Many market players have been hit hard by the pandemic. Some of them got a smaller slice of the declining pie than expected, while others tried to prepare for the post-COVID period with investments and developments. Whatever the decision of the company, like a good captain after weathering a storm, the chief executive must take stock of the state of the company and prepare to move forward. The capital structure of the company must therefore also be reviewed, as the pandemic has certainly left its marks.
The equity/share capital ratio, among many other indicators, illustrates the seriousness and reliability of a company, but it also shows whether the company is complying with the applicable capital structure requirements and whether the company reckons with possible legal consequences of breaching them. The first thing to do is to review these requirements and check whether the company’s equity/share capital ratio is appropriate.
The Civil Code provides for a minimum amount of subscribed capital for each company type as follows:
- for a limited liability company: HUF 3 million
- for a private company limited by shares: HUF 5 million
- for a public company limited by shares: HUF 20 million
- there is no minimum share capital required for private limited and general partnerships
The first condition is that the equity capital must in all cases reach the minimum amount of subscribed capital required by law. As we shall see, if the company is unable to meet this condition for a prolonged period of time, it will ultimately have to decide to convert or dissolve itself.
The second condition is that the equity capital must reach a certain proportion of the subscribed capital: half of the subscribed capital in the case of a limited liability company and two-thirds in the case of a private company limited by shares. As the subscribed capital of the majority of limited liability companies and private companies limited by shares is equal to the legal minimum, this rule is of less importance, since it is not sufficient for a limited liability company with HUF 3 million subscribed capital to have more than HUF 1.5 million equity capital: if the equity capital is less than HUF 3 million, the first condition is still not fulfilled. If the second condition is not met for a company with a high subscribed capital, the company can still decide to reduce its subscribed capital to a level where it will meet the condition.
What actions should be taken if any of these conditions are not met?
If, according to the last annual accounts, either of the above conditions is not fulfilled, the managing director (or the board of directors in the case of a private company limited by shares) must immediately convene the supreme body or, in the case of a single-member company, notify the founder.
The supreme body must then take a decision to resolve the capital situation. If the company’s members (shareholders) are unable or unwilling to resolve the capital situation, the company has the following options:
- may be transformed into a general partnership or a private limited company, which are not subject to the above-mentioned capital protection requirements;
- may merge with another company with more capital;
- create new company (or companies) by division in which the capital requirements are met; if neither is feasible, then
- the company can decide to dissolve itself.
But if they don’t want any of the above, how can members sort out the capital situation?
If the equity capital reaches the minimum subscribed capital for the company form, the situation can easily be resolved by reducing the subscribed capital to the legal minimum. However, if the equity falls below the required minimum subscribed capital, stronger steps are needed to sort out the capital structure.
- The supreme body may order supplementary payment. First of all, it should be noted that this option is only available for limited liability companies and only if the articles of association allow. If not, these must be amended first. The advantage of supplementary payment is that it does not increase the subscribed capital, so only the equity capital increases and the ownership ratios remain. In addition, supplementary payment can be performed by contribution in kind as well. However, since it is not a loan nor does it increase the equity capital, it will not be returned upon the dissolution of the company.
- The equity problem can be solved by an additional contribution from the shareholders, i.e. a capital increase. The contribution by the shareholders can be either cash or contribution in kind. There is no legal requirement for the proportion of cash and contribution in kind, so the capital increase can be made entirely by means of a contribution in kind. For limited liability companies, the value of the contribution in kind does not need to be certified by an auditor. In order to meet the capital adequacy requirements, it is advisable to increase the subscribed capital by a smaller amount and to recognise the larger part of the capital increase in the capital reserve (this is known as a capital increase with a discount). The Accounting Act does not allow shareholders to increase the capital by increasing exclusively the capital reserve, so a certain amount must be paid as subscribed capital, however, there is no legal requirement for a minimum amount of increase in the subscribed capital.
- An indirect but appropriate solution to the capital problem may be for the owners to write off their claims against the company which is recorded as extraordinary income in the company. This step will improve the profit for the year, which will also help to remedy the capital situation. The disadvantage of the above is that although the acquisition of assets in the form of a debt cancellation is not subject to gift tax, the income increases the corporate tax base and does not provide any long-term relief.
- A method apparently similar to the former, but still very different in its effects, is when the shareholder provides his claim against the company as a contribution in kind. Typically, such claim is a previously granted shareholder’s loan, but it can be anything else, such as a dividend claim. The amount of the claim increases both the company’s share capital and its equity capital. The advantage of this method is that it does not require any cash flow, but in return it requires a procedure at the court of registration. However, in companies with multiple shareholders, this method can lead to a conflict because it changes the ownership proportions, since only the quota of the shareholder who has contributed the claim increases. This solution is also not recommended if there is a chance that the company will decide about its liquidation in the foreseeable future: in this case, the tax authorities will classify the transfer as a sham transaction disguising a debt waiver. In this case, the tax office will subsequently assess the corresponding corporate tax and impose a fine on the company.
- Finally, we must mention the incomprehensibly seldom used method of value adjustment. Due to various expenses, depreciation and market trends, companies’ assets are usually not recorded at their real value but ‘only’ at book value. Typically, when the company owns real estate, its accounts show only a fraction of the real market value. This hidden capital element can be used to increase equity capital if the company continues to record the tangible or intangible asset at its real, fair market value after value adjustment.
Why is it important to sort out the capital structure? What is the company risking if it fails to do so?
The answer can be approached on a business level on the one hand and company law on the other hand. Market players look for economic partners whose capital position shows a reliable company. It does not reflect well on the company in the eyes of its partners or prospective partners if the published accounts already show that it has capital problems. On the one hand, this is because the status of the capital situation can lead to conclusions being made about the discipline and preparedness of the management, and the sustainability and reliability of the economic relationship also becomes questionable. On the other hand, an exigent company would pick its partners, so a highly rated market player would not maintain a significant economic relationship with a company whose capital position is unsettled. Therefore, capital adequacy is desirable not only from a compliance point of view but also from an economic point of view.
On the level of company law, the company should take into consideration that the competent supervisory court of registration may take proceedings against the company if it discovers an unsettled capital situation. Although these proceedings are rare and will terminate in most cases after a single notice but they may lead to fines or, in the case of persistent breaches, the compulsory winding-up of the company. The latter outcome should be avoided, as it is now standard practice for a diligent business partner to check the business history of both the manager and the shareholders before entering into a contract, and publicly available company information will be no exception. The outcome of business negotiations may be adversely impacted if such negative information is linked to the partner.