I’ve been covering the steps involved in the Business Formation process. To recap, the steps are:
- Entity selection
- Initial governance matters
- Initial capitalization matters
- Initial agreements among stakeholders
My last post covered the Planning, Entity Selection and Filing steps, which takes us to the point where the state has returned stamped documents establishing a new entity. Now we are at a complex stage: establishing how the business will be managed, initial capitalization, and what the rights of all stakeholders will be going forward.
Initial governance matters
Governance and management of a business entity can be a thorny question, and I will have a lot more to say about in future posts, I am sure. For the moment, all I am focusing on is the methods of setting up the initial governance of the entity.
This will vary depending on the type of entity chosen. For example, in the case of an LLC, an operating agreement among the members must be drafted and signed, which will establish the methods for governance and capitalization. Since an LLC allows for considerable flexibility in that regard, great care must be taken in crafting the operating agreement.
By contrast, in the case of a corporation, the basic governance is established by statute, though it is still highly customizable. Generally, a board of directors must first be appointed by the incorporator. The board has overall authority to manage the corporation, and once there are shareholders they can be elected and removed by shareholder vote. Once the board is formed, the board usually takes a number of actions. The first is usually to adopt bylaws. The bylaws set out basic governance matters as it relates to the board: how many votes are required for certain actions, board appointment procedures, etc. Then the board may appoint officers. These are the persons responsible for day-to-day management of the entity, for example the CEO. Boards can appoint as many officers as they wish, and can expand or limit the scope of such officers’ authority. The board will also usually take a number of other actions, such as authorizing bank accounts, officer actions, and entry into capitalization transactions (as discussed below).
It is very important to follow proper governance procedures, including shareholder and board meetings, preparation of minutes and resolutions, maintenance of a minute book and other corporate formalities. Failure to follow these procedures can lead to negative consequences, including shareholder challenges to proper authorization of transactions, the perception of risk by investors and acquirers, and loss of the benefits of limited liability.
The next step is the initial capitalization. The following reflects the capitalization of a corporation, as the capitalization of an LLC will vary greatly depending on its Operating Agreement. A corporation may have a single stockholder, which makes things easy until such time as there are additional stockholders. But once there are one or more stockholders, how to value and allocate shares to each can be complex.
Once stock has been authorized for issuance by the corporation, the corporation may issue stock to the founders, investors or others. Typically, stock will be issued in exchange for a “contribution to capital”, which can be cash or another asset. Founders or others may also contribute or otherwise assign intellectual property in the form of business plans, mockups, prototypes or whatever other assets the company’s business will be based on. These assets form the basis of the business of the corporation, and it is important for the corporation and its stockholders/founders to avoid intermingling their personal assets and the assets of the corporation (on an ongoing basis, if the business needs more money or other assets, then there should be a documented arrangement for the founders or others to either contribute, loan or otherwise transfer such assets. And if someone owns assets that will be used by the business but they want to retain ownership of those assets, then use of the assets should be licensed to the entity).
In each case, agreements should be drawn up specifying the amount and form of capital that is contributed, and the number of shares that are received in exchange. There should be stock certificates reflecting the shares issued, and a stock ledger needs to be established by the corporation’s officers that tracks all stock and transfers of stock.
Then there is the issuance of stock to founders or others in exchange for their contribution of ideas, labor, or other things often called “sweat equity”. Different founders may have different ideas on how to handle this. For example, some founders may determine that even though one of them is not making a capital contribution, he or she should be entitled to a stock grant because the business was their idea or they have particular domain or technical expertise that is needed to help the business flourish. But many founders think that sweat equity should be earned in return for the labor put into the business. Therefore, founder’s stock is often structured to “vest,” meaning that the stock is earned over a period of time. That way, if a founder leaves shortly after starting the enterprise they do not take a large chunk of equity with them.
Sometimes founder’s stock is structured as a separate class of stock from common stock, so as to grant the founders particular rights of control over the governance of the business. However, once there are investors, those special rights will be subject to negotiation.
One issue to note: a founder or employee of a company with unvested stock or options will probably want to make what’s known as an Internal Revenue Code Section 83(b) election (known simply as an “83(b) election”). In order to not recognize income on the difference in value of a stock from the time when unvested stock or options are issued or purchased and the time when the stock or options vest, such person MUST make an filing with the IRS within 30 days (no exceptions) of the original issuance of the unvested stock or options. In addition to freezing ordinary income or alternative minimum tax recognition (if any) to the issuance date, an 83(b) election also starts the one-year capital gains holding period on the stock.
I am only scratching the surface of the issues that come up in initial capitalization, but as you see it can be complex and particularized. An important takeaway is that all capitalization transactions need to be well-documented and authorized by the board to avoid potential disputes in the future (among other things).
Initial agreements among stakeholders
Once a company has been capitalized and its governance procedures are in place, many find it useful to have shareholders enter into agreements among themselves and with the company. Typically these agreements are adopted in order to foster cohesion among the shareholders and allow the company to focus on building a business rather than dealing with changing strategies from a fluid set of shareholders, and to ensure that the company is responsive to the needs of the investors. For example, the shareholders may wish to enter into an agreement among themselves that governs the sale of stock by any individual shareholder. Such agreement would grant rights of first refusal, co-sale rights, or other rights to the other shareholders. Or the shareholders may wish for the company to grant them certain rights as investors, such as information rights (access to company information), registration rights (the right to compel a public offering), first-offer and preemptive rights, and many others.
Use of these agreements is highly dependent on the situation and the requirements of investors. If you are considering a seed investment in a company, you should consider how these agreements will protect your investment.
This is a very brief overview of the issues that arise in Business Formation. The key takeaway: Incorporating is a lot more complex than filing documents with the State. Entrepreneurs need to think through a number of issues that will affect their business in the future, and it is helpful to have solid advice along the way.