Legal capital (LC) is the amount of capital that can’t leave the company. This means a company can’t use or disburse this capital by the way of dividends or any other purpose. It is basically the common stock’s par value and preference shares’ stated value that a company sells or issues to the shareholders.
Par value or face value is basically the minimum price of the shares that investors need to pay when a company goes for an IPO (initial public offering). A company records the total par value of its shares as legal capital on the accounting ledger. A point to remember is that some of the states have the requirement for LC, whereas some may not have this requirement.
Calculating the LC of a company is simple and easy. It is the total par value of all the shares issued by the company so far since its incorporation. In other words, it is the par value of all the cumulative shares issued by the company. For instance, if a company issues 10,000 shares at a par value of $10, then the legal capital would be $100,000.
Purpose of Legal Capital
The initial purpose of the LC was to help a company develop a reserve, which the management could access in time of need. Or, it helps to protect creditors if a company defaults. However, the companies issuing shares at lower par value negated the purpose of such reserves creation and back up.
For example, suppose Company A issue shares at a par value of $0.02. In such a case, only $0.02 per share will come as a reserve. And, all other amounts that the company gets, such as share premium, would go to the additional paid-in capital account. In this case, even if Company A issues a million shares at $10, the total legal capital would be just $20,000.
Features of Legal Capital
Following are features of the LC:
- As said above, it helps to protect the creditors in case the company is unable to pay them because of a financial crisis, or any other event.
- The amount is only on the basis of the shares already issued. This does not apply to the stocks for which a company has got issuance approval, but is yet to issue them.
- The total assets value of a firm must be equal or greater than the sum of its liabilities and the legal capital. This means – Assets >= Liabilities + Legal Capital.
Following are the advantages of LC:
- It offers protection in the event of a financial crisis.
- As discussed this could be used for discharge of creditors and other liabilities but it can not be returned to the shareholders under any circumstances. We can say, shareholders have no control over it.
- Such a capital ensures the value of assets is always more than the liabilities’ value.
- A company can not give dividends or acquire/buyback capital shares as if doing so risks the legal capital.
Is There a Need?
In the present environment, the LC concept has lost its relevance. Shareholders now see it as the blockage of their funds. Majority of share issue nowadays is at very less par value (such as $0.01) or no par value at all. In case, there is no par value and the laws also do not make it mandatory, then shareholders normally need to invest a set amount of legal capital.
Also, a majority of common stock nowadays do not offer dividends. However, the dividend is still common in the case of preference shares. So, for the purpose of preference dividend companies need to declare the par value of the preference shares. Thus, in such a case, a company usually reports the par value of the preference shares as its legal capital.
Minimum Legal Capital
Minimum Legal Capital is also a similar concept. Basically, it is the amount that the law requires shareholders to invest in the business as assets. Or, we can also say that it is the least amount of assets that shareholders need to invest in a firm. This minimum level is also on the basis of the par value of the shares.
For example, suppose law requires a shareholder to invest assets worth three times the stock’s par value. If the par value of $3 and 100 shares are outstanding, then the shareholder would have to invest $900 worth of assets.
A point to note is that this minimum level refers to the initial contribution from the shareholders. If a company keeps incurring losses, then the shareholders are not needed to keep investing to maintain its minimum level.
Such a requirement is in place to protect creditors in case shareholders form a company with unfair intent. Creditors are at a loss if shareholders invest less capital but take massive loans, and later distribute the assets and file for bankruptcy. Since the shareholders have limited liability, creditors can not go after them or file a lawsuit. But, creditors have an option to file a lawsuit for the company’s assets.
The concept of legal capital was created with good intent to offer protection to the creditors. However, the concept has lost its relevance nowadays. Companies now don’t see it as important and bypass it by issuing shares at low par value or no par value at all.