligence, online advertising, search engine technology, cloud computing, computer software, quantum computing, e-commerce, and consumer electronics. It has been referred to as "the most powerful company in the world" and one of the world's most valuable brands due to its market dominance, data collection, and technological advantages in the area of artificial intelligence. Its parent company Alphabet is considered one of the Big Five American information technology companies, alongside Amazon, Apple, Meta, and Microsoft.

Google was founded on September 4, 1998, by computer scientists Larry Page and Sergey Brin while they were PhD students at Stanford University in California. Together they own about 14% of its publicly listed shares and control 56% of its stockholder voting power through super-voting stock. The company went public via an initial public offering (IPO) in 2004.

In 2015, Google was reorganized as a wholly owned subsidiary of Alphabet Inc. Google is Alphabet's largest subsidiary and is a holding company for Alphabet's internet properties and interests. Sundar Pichai was appointed CEO of Google on October 24, 2015, replacing Larry Page, who became the CEO of Alphabet. On December 3, 2019, Pichai also became the CEO of Alphabet.

The company has since rapidly grown to offer a multitude of products and services beyond Google Search, many of which hold dominant market positions. These products address a wide range of use cases, including email (Gmail), navigation (Waze & Maps), cloud computing (Cloud), web browsing (Chrome), video sharing (YouTube), productivity (Workspace), operating systems (Android), cloud storage (Drive), language translation (Translate), photo storage (Photos), video calling (Meet), smart home (Nest), smartphones (Pixel), wearable technology (Pixel Watch & Fitbit), music streaming (YouTube Music), video on demand (YouTube TV), artificial intelligence (Google Assistant), machine learning APIs (TensorFlow), AI chips (TPU), and more. Discontinued Google products include gaming (Stadia), Glass, Google+, Reader, Play Music, Nexus, Hangouts, and Inbox by Gmail.

Google's other ventures outside of Internet services and consumer electronics include quantum computing (Sycamore), self-driving cars (Waymo, formerly the Google Self-Driving Car Project), smart cities (Sidewalk Labs), and transformer models (Google Brain).

Google and YouTube are the two most visited websites worldwide followed by Facebook and Twitter. Google is also the largest search engine, mapping and navigation application, email provider, office suite, video sharing platform, photo and cloud storage provider, mobile operating system, web browser, ML framework, and AI virtual assistant provider in the world as measured by market share. On the list of most valuable brands, Google is ranked second by Forbes and fourth by Interbrand. It has received significant criticism involving issues such as privacy concerns, tax avoidance, censorship, search neutrality, antitrust and abuse of its monopoly position.

History

Early years

Google began in January 1996 as a research project by Larry Page and Sergey Brin when they were both PhD students at Stanford University in California. …

While conventional search engines ranked results by counting how many times the search terms appeared on the page, they theorized about a better system that analyzed the relationships among websites. They called this algorithm PageRank; it determined a website's relevance by the number of pages, and the importance of those pages that linked back to the original site. …

Page and Brin originally nicknamed the new search engine "BackRub", because the system checked backlinks to estimate the importance of a site. …

Eventually, they changed the name to Google; the name of the search engine was a misspelling of the word googol, a very large number written 10100 (1 followed by 100 zeros), picked to signify that the search engine was intended to provide large quantities of information.

Google was initially funded by an August 1998 investment of $100,000 from Andy Bechtolsheim, co-founder of Sun Microsystems. ...

Google received money from [three] other angel investors in 1998: [Bechtolsheim's co-founder David Cheriton,] Amazon.com founder Jeff Bezos and entrepreneur Ram Shriram. …

After some additional, small investments through the end of 1998 to early 1999, a new, $25 million round of funding was announced on June 7, 1999, with major investors including the venture capital firms Kleiner Perkins and Sequoia Capital. …

[Following the closing of the $25 million financing round, Sequoia encouraged Brin and Page to hire a CEO. Brin and Page ultimately acquiesced and hired Eric Schmidt as Google’s first CEO in August 2001.

In October 2003, while discussing a possible initial public offering of shares (IPO), Microsoft approached the company about a possible partnership or merger. The deal never materialized. In January 2004, Google announced the hiring of Morgan Stanley and Goldman Sachs Group to arrange an IPO.][2]

Initial public offering

On August 19, 2004, Google became a public company via an initial public offering. At that time Larry Page, Sergey Brin, and Eric Schmidy agreed to work together at Google for 20 years, until the year 2024. The company offered 19,605,052 shares at a price of $85 per share. Shares were sold in an online auction format using a system built by Morgan Stanley and Credit Suisse, underwriters for the deal. The sale of $1.67 billion gave Google a market capitalization of more than $23billion. …

[There were concerns that Google's IPO would lead to changes in company culture. Reasons ranged from shareholder pressure for employee benefit reductions to the fact that many company executives would become instant paper millionaires. As a reply to this concern, co-founders Brin and Page promised in a report to potential investors that the IPO would not change the company's culture.] …

The stock performed well after the IPO, with shares hitting $350 for the first time on October 31, 2007, primarily because of strong sales and earnings in the online advertising market. The surge in stock price was fueled mainly by individual investors, as opposed to large institutional investors and mutual funds. GOOG shares split into GOOG Class C shares and GOOGL class A shares. The company is listed on the NASDAQ stock exchange under the ticker symbols GOOGL and GOOG, and on the Frankfurt Stock Exchange under the ticker symbol GGQ1. These ticker symbols now refer to Alphabet Inc., Google's holding company, since the fourth quarter of 2015.

....

[1] Entry on "Google," accessed 1/16/2017; footnotes removed. I reproduce this text here under Wikipedia's Creative Commons license, and make no claim to copyright in the text.

[2] This insert is from the separate Wikipedia entry on "History of Google." The same disclaimer as in the previous footnote applies.