5.2 Share-based Equity and Equity That Is Not Share-based 139may validly choose not to comply with the company’s contractual obligations; if
the company fails to comply with its contractual obligations, the company might
be sued, but the internal decisions taken by the company’s corporate bodies would
remain valid. As legal outsiders, debtors would only in extreme cases (such as in-
solvency or near-insolvency) be able to control the company. One could say that
holders of debt instruments do not participate in the governance of a company;
rather they act as a constraint on governance.^23
The obvious difference between shareholders and debtors is that while distribu-
tions to shareholders are constrained by mandatory provisions of company law,
the company has a contractual duty to repay its debts.
Why turn to shareholders? A limited-liability company can turn to shareholders
as providers of share-based equity instead of other investors for many legal rea-
sons.
First, shareholders have a number of important functions. Issuing shares not
only enables the company to raise funding but also makes it possible to manage
the pool of shareholders and increase its quality as the firm’s agents (for share-
holders as agents, see Volume I).
Second, a shareholder will usually be entitled to funds that the company dis-
tributes to shareholders at some point, and the value of shares will change over
time. If investors believe that funds will be distributed to shareholders and that
there will be an increase in share price, the company may be able to raise funding
at lower cost.
Third, shareholders’ capital increases managerial freedom. Shareholders do not
have an automatic right to repayment of their capital. Company laws usually make
it difficult for minority shareholders to cause the company to distribute funds to
shareholders.
Fourth, constraints on the distribution of assets to shareholders can make share-
holders a suitable source of equity capital where the company seeks to match a
long-term investment with long-term funding.
Fifth, the issuing of shares is an established way to increase equity according to
IFRS and other accounting rules, and other ways to increase equity might not be
available (see “Equity according to IFRS” above).
Sixth, some existing or new shareholders may be a suitable last resort of fund-
ing because of the private benefits that they enjoy. For example, a lender might be
prepared to convert a loan into new shares in a near-insolvent company if this is
the only way to prevent a credit loss from occurring, and a parent company would
usually keep a subsidiary alive because of the adverse consequences of failure to
do so.
(^23) For the distinction between governance and constraints on governance, see Chapter 2 of
Mäntysaari P, Comparative Corporate Governance. Shareholders as a Rule-maker.
Springer, Berlin Heidelberg (2005).