Legal Capital

Legal capital is the minimum amount of a corporation's equity that state corporate law requires it to keep within the business for the protection of creditors. In most cases it equals the total par value of the shares the company has issued, or the stated value assigned to no-par shares by the board. A corporation generally may not pay dividends or buy back its own shares if doing so would reduce its equity below this amount.

The concept grew out of nineteenth-century US law, when shareholders' limited liability meant that a creditor could look only to the company's own assets for repayment. Legal capital was meant to be a permanent cushion that the owners could not withdraw. Today it is mostly a legal and presentation matter, and many states have replaced it with solvency-based tests, but the par value figures still appear in the equity section of US balance sheets.

When a company issues shares for more than their par value, the proceeds are split into two parts. The par amount goes to the common stock or preferred stock account and represents legal capital. The excess goes to additional paid-in capital. The calculation is:

Here $\text{Shares issued}$ is the number of shares sold, including any later repurchased as treasury stock in most states, and $\text{Par or stated value per share}$ is the nominal amount set out in the articles of incorporation or fixed by the board.

A startup issues 2,000,000 shares of common stock with a par value of $0.01 each, at a price of $5 per share, raising $10,000,000 in cash. The journal entry debits cash $10,000,000, credits common stock $20,000 and credits additional paid-in capital $9,980,000. The company's legal capital is $20,000, even though the shareholders contributed $10 million. Under a strict legal capital regime, the company could distribute up to its surplus (equity above $20,000) as dividends, provided it also remained able to pay its debts.

If the shares had a par value of $5, legal capital would be the full $10,000,000 and none of the contributed money could be returned to shareholders as a dividend. This is one reason modern companies set par values very low, often a fraction of a cent.

The rules vary by state. Delaware, where many large US companies are incorporated, still uses the idea: its corporation law generally limits dividends to surplus, defined as net assets in excess of capital, or to current and prior-year net profits. By contrast, the Model Business Corporation Act, revised in 1980 and followed by a majority of states, dropped par value and legal capital in favor of two tests: a company may not make a distribution if it would be unable to pay its debts as they fall due, or if its total assets would fall below its total liabilities plus any preferential amounts owed to preferred shareholders. Directors who approve unlawful distributions can be personally liable.

Outside the United States, similar ideas appear as "share capital" maintenance rules, for example in the European Union and the United Kingdom, where public companies must hold a minimum share capital and may pay dividends only out of distributable profits.

• Legal capital is not the same as total paid-in capital. It is usually a small part of what shareholders actually invested.
• Legal capital is not cash. It is a figure in the equity section of the balance sheet, and the business may spend the cash it raised on any purpose.
• Par value says nothing about market value. A share with a $0.01 par may trade at $100.
• A legal capital test does not guarantee that a company can pay its creditors. A business can have plenty of surplus on paper and still face insolvency, which is why most modern statutes rely on solvency tests as well.

Legal capital is part of the broader idea of capital stock and contributed equity, and it interacts with the accounting equation only as a subdivision of equity, not as a separate asset or liability.