Equity in a Company
Equity constitutes the basis of a company’s solidity. Equity is normally invested in the company for an undefined period. Upon incorporation of a company, its founders, and possibly other individuals or entities, possibly subscribe for the company’s shares and pay for the subscription in cash or other property (so-called contribution in kind). The subscription payment of the shares can be used to accumulate the company’s share capital, which is part of its restricted equity and a mandatory requirement for public limited liability companies (at least EUR 80.000). The subscription price of the shares can alternatively be credited entirely in the reserve for unrestricted equity.
Depending on its nature, equity capital can be divided into restricted equity, which cannot be distributed to shareholders without complying with the statutory procedures regarding creditor protection, and unrestricted equity, which can be distributed without regard to the company’s creditors. Under the Companies Act, restricted equity consists of share capital as well as of the fair value reserve and the revaluation reserve as defined in the Accounting Act. Other reserves, invested unrestricted equity, as well as the profits generated during the financial period and previous financial periods are all unrestricted equity. Invested unrestricted equity is often considered to include the so-called holding gains, entered in the revaluation fund of the balance sheet, i.e. increases in the value of assets. However, in accordance with the principle of prudence, this is possible only to the extent such gains exceed the tax liability attributable to such gains.
In case of bankruptcy, the equity investors of a company, i.e. the shareholders, have the weakest position, as the debt investors (company creditors) have higher priority in the distribution of the estate’s assets. This means that in practice, shareholders often lose their entire investment in the event of a bankruptcy. On the other hand, shareholders’ liability for the obligations of the company is generally limited to the subscription price paid for the shares (limited liability). This limited liability under the Companies Act relates to the principle of integrity of a limited company’s restricted equity, which means that the share capital can be returned to the shareholders only through specific procedures regarding creditor protection. Hence, the objective is to protect the company’s creditors, and to secure their outstanding debt.
A company’s management has been assigned specific duties in case the equity of a company decreases to less than half of the share capital, or is negative. If the Board of Directors of a limited liability company discovers that the company’s equity is negative, it shall, without delay, submit a notification regarding loss of the share capital for registration with the Trade Register. Violation of the duty to notify such loss may be relevant when assessing the possible personal liability of the Board of Directors. In addition, if the Board of Directors of a public limited liability company discovers that the company’s equity has decreased to less than half of the share capital, the Board shall, without delay, prepare financial statements and an annual report, in order to establish the company’s financial position. If, according to such balance sheet, the company’s equity is less than one half of the share capital, the Board of Directors shall, without delay, convene a general meeting of shareholders, to consider measures to remedy the company’s financial position. In a private limited liability company, the Board is not required to prepare the financial statements and the annual report. On the other hand, the registration in the Trade Register regarding equity loss cannot be removed until the company’s equity again is more than half of its share capital, based on financial statements prepared by the company.