Considerations in Business Formation – Part I

In keeping with my promise to start at the beginning, my next few posts will be on business formation and subsequent posts will be on the different business entity types. Today I will focus on a few basic questions surrounding business formation, and the first few steps in business formation.

What does business formation mean in the legal context?

In a legal context, business formation is the process of planning and documenting the initial formal relationships among stakeholders that will govern the ownership and management of the business as it moves forward.  It encompasses planning and executing choices regarding entity structure, governance, capitalization, and tax strategies for the business as well as its founders and investors.

Its important to note that I am not discussing the full scope of legal services that may be needed at the inception of a business, which may include commercial contract drafting, intellectual property documentation and filing, or documentation of employment relationships. Rather, I  am focusing only on the initial set-up of the entity and it’s relationship to its founders, shareholders, board member and officers.

What steps are taken in business formation?

The process for business formation can be broken down into the following steps:

  • Planning
  • Entity selection
  • Filing
  • Initial governance matters
  • Initial capitalization matters
  • Initial agreements among stakeholders

The first step, and a very important one, is to develop a plan for business formation. There are a number of factors that impact determination of the best legal structure for a business, including the business plan, investment and capitalization plans, the personal financial and tax positions of the founders and investors, and tax planning for the business based on projected revenues and profits. Determining how the entity is best capitalized and governed in advance of forming the entity will help avoid costly mistakes.

Entity selection

Once these factors have been considered and a plan has been established, an entity structure can be selected based on the various considerations. This encompasses both (i) selecting the initial entity or structure for ownership of the business operations (i.e., LLC, corporation, or other entity or structure), and (ii) selecting the jurisdiction in which such entity or entities will be incorporated or formed.

The choice of jurisdiction is important because business entities are governed by state law, and in most circumstances the laws of the state of incorporation will govern all matters related to managing the entity as well as all disputes among the entity and its shareholders. Even though most states offer substantially similar entities, there are differences in the way they are regulated, taxed, and how disputes are resolved in their courts.

In addition to other considerations, an analysis of the purposes of the enterprise may be appropriate, as either a non-profit corporation or one of California’s two new entities, a “flexible purpose corporation” or “benefit corporation” might be better suited to the purposes of the business.

Due to this complexity, the choice of entity is best determined once there is a basic business plan in place and some thought has been put into the business formation process as a whole.

Filing of formation documents

Once an entity and jurisdiction is chosen (or, in some cases, a structure of entities), then documents are prepared and filed with the state in which the entity is to be incorporated or formed. These documents must reflect a number of elements of the plan for governance and capitalization of the entity. For example, incorporation filings must include descriptions of the economic and voting rights of each class of stock, and the articles of organization for an LLC must specify that the LLC will be managed by appointed managers, as the default option is that management power is vested in each member of the LLC. Once the documents are filed, they are reviewed by the state for compliance with applicable law. If satisfactory, the documents are stamped and the entity comes into being.

Incorporation documents are a matter of public record, and with payment of a small fee they can be obtained and inspected by investors (among others) to verify the dilution of the capital stock of the corporation.

Now that you have an entity, what’s next? Governance matters need to be established, the entity needs capitalization in order to begin to conduct business, and the shareholders may wish to enter into certain agreements among themselves. I’ll discuss these in my next post.

Considerations in business formation – Part II