By Richard Harroch
Many businesses today are established as corporations. Corporations are separate legal entities that are typically used to operate a business. Corporations give you the advantage of limited liability, meaning that when you incorporate a startup, you risk only the amount you invest in the company—provided that you properly operate the corporation.
Corporations are not complicated to set up. However, you do have to follow some important steps and create a number of documents. In this article, I give an overview of the key elements in creating a corporation.
Incorporating a Startup: Preliminary Corporate Foundation Issues
Forming a corporation requires you to take some basic steps. Corporations are subject to state statutes, and the rules and procedures for creating corporations vary from state to state. Before you incorporate a startup business, make sure that you consult your state’s laws for the precise rules.
Naming the Corporation
Choosing a name for your corporation isn’t something you should do casually. Your company’s name is a serious decision that impacts your ability to create the documents necessary to properly form the corporation. Not only does the name you choose affect your customers’ image of your company, but the uniqueness of your name can also affect future trademarks, service marks, and your ability to conduct business in your own state and in other states.
Before you choose a name for your corporation, conduct the following searches:
- Has another company filed a conflicting trademark or service mark with the U.S. Patent and Trademark Office?
- Is your proposed name available in key states in which you intend to do business? A conflict in another state generally prevents the company from qualifying to do business in that state under that corporate name.
- Can you get the desired domain name?
Have Several Names in Mind
Unfortunately, many business names are already taken, so be prepared to check the availability of several names at once. Also, remember that the state corporation statute typically requires that your corporation’s name include the word “Corporation,” “Company,” “Inc.” or “Incorporated.” Similarly, many laws prohibit the use of certain words, such as “Bank” or “Insurance” in the corporate name unless the corporation qualifies as such entity.
After a Name Is Cleared
After you receive a clearance on a name, you can either incorporate your startup right away with the name or reserve it for a while (time periods may vary) by filing a Name Reservation. The Secretary of State’s office can provide you with the procedure.
Choosing a State of Incorporation
Because the laws that affect corporations vary from state to state, many people ask which state to incorporate their startup businesses in. As a practical matter, most of the time the answer is to incorporate a startup under the laws of the state in which the corporation intends to conduct its principal business. Thus, if you are a California business, then California incorporation probably makes sense.
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Delaware, which has a well-developed body of corporate law, is also a favorite haven for incorporation. However, if you are doing business in another state and incorporate under Delaware law, you will have extra filings and costs. Delaware may make sense if the company is backed by a venture capitalist with a clear goal of going public.
Most states have pamphlets on how to incorporate a startup, with sample forms that you can get from the Secretary of State’s website.
Creating the Articles of Incorporation
After you select the corporate name and state of incorporation, you must file the official document creating the corporation with the Secretary of State. This can be filed by your corporate lawyer or with the help of an online incorporation service such as CorpNet.com or MyCorporation.com. This document is called the Articles of Incorporation or the Certificate of Incorporation, depending on the state.
The Articles of Incorporation are typically short—two to three pages long. The key sections are as follows:
- The corporate name. This section of the Articles identifies the formal name of the corporation.
- The purpose of the corporation. Many states, including California and Delaware, allow this section to simply state that the purpose of the corporation is to engage in any lawful activity for which the corporation may be organized in that state. You usually fare better when this clause is more general because you then have the flexibility to expand your business into almost any area. Most state statutes provide that the corporation can have a perpetual duration. You generally don’t want the Articles to provide for a fixed term of existence.
- The authorized capital. This section must set forth the total number of shares that the corporation can issue, the per value share, and the different classes of stock. Typically, you have only one class of common stock, but sometimes you can issue both common stock and preferred stock. This section should authorize a sufficient number of shares to cover the founder’s shares plus shares that may be issued to future employees or investors. If the state doesn’t charge you extra, think about authorizing 10,000,000 or more shares.
- Name and address of registered agent. Most states require the corporation to designate the name and address of a registered agent for service of process in the state. The registered agent is the person given notice of lawsuits filed against your company. If you are incorporating in a state other than where you maintain your principal office, you can designate various professional registered agent companies for a fee.
- Other required provisions. Depending on the state law, some provisions, such as preemptive right to purchase future shares, must also be contained in the Articles to be effective.
Sample forms of Articles of Incorporation can be found in the Forms & Agreements section of AllBusiness.com.
Capitalizing the Corporation
The corporation needs to sell stock to its founding shareholders as part of properly organizing the corporation. This stock sale is sometimes referred to as capitalizing the corporation, and the purpose of the sale is to inject startup funds into the corporation to get it going. Although no minimum amount of money needs to be contributed in order to properly form a corporation, you should consider capitalizing the company with sufficient funds to meet its anticipated early needs.
Understanding Classes of Stock
When you incorporate a startup, you can provide many classes of securities to investors in exchange for the capital that they make available. Two of the most common securities are common stock and preferred stock, and you need to know the difference between these two types of securities:
- Common stock. Common stock is shares in the corporation that have no preferences or priorities over other classes of stock. The rights to distributions, number of votes per share, liquidation rights, and other rights are typically the same for all shareholders on a share-by-share basis.
- Preferred stock. Preferred stock is shares that give the holders various benefits over the common stock holders. Many professional investors, including venture capitalists, favor preferred stock over common stock. Preferred stock often has the following rights:
- A priority on the business’s assets upon liquidation
- A priority on any dividends
- Special voting or veto rights
- A right to force the company to buy back the shares at some point in the future (known as redemption rights)
- A right to convert to common stock based on a formula
- Protection against certain stock splits, stock dividends, and future cheap issuances of stock (known as anti-dilution rights)
- A possible separate right to elect a designated number of directors
Issuing Stock and Securities Laws
In issuing shares to its initial shareholders, the corporation must ensure that it complies with both state and federal securities laws. These laws apply whenever you offer or sell a “security,” such as common or preferred stock. Typically, the issuance of shares to a small number of founding shareholders qualifies for a “private placement”-type of exception from the registration requirements of securities laws. But double-check with your lawyer.
Keeping a Stock Ledger
The company must keep good records of stock issuances, showing the amount of stock issued, dates issued, and funds received. A Stock Ledger can help the company organize this information. Keeping copies of all stock certificates that the company issues is generally a good idea, at least while the company is privately held. Some online services such as Carta provide an online outsourced service for this.
Action of Incorporator
The incorporator is the person who initially organizes the corporation. The incorporator uses a document called an Action of Incorporator to perform important functions, such as adopting bylaws, electing directors (if they are not named in the Articles of Incorporation), and signing the Articles of Incorporation. The incorporator can be a lawyer, a prospective shareholder, or another interested individual.
Unless the Articles of Incorporation name the initial directors, you must create an Action of Incorporator to name the corporation’s first board of directors and permit the corporation to transact business lawfully. Make sure that the document is dated or effective on or after the date of incorporation, and insert the document in the corporation’s minute book.
The Owners and Operators of the Corporation
The shareholders of the corporation are the “owners” of the corporation, the investors who receive ownership in the corporation in return for money or assets they invest.
The shareholders elect a board of directors, who have overall responsibility for the business of the corporation. The board, in turn, elects the officers of the corporation (CEO, vice president, secretary, and chief financial officer, typically). The officers handle the day-to-day affairs of the corporation.
The Board of Directors
The directors must act in connection with the best interests of the corporation and its shareholders. Board members can provide valuable wisdom and experience in guiding a company to success.
Board members maintain a fiduciary relationship with the company (a relationship founded in trust and confidence).
The size of the board is up to the discretion of the shareholders. Generally, you want to avoid an unwieldy number of directors or an even number of directors (to avoid deadlock). The board should meet on a regular basis. After filing the incorporation papers with the Secretary of State, the board needs to adopt organizational resolutions (either at a meeting or by unanimous written consent). These organizational resolutions concern preliminary matters for properly establishing the corporation, as described in the following section.
Initial Actions by the Board of Directors
The board of directors can accomplish the organizational resolutions of the corporation by adopting them in a meeting that they call in accordance with the corporation’s bylaws or by unanimous written consent. Generally, the directors authorize the following:
- Issuing securities and granting warrants, options, or other rights to purchase securities
- Adopting a stock option plan
- Amending the Articles of Incorporation or bylaws
- Entering into major contracts, leases, or other obligations
- Declaring distributions, dividends, or stock splits
- Borrowing significant sums and providing security for loans
- Entering into Employment Agreements with key employees
- Electing officers of the company and setting or changing their compensation and terms of employment
- Adopting or amending employee benefit plans
- Calling shareholders meetings
- Buying or selling significant assets
- Adopting company policies
The founders of the business typically buy stock in the company and are the first shareholders. Later on, investors can contribute money or other assets and also become shareholders.
Various actions of the corporation require action by the shareholders, and these actions must be reflected in minutes of meetings or by appropriate written consents. A corporation is typically required to hold annual meetings of shareholders, the principal purpose of which is to elect the members of the board of directors.
Some of the actions for which shareholder approval may be required or desirable include the following:
- Merger or reorganization of the corporation
- Amendment to the Articles of Incorporation
- Amendment of the bylaws (other than an amendment settling the exact number of directors within the range established by the bylaws or Articles of Incorporation)
- Sale or transfer of all or substantially all of the corporation’s assets
- Approval of contracts with interested directors
- Issuance of certain securities
- Adoption of stock option plans
- Dissolution or winding up of the corporation
The bylaws of a corporation contain the rules and procedures that govern the rights and powers of shareholders, directors, and officers. Most lawyers have a prepared “standard” set of template bylaws that may be modified to meet your company’s specific requirements.
The bylaws are typically adopted by the incorporator or by the board of directors in the organizational meeting, or with written consent in place of the organizational meeting. This organizational meeting or written consent is the first action taken by the board of directors in connection with the formation of the corporation (listed earlier in this article, under “Initial Actions by the Board of Directors”).
The bylaws cover the following:
- The size of the board of directors
- When and how board meetings are called (including notice)
- When and how shareholder meetings are called (including notice)
- Duties and responsibilities of directors and officers
- Procedures for exercising voting rights
- Regulation of the transfer of corporate stock
- Indemnification obligation for officers, directors, and agents (indemnification refers to protection from lawsuits and claims)
- The company’s fiscal year
- General corporate matters
Bylaws generally may be adopted, amended, or repealed by the board of directors or by a vote of the shareholders, and the bylaws may limit the board’s powers in this respect.
Right of First Refusal Agreement
Shareholders of startup companies often enter into a Right of First Refusal Agreement requiring shareholders to give the company or the shareholders the priority right to match any offers to buy shares in the company. This right arises when a shareholder wishes to sell his or her stock. Such an agreement is usually desirable to try to keep stock in friendly hands and maintain the continuity of the corporation. This agreement is sometimes included within the Buy-Sell Agreement.
Key provisions of the Right of First Refusal Agreement include the following:
- Restrictions on transfer
- Right of first refusal
- Legend on a stock certificate
- No transfer to competitors
- Term of agreement
- Will provisions
- Spouse/partner’s consent
A sample of Right of First Refusal Agreement for a California corporation can be found in the Forms & Agreements section of AllBusiness.com, along with many other helpful forms for incorporating a startup.
Copyright © by Richard D. Harroch. All Rights Reserved.
About the Author
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a venture capital fund in the San Francisco area. See all his articles and full bio on AllBusiness.com.
This article was originally published on AllBusiness.com.