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SETTING UP THE BUSINESS ENTITY
Once the decision is made, properly setting up a business entity requires a great deal of effort. Below we provide the primary steps involved in setting up the entity and preparing it to accomplish the startup’s objectives.
• Note: Recall that a sole proprietorship and partnership may arise by the default actions of the business owner(s). This section refers to the process of registering an entity with the state and preparing the organizational governance documents.
What goes into the entity formation process?
Contrary to popular belief, the entity formation process can be somewhat complicated. Many people believe entity formation to be easy because the actual filing and receipt of the formation documents is a simple process. However, as discussed in previous chapters, there is much more that goes into setting up a business entity effectively. That is, setting up the entity so that it is customized to meet the needs of the business. The following paragraphs give a step-by-step overview of the things that need to be either done or considered when forming the entity.
What do I file with the state Secretary of State’s Office?
First, the organizer (or incorporator) will visit the Secretary of State’s webpage and verify the availability of the intended business name. If the name is available and she is not going to immediately file all of the necessary documents, she will want to reserve the name. This will prevent others from taking the name in the interim. Next she must file the application for formation (the articles of incorporation or articles of organization). Most state’s have an electronic system to prepare the application that takes the organizer through some simple steps. While this is a simple manner of creating the organizational documents, it is often advisable to add company specific provisions (such as restrictions on the right to amend the articles). The organizer can always prepare her own articles and upload it through the electronic system.
What tax documents do I file?
During the filing process, the incorporator will prepare and file Form SS-4 (Application for Employer Identification Number) with the IRS and also apply for a state tax reporting number. If the business sells goods, it may also be necessary to apply for a state sales tax number. Later, the incorporator or an appointed officer will undertake to set up deposit or withholding accounts for employee income and payroll taxes. Luckily, numerous software products make it easy to withhold these taxes and report and deposit them with the appropriate taxing authority.
When do I draft the entity governance documents?
Any time before or during this process, the organizer should begin preparing the partnership agreement, operating agreement, or bylaws. Drafting these documents requires a great deal of work and consideration regarding the business operations. The documents will govern nearly every aspect of the business operations including: decision-making; authority or voting rights of owners; composition of the board; etc. The provisions typically included in the governance documents are numerous and can be complex. A great deal of business strategy and ethos goes into these documents. For this reason, the organizer should work with all of the founders to address the governance provisions. It is also advisable to consult an attorney in drafting these provisions.
What actions do the organizers of a partnership take?
GPs arise by default, while LPs and LLPs must be filed with the state. The formation of the partnership, however, is only one aspect of setting up the business entity. The next step is for the individual partners to enter into a detailed partnership agreement outlining the rights, authority, ownership, and liability of the individual partners. Each partner must sign the agreement for it to be effective against that partner. The partnership may also ratify and agree to hold the organizer harmless for any activity in establishing the partnership.
What actions do the organizers of the LLC take?
Organizers of a LLC must undertake procedures similar to that of a partnership that files with the state. The LLC is not required to have formal meetings, but the members should act quickly to adopt an operating agreement. Like the partnership agreement, the operating agreement should cover all of the important structural, financial, and operational aspects of the business. The LLC may also ratify or agree to hold the organizer harmless for activities undertaken in forming the LLC.
What actions do the incorporators and initial board of directors of a corporation take?
The Secretary of State’s Office will review the application for incorporation and either accept or reject the application. If the application is rejected, the department will indicate the deficiency in the application and allow amendment. Once the corporate charter is issued, the corporation now exists. Now the incorporator has to take steps to set up the corporate structure. The first step is to call a corporate meeting. In this meeting the incorporator will appoint the initial directors and the corporate secretary. The corporate secretary will record this action in the minutes and may prepare a resolution for the incorporator. At this point the board of directors has authority. The board prepares and signs the “Actions of Incorporator”, which adopts or ratifies all previous actions taken by the incorporator and relieves her from her responsibilities. Next the board will approve all expenses associated with formation, including any funds paid to the incorporator. Now the board of directors must take numerous actions to completely setup the entity structure.
The next task for the board of directors is to adopt the corporate bylaws. This is done by identifying the bylaws in the initial meeting and voting on their acceptance. Again the corporate secretary may prepare a resolution for the board’s signature. At this point the board will proceed with the meeting in accordance with the rules for director meetings as laid out in the bylaws. The board will then address the following tasks in any given order:
• Authorizing the principal office or place of business;
• Preparing and filing of qualification to do business as a foreign corporation in any other states;
• Designating the corporate fiscal year;
• Ratifying the corporate Employer Identification Number;
• Designating the size of the board of directors (which is generally included in the bylaws);
• Undertaking the election of officers;
• Designating of management powers as appropriate;
• Authorization of corporate stock (number of shares and classes of shares if there are multiple classes);
• Approving the issuance of founder’s stock (common stock) to the business founders;
• Approving any stock option grants to founders (if applicable);
• Approving the minutes,
• Authorizing the corporate seal and stock certificates;
• Approving the subchapter “S” tax election for the corporation (if applicable);
• Authorizing the management to open bank accounts;
• Approving any proprietary information and inventions agreements;
• Approving any indemnification agreements with officers and directors;
• Approving any stock option or issuance plans or option agreements’
Many of the actions of the board are authorized in the articles of incorporation and bylaws. The board can only act within the bounds of these governing documents.
What actions do the shareholders of the corporation take?
The initial meeting will generally conclude by a call for the shareholders (i.e., founders) to vote to formally elect the board of directors. Remember, the initial board of directors was appointed by the incorporator. It is important to have the newly minted shareholders to follow the bylaws and formally elect the standing members of the board. Generally, the shareholders will also vote for secondary tasks, such as approving the indemnification agreement for officers and directors and approving the stock option or issuance plans.
• Note: Many of these actions (by directors or shareholders) may be taken outside of a formal meeting through signed consents. When this happens the consents must generally be unanimous, unless the bylaws expressly indicate otherwise. Corporate formalities require that the company maintain records of all corporate meetings, resolutions, stock issuances, and initial capitalization data. Most corporations use commercial software to track this information.
What formal steps should the corporate board take with regard to issuing corporate equity?
During the initial meeting, the board of directors generally issues “Founders’ Restricted Stock” to the company founders. This is a form of common stock that is expressly restricted from resale by the founders. The issuance is done through purchase agreements or subscription agreements. The purchase agreement may contain standard terms by which the stock vests in the founders over a period of time (i.e., the restrictions will lapse a little each year). When issuing equity, the corporation should prepare the following documents:
• Stock Certificates and Receipts for the receiving founders,
• Memoranda memorializing the IRC Section 83(b) tax elections of each founder (discussed further in Chapter 13),
• All federal and state-required securities filings for stock issuances to founders (generally not applicable for issuance to the founders), and
• Any stock option or issuance plans and agreements.
Preparing stock issuance plans with vesting rights or stock option agreements can be quite complicated. It is advisable to consult a business attorney when drafting these documents.
What formal steps should the members of a partnership or LLC take with regard to issuing business equity?
In a corporation, the board of directors issues shares of stock to the shareholders in exchange for some value. In a partnership or LLC, the partners or members must vote to grant ownership interest in the business entity to a new partner or member. Ownership interest in the partnership is generally recorded in the partnership agreement. There are no individual documents evidencing ownership to be distributed to the new partner. In an LLC, ownership is generally recorded in the operating agreement and represented as an ownership unit. This unit may be physically distributed (similar to shares of stock) to the members. Often times, however, the LLC does not create certificates evidencing ownership; rather, evidence of ownership is maintained solely within the operating agreement. Within both the partnership and the LLC, the governing documents will indicate the voting procedure and requirements for issuing new business equity.
What employee and intellectual property matters should the board of directors or officers’ address?
Establishing relationships with employees and securing intellectual property for the corporation are primary concerns for the newly appointed officers. Without the key employees and intellectual property driving the business activity, the company has very little value. The directors must act to secure employment contracts with officers. Officers will undertake employment contracts with key employees.
• Note: The officers will need to establish an employee handbook outlining the general operating procedure for employees and containing all federal employment law disclosures.
The officers must then turn to the issue of securing all intellectual property of relevance for the corporation. Remember, in startup ventures the company’s intellectual property is often the most valuable asset. Founders who have worked on or participated in the creation of the intellectual property have ownership rights in that property. Those ownership rights need to be transferred to the corporation.
How does the corporation secure intellectual property rights?
The first step is to execute assignment of intellectual property agreements with the founders and anyone who worked on the creation of the intellectual property. The officers should then execute proprietary information and invention agreements with all permanent and temporary corporate employees. Any independent contractors of the company will be required to sign service agreement containing work-for-hire clauses for all work product or inventions. If relevant, employees should sign non-disclosure agreements for all trade secrets, research, and intellectual property. Securing intellectual property rights may include the officers making any patent applications or filing for federal trademark protection.
• Note: Within a startup, many of the activities outlined for shareholders, officers, and directors will be carried out by the same individuals. Remember that it is important for these individuals to indicate their status and authority in undertaking any of the above actions. While it is difficult, it is important to maintain corporate formalities.
Incorporation and Organization Documents
Incorporating and organizing a startup generally requires the following steps:
- Reservation of Corporate Name: Prior to filing the articles of incorporation, you should research to see if the desired corporate name is available. If the name is already registered in the state, then it will be unavailable. The reservation of name can take place before the actual filing of the articles of incorporation. The name is reserved until the time of filing.
- Note: Just because a name is available for registration in a state does not mean that it is not protected. There may be common law or federal trademark rights in a name. This means that, even if a corporate name is registered in a state, the owner of the trademark may be able to prevent use of the name in commerce.
- Filing Articles of Incorporation: The Articles of incorporation is the document used to bring the corporation into existence. The incorporator may draft and file customized articles of incorporation, or she may simply fill out the form on the state secretary of state’s website. See our business entity lectures for more information on filing the articles of incorporation and their contents. One important thing to remember about the articles of incorporation for a startup seeking investment capital, the articles will need to authorize more than one class of stock. Investors will desire a preferred class of stock. The board will not be able to grant the preferred shares without authorization in the articles.
- Note: See the business entities lecture series for more information on what goes into a organizing a business entity.
- Sample: Find a sample article of incorporation at https://www.orrick.com/Events-and-Publications/Documents/1947.pdf
- Developing Bylaws: The bylaws cover the internal governance of the organization. For more information on what is contained in the bylaws, see our business entities lecture series.
- Note: This includes drafting the certificate for the corporate secretary to certify records of the corporation. For more information on the information included in the bylaws visit our business entities lecture series.
- Sample: Find sample Bylaws at https://www.orrick.com/Events-and-Publications/Documents/1948.pdf
- Action By Incorporator: This document is executed by the incorporator to appoint the initial board of directors and to adopt the bylaws. Remember, the incorporator has taken all actions necessary to bring the corporation into existence. In order to transfer control of the corporation over to the directors and shareholders, the incorporator must appoint an initial board of directors to take control. In some cases the board will simply be one person. The first actions of the board will be to adopt the bylaws and appoint a corporate secretary to memorialize board records.
- Sample: Find initial action of incorporator at https://www.orrick.com/Events-and-Publications/Documents/1949.pdf
- Board Consents or Resolutions: Once the board is in place, it must follow the directions outlined in the bylaws for operating the company. The next steps will be the Initial Board Actions to establish the corporate structure and take steps to establish corporate operations. The initial board of directors may hold or meeting or take the initial actions through consent. Remember, often the initial board is a single individuals who finishes establishing the corporation and setting in motion the process for funding from shareholders, election of directors, and appointment of officers.
- Sample: Find sample Board Consent and Resolutions at https://www.orrick.com/Events-and-Publications/Documents/1950.pdf
- Stockholder Consents: Once the board approves stock subscription agreements, the corporate shares are distributed to stockholders (the owners of the corporation. The stock holders now have the authority to vote as laid out in the bylaws. Generally, once the initial actions are taken and corporate shareholders are in place, the initial board will step down and allow the shareholders to formally elect the board of directors. On top of the authority to vote for and elect the board of directors, Stockholders must consent regarding the following organization and corporate governance matters:
- Election of Board of Directors (remember, the incorporator appointed the initial board members).
- Approval of form of Indemnification Agreement for officers and directors
- Sample: https://www.orrick.com/Events-and-Publications/Documents/1943.pdf
- Approval of Stock Option/Stock Issuance Plan
- Sample: https://www.orrick.com/Events-and-Publications/Documents/1967.pdf
Initial Board Actions
The initial board is charged with establishing the operations of the corporation. This begins with resolutions approving and authorizing certain corporate actions. Approving or setting these actions in motion are the core responsibilities of the board. They will take the following organization and corporate governance matters through resolutions at a meeting or through resolutions via consent agreements:
- Adopt Actions of Incorporator: This means that the board will officially ratify actions of incorporator in bringing the corporation into existence. This includes the solicitation of support and pledges from shareholders to fund the initial corporation. This action relieves the incorporator from liability for reasonable actions taken on behalf of the corporation and authorizes reimbursement for the organizational expenses incurred during formation.
- Note: Failure to ratify all of the actions of the incorporator may leave the incorporator potentially personally liable for those actions. Further, intentional misconduct (fraud) by the incorporator cannot be ratified by the corporation to relieve personal liability.
- Corporate Bylaws: Often the corporate bylaws are adopted in the actions of incorporator. In this way, the bylaws provide the procedure for the initial board actions. If no, the corporation will adopt the Corporate Bylaws (if not done through the actions of incorporator)
- Note: The corporation may initially elect subchapter “S” tax status. This is generally not available for startup ventures if preferred shares are authorized in the articles. Also, this will not be available in the event of an equity round by institutional investors.
- Appoint Officers: Much of the activity to bring about board operations must be carried out by officers. Under state corporate law, the board is not empowered to carry out many of the daily operations of the corporation. As such, the corporation must immediately undertake the process outlined in the bylaws to elect the board and appoint officers. This will include a designation of authority of officers or managers of the corporation.
- Note: It is assumed that executives or presidents of a corporation have authority to act in any manner on behalf of the corporation. Many of the activities to be undertaken by the officer, however, will require a resolution by the board of directors. For example, opening an account with a financial institution will generally require certified board resolutions authorizing this action by the officer charged with that responsibility.
- Indemnifications Agreements: As part of the appointment of officers, the board will often approve indemnification agreements with the officer. These agreements provide for indemnification of officers for personal liability for actions taken on behalf of the corporation. The board will also approve separate resolutions that approve indemnification for decisions made by directors.
- Note: Officers and directors of corporations generally receive a high degree of protection from liability pursuant to the “business judgment rule”. Nonetheless, it provides comfort to officers and directors that they will not be held personally liable for actions or decisions made on behalf of the corporation. Many states limit the ability of the corporation to indemnify against acts by officers or directors that are illegal or intend to harm the corporation.
- Sample Indemnification Agreement: https://www.orrick.com/Events-and-Publications/Documents/1956.rtf
- Corporate Identity Issues: Much of the corporate identity information is required in the articles of incorporation. Establishing these things are outside the ordinary course of operations and must be adopted by the board of directors.
- Note: Examples of resolving to corporate identify information includes: Authorization of principal office, authorization of registered agent, foreign qualification to do business in given locations, establishing the corporation’s fiscal year, applying for a tax Employer Identification Number, D/B/A “fictitious name” filing in jurisdictions that require such filing, etc.
- Issuance of Shares: The incorporator will have drummed up support for the corporation prior to formation. Only the board is capable of issuing shares. As such, the founders of the corporation will enter into subscription agreements with the corporation. The agreements will be pre-signed by the founders (soon-to-be shareholders). The board will approve the issuance of stock (or Options if Applicable) to the founders by resolving to enter into the applicable subscription agreement.
- Note: This will be executed through a subscription agreement, which is discussed in a separate lecture. Multiple classes of stock will generally be authorized. Preferred shares are generally not issued until an equity round is approved.
- Corporate Records: The board will establish the official records of the corporation.
- Note: The responsibility of maintaining the records rests with the corporate secretary; but, approving the minute books, corporate seal, and stock certificates is the role of the board.
- Financial Authorization: Many institutions dealing with the corporation will requires specific board authorization to render services to the corporation. That is, officers of the corporations will have to take the board minutes or certified board record in order to deal with the third party.
- Note: Examples of action requiring specific board authorize includes: opening bank accounts, credit cards, lines of credit, payment systems, etc.
- Intellectual Property Agreements: Often founders of the corporation will transfer their rights in intellectual property to the corporation. Remember, the business activity probably existed prior to the formation of the corporation. As such, the intellectual property rights held by inventors or business founders may need to be transferred to the corporation. These intellectual property rights may be extremely valuable (if not essential) assets to corporate operations. As such, the board may approve any agreements concerning proprietary information or inventions agreements transferred to the corporation.
- Note: In some cases the subscription agreement accepted by the corporation will reference the transfer of intellectual property rights to the corporation. Later, officers of the corporation may enter into intellectual property agreements on behalf of the corporation.
- Equity Plans: Stock plans of the corporation line out the types of stock (classes and characteristics of each class), the rights of stockholders, the rights or option or warrant holders, etc. These plans become incredibly important with the issuance of multiple classes of shares. Approve Stock Option/Stock Issuance Plan and forms of Option Agreements.
- Sample Approval of Stock Plan: https://www.orrick.com/Events-and-Publications/Documents/1966.pdf
- Sample Approval of Restricted Stock Grant: https://www.orrick.com/Events-and-Publications/Documents/Board-Approval-of-RSP-Grant.pdf
- Sample Approval of Option Grant: https://www.orrick.com/Events-and-Publications/Documents/1968.pdf
Capitalization is the funding of the business venture. A startup will be capitalized by contributions from founders. In exchange for contributed value (funds or assets) the founders will receive shares of the corporation. The corporation should follow the following steps regarding capitalization:
- Subscription Agreements: A subscription agreement (or stock-purchase agreement) is the agreement entered into by founders of the corporation to purchase shares of the corporation in exchange for a given amount of value. The subscription agreement will lay out the specific types of shares purchased and the rights of the holder of those shares. It may also place additional restrictions on the shares and establish a period of time over which ownership of the shares vest in the purchaser.
- Note: A subscription agreement may have appendices containing additional information, including the company’s capitalization table and the stock ledger documentation corporate ownership.
- Sample Common Stock Purchase Agreements: https://www.orrick.com/Events-and-Publications/Documents/1951.pdf
- Sample of Restricted Stock Purchase Agreement: https://www.orrick.com/Events-and-Publications/Documents/1975.pdf
- Sample Capitalization Table: https://www.orrick.com/Events-and-Publications/Documents/1953.xls
- Sample Stock Ledger: https://www.orrick.com/Events-and-Publications/Documents/1954.doc
- Stock Certificates: The board generally issue Stock Certificates and Receipts for the purchasers of shares. The stock certificates represent a share of stock of the corporation. Some corporations do not issue stock certificates; instead, these corporations send out notices of Issuance of Uncertified Common Stock.
- Sample: A sample of stock certificates may be found at https://www.orrick.com/Events-and-Publications/Documents/1952.pdf
- Sample: A sample notice of issuance of uncertified common stock can be found at https://www.orrick.com/Events-and-Publications/Documents/Notice-of-Issuance-of-Uncertificated-Common-Stock.pdf
- 83(b) Elections: The board may prepare of Memorandum regarding the 83(b) Elections by the founding shareholders. The 83(b) election must be made at the time of issuance. This election locks in the tax basis of the stock at the time of issues. This is important for equity that vests over a period of time and may significantly increase in value by the time it vests. It will avoid an unfortunate tax situation.
- Sample: A sample 83(b) Election Memorandum can be found at https://www.orrick.com/Events-and-Publications/Documents/1955.pdf
- Securities Filings: Prepare and File Federal and State securities filings for stock issuances to shareholders (Founders)
- Note: See our Securities law lecture series for more information on the federal and state requirements for securities filings.
- Stock Issuance & Option Plans: Prepare Stock Option/Stock Issuance Plan & Agreement & Stock Option Agreement or Early Exercise Stock Option Agreement
- Sample Stock Plan: https://www.orrick.com/Events-and-Publications/Documents/1965.pdf
- Sample Option Agreement: https://www.orrick.com/Events-and-Publications/Documents/1965.pdf
- Buy-Sell Agreements: The corporation will want to ensure that the companies shares are not transferred to third parties except under the circumstances approved by the corporation. The buy-sell agreement may provide any number of rights to the corporation, such as the right of first refusal to purchase shares.
- Note: A well-drafted buy-sell agreement is incredibly important. It can, however, by complex. It is a good idea to seek professional assistance from an attorney skilled in drafting buy-sell agreements.
- Consents to Service: Prepare and file Form U-2 Uniform Consent to Service of Process (in connection with securities filings).
Employee and Contractor Matters
- At-Will Employment Offer Letter: The at-will employment letter will outline the rights of employer and employee to end the employment relationship.
- Note: State law differs with regard to the extent to which an employee is at-will.
- Proprietary Information and Inventions Agreement: Employees will often develop intellectual property in the course of employment. A detailed invention agreement will outline the ownership rights of the corporation with regard to employee inventions. Lastly, employees will come into contact with proprietary information of the corporation, such as trade secrets or R&D not currently subject to intellectual property protection. This agreement puts employees on notice of the restrictions from disclosure or use of this information outside of the business.
- Note: Often, founders will come into the firm by contributing valuable intellectual property. This is generally covered in the shareholder subscription agreement.
- Sample Confidential Information and Invention Assignment Agreement (Employees): https://www.orrick.com/Events-and-Publications/Documents/1960.rtf
- Independent Contractor Services Agreement: This agreement establishes the ownership rights of the corporation with regard to intellectual property created by independent contractors in the course of a project.
- Note: As with employees, independent contractors may contribute to the development of intellectual property.
- Sample Confidential Information and Invention Assignment Agreement (Consultants): https://www.orrick.com/Events-and-Publications/Documents/1961.rtf
Intellectual Property Matters
- Unilateral and Mutual Nondisclosure Agreement: This puts employees, contractors, suppliers, etc., on notice regarding the prohibition against disclosure of certain trade secrets or intellectual property.
- Assignment of Intellectual Property from Founders to the Company: This may be contained within the subscription agreement or as a standalone document.
- Memorandum regarding Trademark Matters for a New Company: The company may resolve to preserve a specific trademark right through registration.