Capitalizing Reserves: Basics that You Need to Know

A capitalizing reserve is one of the mechanisms of increasing capital in share companies. In simple terms, it is the conversion of the reserves of the companies into shares (equity). But if no new money is not injected into the company, how can we say that it is a means to increase the capital of the share company? Once the reserve is converted into shares, who owns the shares? This piece of writing answers these questions.

Increasing Capital

Share Companies may want to increase their capital to finance their operation. And there are two and sometimes three ways of increasing the share capital (see Article 442 of the new Commercial Code). The first one is debt. The company may issue bonds and debentures to borrow money from external lenders such as banks. By so borrowing the money, the company may acquire the necessary finance. The second method is by issuing new shares and selling them either to the shareholders or to external buyers. The third method recognized by the Commercial Code is capital increase by increasing the par value of the existing shares. If, for instance, the par value of the shares of the company was 1000, the company may increase it to 2000 and the shareholders will be expected to pay additional money unless it decided to cover the difference from the reserve or profits to be distributed to shareholders.

Dealing with the second method (issuing new shares), there are four ways in which newly issued shares may be paid. The first is through cash i.e. buyers will pay cash or in-kind equivalent to the shares they bought. Secondly, it could be paid by converting debentures into shares. The third is pre-existing debts of the company. That is to say that shares may be issued to pay the current debts of the companies. And fourthly, it could be paid by capitalizing the reserves or other funds that did exist with the company. The below discussion focuses on the last method of payment.

What is a Reserve?

Reserve refers to money that is set aside by the company from its profits. This reserve could be a mandatory reserve or a voluntary reserve. The mandatory reserve is called legal reserve according to Articles 433 and 434 of the new Commercial Code. Companies are required to reserve five percent of their net profits each year until the total amount of reserve equals five percent of the capital of the company. Voluntary, on the other hand, is a reserve that is not required by law but companies keep the fund for various reasons including any unexpected short-term expenses. These include supplementary reserve, optional reserve, and free reserve as envisaged under Article 434 of the new Commercial Code.

Capitalizing Reserve: Does it Really Increase Capital?

Capitalizing reserve is converting the reserve into shares. In other words, the company issues shares and uses the reserve to pay the price of the shares. The sensible question, here, is if the company is using the money that already had with it, how could capitalizing it increases the capital of the company?

True is that the company is not receiving any new money from outside but here is how it works:

Capital share, in its legal sense, refers to the legal capital of the company that is stated in the Memorandum of Association of the company. So, by capital, the law is not referring to the accounting terminology which means cash or liquid assets. Rather, it refers to the number of allotted shares multiplied by their par value. If you are thinking of the accounting term, then capital may include the reserves but from the legal point of view, reserves are not shares or capital shares. So, converting the reserve to shares makes sense.

So, the overall capital of the company does not increase in these situations but the legal capital does.

So, Who Owns the Shares?

As shareholders are not paying for the shares, one may ask who owns the shares. The answer is the shareholders.

The reserve is a profit of the company which is not distributed to shareholders as dividends. When this money is used to issue new shares, the shares will be distributed to shareholders as a bonus proportion to their percentage of holdings.

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