Let’s Talk Legal will be a recurring column written by Alexander Davie, co-founder and member of Nashville-based Riggs Davie PLC. Davie advises startups and emerging companies in all areas of business law.
When it comes to incorporating a startup, founders often file articles of incorporation (a.k.a. a charter or a certificate of incorporation) with their state’s secretary of state and stop there. They think that the filing is enough to form the corporation. However, forming a corporation involves a number of additional steps, and a corporation is not validly formed unless many of these steps are performed. So, here are the most important ones.
- Appoint Directors. To be validly incorporated, a corporation needs a board of directors. Some forms of articles of incorporation include a designation of initial directors. If that’s the case, then this step has been performed. But most of the time, the articles just designate the incorporator. In that case, they will need to have the incorporator appoint the initial directors, which is often done by a document called a “Written Consent” or something similar.
- Adopt Bylaws. To be validly incorporated, a corporation also needs to have adopted bylaws. Not only do you need to have the bylaws actually drafted, you also need board minutes that show the board adopted them. This can also be done by a document called “Written Consent of the Board of Directors Without a Meeting.” It can also be done at an actual meeting of the board. I also strongly recommend appointing officers and attending to a host of other routine board matters at this meeting or in this consent.
- Issue Stock. A corporation must have shareholders. I find that this step is frequently ignored. Validly issuing stock involves a number of steps. Many courts have ruled that if these steps are not substantially followed, the stock is not valid, so it’s important to attend to these. To validly issue stock, (a) there needs to be sufficient authorized but unissued stock listed in the articles; (b) a board resolution needs to be passed authorizing it, either at a meeting or by a written consent without a meeting; (c) the corporation needs to issue a stock certificate for the stock; (d) there should be a written subscription or stock purchase agreement between the corporation and each founder outlining the terms of the purchase, including the price paid to the corporation; (e) that purchase price should actually be paid to the corporation (so set it low if you need to); and (f) the stock should be listed on a stock ledger for the corporation.
- Get an EIN Number. All entities in the United States are required to have EIN numbers. It’s essentially like the corporation’s social security number. The corporation will need it to file taxes, open a bank account or even get paid by customers. It is quite easy to obtain from the IRS’s website. Often states, counties and cities also have business tax registrations or business license requirements, so pay attention to these as well.
- Get a Shareholders’ Agreement in Place. While not required, I always recommend that startups with more than one founder get a shareholders’ agreement signed between the shareholders. A shareholder agreement prevents your co-founder from selling his or her shares to a random person. It also usually contains provisions that deal with what happens to the shares of a founder who dies, becomes disabled or loses their shares in a bankruptcy or divorce. Potential investors often look for a shareholder agreement to be in place, so if you don’t have one, they may demand that all of the shareholders sign one. If a shareholder refuses to at that point, it can jeopardize the investment.
- Consider Subjecting the Founders’ Stock to a Vesting Schedule. While not required, I frequently recommend that startups with multiple founders subject the shares issued to founders to a vesting schedule. Without one, if one of the founders were to die, become disabled or otherwise leave the company, that founder would be able to keep all of his or her shares, regardless of whether the services that were expected from that founder were actually performed. For example, if a founder were to leave the startup for whatever reason one year after the formation of the company, and that founder owned 3 million shares outright (let’s say 50 percent of the company’s currently outstanding shares), then the company would be stuck with that founder (or his or her heirs) as a large shareholder in the company, even if that founder’s actual contribution ended up being very small. In contrast, if the founders had each been subject to a four-year vesting schedule, then the departing founder (or his or her heirs) would only be able to keep 750,000 shares (or 12.5 percent of the company’s then-outstanding shares). The other 2.25 million would be available to be awarded to someone else as compensation to take the place of the departed founder.
There is no point in spending the money to file articles of incorporation only to not have a valid corporation in place. Founders rely on the limited liability protection that a corporation provides, but many don’t realize what is necessary to get that protection in place. In addition, it’s a good idea to prepare for unforeseen contingencies that may come up, through a shareholder agreement and a vesting agreement. Attending to these steps will give a corporation a firm legal foundation.