Organization and Financial Structure of Corporations

1. Organization and Financial Structure of Corporations 42 C H E A P T R “Our business is company creation.” Ann Winblad, venture capitalist, quoted in Fortune (Sellen and Daniels, Oct. 1999)

2. Learning Objectives • Promoters and preincorporation transactions • Incorporation and defective attempts • Financing for-profit and nonprofit corporations • The nature and operation of shares 42 - 2

3. Overview • Each state has enacted laws detailing how a corporation may be created • A promoter of a corporation incorporates the business, organizes the initial management team, and raises initial capital • A promoter may be the one who originated the idea for the firm or may be a professional hired to undertake incorporation activities 42 - 3

4. Preincorporation Contracts • A promoter will be liable for contracts made during the preincorporation period unless the corporation adopts the contracts made by the promoter (adoption) and the third party agrees to substitute the corporation for the promoter (novation) • Like agency ratification, may be express or implied • Contracts adopted typically: employment and real property lease or purchase 42 - 4

5. Share Subscriptions • Preincorporation share subscriptions are contracts in which a prospective shareholder offers to buy a specific number of shares in a new corporation at a stated price • Under the Model Business Corporation Act (MBCA), a prospective shareholder may not revoke a preincorporation subscription for a six-month period 42 - 5

6. Promoter Duties • A promoter is not an agent of the proposed corporation or investors since they did not appoint the promoter, but a promoter owes a fiduciary dutyto the corporation and to its prospective investors • No self-dealing, duty of loyalty, etc. • A corporation may compensate a promoter with shares 42 - 6

7. Incorporation • A U.S. business may incorporate in any state • Fees, taxes, and laws vary from state to state • See, e.g., Virginia State Corporation Commission: • www.scc.state.va.us/ A Texas Corporation Stock Certificate 42 - 7

8. Steps in Incorporation • Prepare articles of incorporation • Sign and authenticate articles by one or more incorporators • File articles with secretary of state and pay fees • Receive copy of articles of incorporation stamped “Filed” by secretary of state, along with fee receipt • Hold organizational meeting for purpose of adopting bylaws, electing officers, and transacting other business 42 - 8

9. Incorporation Details • The articles of incorporation (or charter) is the basic document stating the rights and responsibilities of a corporation, its management, and its shareholders • Must add extension to name indicating corporate form: Inc., Corp., Co., Ltd. • Must include other specifics, such as number of shares authorized, initial registered office and agent’s name, name and address of each incorporator 42 - 9

10. Incorporation Details • Other provisions (not inconsistent with law) may be added to articles of incorporation or may be included within corporate bylaws • See Fig. 2, page 990 • To retain corporate status, a corporation must file an annual report with the secretary of state of the state of incorporation and pay an annual franchise fee or tax 42 - 10

11. Defective Incorporation • Sometimes, an attempt to incorporate fails • One consequence is that the corporate shield does not exist to protect shareholders, officers, and directors from personal liability • Another possibility is that a party to a contract involving the defective corporation may claim nonexistence of the corporation to avoid a contract made in the name of the corporation 42 - 11

12. De Jure Corporation • De jure corporation: exists when promoters and incorporators substantially comply with each mandatory (shall, must) requirement to incorporate the business • The validity of a de jure (by law) corporation cannot be attacked except by the state of incorporation due to noncompliance with state corporation laws 42 - 12

13. De Facto Corporation • De facto corporation: exists when promoters fail to comply with all of the mandatory requirements, yet comply with most of the mandatory provisions • The validity of a de facto corporation could be attacked by a third party, or itself, or the state of incorporation, but may be treated by as a corporation under the judicial doctrine of corporation by estoppel 42 - 13

14. The MBCA • Under the MBCA, filing the articles of incorporation is conclusive proof that the corporation exists • MBCA imposes joint and several liability for a purported corporation’s contracts and torts on managers and shareholders who both (1) participate in operational decisions of the business and (2) know the corporation does not exist 42 - 14

15. Non-Profit Incorporation • A non-profit corporation incorporates in the same way as a profit corporation, but must declare whether it is a: • public benefit corporation, mutual benefit corporation, or religious corporation • Nonprofit corporation’s articles must also state whether it will have members 42 - 15

16. Financing Corporations • For-profit corporations are financed by: • Sale of securities, including shares, debentures, bonds, and long-term notes payable • Bank loans • Short-term financing (e.g., inventory financing) 42 - 16

17. Equity Securities • Equity securities, better known as stock or shares, create an ownership relationship, thus stockholders or shareholders own a corporation • State laws permit corporations to issue classes of shares with specific rights: • Common • Preferred 42 - 17

18. Common Shareholders • Claims for dividend payments or asset distribution on liquidation are subordinate to creditor or preferred shareholder claims • However, common shareholders have the exclusive right to elect corporate directors and exclusive claim to corporate earnings and assets that exceed the claims of creditors and other shareholders 42 - 18

19. Preferred Shareholders • Preferred shareholders generally receive liquidation and dividend preferences over common shareholders • A corporation may have several classes of preferred shares with specific rights related to dividend payments, asset distribution upon liquidation, voting, stock redemption, and stock conversion 42 - 19

20. Share Types • Authorized shares are shares a corporation is permitted to issue by its articles of incorporation • A corporation may not issue more shares than authorized • Issued shares have been sold to shareholders • Outstanding shares are currently held by shareholders 42 - 20

21. Options, Warrants, & Rights • A board of directors may issue options for purchasing the corporation’s shares • Issued to top-level managers as an incentive • Warrants are options evidenced by certificates • Rights are short-term certificated options that are usually transferable • Used to give present security holders an option to subscribe to more shares 42 - 21

22. Debt Securities • Corporations may borrow money to operate by issuing debt securities, such as bonds, debentures, and notes payable • Debt securities create a debtor–creditor relationship between the corporation and the security holder 42 - 22

23. Debt Securities • Debentures are long-term, unsecured debt securities with a 10 to 30 years term • Having an indenture, or a contract stating the rights of the debenture holder • Bonds are long-term, secured debt securities • Identical to debentures except that bonds are secured by collateral • Notes generally have less than a five year term and may secured or unsecured 42 - 23

24. Consideration for Shares • MBCA permits shares to be issued in return for any tangible or intangible property or benefit to the corporation, including cash, promissory notes, contracts for services to be performed for the corporation, services performed for the corporation, and securities of the corporation or another corporation 42 - 24

25. Consideration for Shares • The board must issue shares for an adequate dollar amount of consideration • Par value is an arbitrary dollar amount that may be assigned to shares by the articles of incorporation • Does not reflect the fair market value, but is the minimum amount of consideration for which the shares may be issued 42 - 25

26. Share Subscriptions • Under the terms of a share subscription, a prospective shareholder promises to buy a specific number of shares at a stated price • Generally in writing, though not required • A share certificate may not be issued to a share subscriber until the share price has been fully paid 42 - 26

27. Transfer of Shares • Share certificates are registered with the corporation in name of a specific person • Indorsement of a share certificate on back by the registered owner and delivery of the certificate to another person transfers ownership of the shares • Under the UCC, a corporation owes a duty to register the transfer of any registered shares, provided it has proper indorsement 42 - 27

28. Transferability & Restrictions • Shares in a publicly held corporation are freely transferable, but often close corporations (less than 50 shareholders) restrict transfer to ensure control • Four categories of transfer restrictions: (1) rights of first refusal and option agreements, (2) buy-and-sell agreements, (3) consent restraints, and (4) provisions disqualifying purchasers 42 - 28