When a group of investors or entrepreneurs pool their resources to create a company, they create a capitalization table, or "cap table." This document is a record of which shareholders have contributed what assets to the company. Contributed assets can be in the form of cash, stock, or property. If a shareholder or member of a partnership contributes property, however, and then the company pledges that property as collateral on a loan, that can raise some dicey accounting issues.
When a company signs a debt agreement with a creditor, pledging a specific asset as collateral, that asset frequently gets transferred to an escrow company. This company holds the asset on behalf of both parties. If the debtor company defaults on the loan, the escrow company transfers the collateral to the creditor.
Accounting for Collateral
When an asset is transferred from the company's books to an escrow company, those assets are no longer the technical property of the company. Another entity holds title to those assets. When this happens, it is possible that the company will remove the asset from the capitalization table.
Compensating the Shareholder
If a shareholder's contributed asset gets removed from the capitalization table, the shareholder should be compensated to keep his pro rata claim on company assets in line with his actual contribution. After all, if the company defaults, all shareholders should take an equal hit, and not just one shareholder. In fact, it may be illegal for S corporations to do so, since they can only issue a single class of stock. This means that all shares must be treated equally.
Preventing the Issue
To prevent confusion when contributed assets, including stock, are pledged as collateral, convert the market value of assets at the time of contribution into a dollar amount, and then convert that dollar amount into a specific number of shares in the company. This way, any donated stock or assets becomes company property, rather than shareholder property. The shareholder is instead credited with equity, and bookkeeping is substantially simplified. Then the stock pledged as collateral does not need to be subtracted from any individual shareholder's entry on the capitalization table. Only the company balance sheet needs to be adjusted.
- Security Analysis; Benjamin Graham and Stephen Dodd
- Huffington Post: How To Draw Up a Capitalization Table
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