In law, the formation of a separate legal entity is valuable for several reasons. First, it may protect the identity of the actual owners; secondly it creates a distinct and separate , Chief Justice John Marshall of the Supreme Court; finally the entity conducts business and is allowed to own property, sue and be sued in a court of law and act as a separate being from its owners. The only difference between an individual and a corporation in law is that an individual is allowed to vote in a political election.
The formation of a corporation is simply an application process and the granting of a charter (like a license) to exist by the Secretary of each state in the union. An application is submitted with the ‘Articles of Incorporation’ or some form of ‘Certificate of Incorporation’. Once the fee is paid the Secretary grants permission and the entity is formed.
The articles of incorporation are not detail driven, they set forth the primary goal of the corporation. The details are set out in the by-laws of the company. The by-laws establish the governing process and organizational structure for the company. Ownership of the entity is documented with certificates known as stock. The owners are called stockholders or shareholders and they in-turn create an agreement among each other to formalize their relationship.
This article elaborates on the three levels of corporate documentation: 1) articles of incorporation, 2) by-laws and 3) the stockholders agreement. In addition it touches base with what is a corporate resolution and how it is processed and recorded. This particular chapter in this series is merely an introduction to all the various types of corporate documentation. Future articles (chapters) go into greater detail about each and also explain the various governing options and processes.
Articles of Incorporation
The articles of incorporation contain mandated information required by the respective state. The articles provide all the information needed by the state. Remember the state is interested in who is the entity; where is it located; why does it exist; and how does someone get in contact with this entity (who is the registered agent). The following is a list with a short description identifying the most common articles:
(1) Name of the Company – must be unique from other corporate entities in that state
(2) Formal Statement of Existence – consists of:
a) Purpose – such as ‘conduct business’
b) Location – address of main office
c) Duration – usually in perpetuity
(3) Stock/Ownership – classes of stock, voting power, number and value of shares
(4) Name and Addresses of Incorporator(s) – includes initial directors and their respective addresses
(5) Board of Directors – number of members
(6) Initial Stockholders – some states require identification of all initial shareholders and their respective subscription (ownership position)
(7) Statement of Limited Liability – some states require a statement of limited liability as one of the elements of a stock corporation application; this statement notifies all parties that the shareholders have a ‘limited liability position’ in regards to ownership
In general, the articles substantiate and confirm legal compliance of the charter (license) to operate which is then approved and granted the ability to conduct business by the state. Each year the company renews its charter by first paying a fee; secondly identifying the respective director(s) and officers; and generally confirming the status of the corporate structure.
One final note to the articles of incorporation. When a company renews its charter each year it also identifies its resident agent and the agent’s address. Most companies use their corporate attorney to receive notices or service (court and government letters), i.e. act as their agent. With small business, this may not be necessary. The corporate address is sufficient and saves the business a lot of money each year. Most law firms charge $200 a year to simply receive the renewal notices from the state and generally receive service. They in turn have one of their secretaries forward the mail to the company and ask that you mail them a copy of the completed forms when done for their records.
The real power to control a company lies with the stockholder(s). In small business most if not all shares are owned by one or a few individuals. Their respective position of ownership affords them control; that is, the ability to dictate policy. However, as more stockholders are added to the pool of owners, the ability to control becomes more difficult. This is where the by-laws come into play.
The by-laws are the rules of organization and power structure. They lay out the two levels of power for directors and officers.
Directors are elected by the stockholders. The size (number of members) is set in the by-laws and reported to the state via the articles of incorporation. Often in small business shareholders with a minimum number of shares are allowed to appoint a director and are allowed to vote for at-large directors. Here is an example:
Demo Hardware is a six store hardware chain that is family owned and closely held. There are five shareholders, each with a 20% position of ownership. The by-laws state that there are seven members on the board of directors. Any shareholder with a 20% minimum position of ownership is allowed to appoint a director. Any remaining board member openings are referred to as ‘at-large positions’ and are filled by majority vote.
This rule allows each of the shareholders to appoint their own director and to vote their stock percentage for the remaining two board seats. This prevents any single shareholder from fully controlling the company.
Demo fills the two openings with their CPA and a local university professor.The by-laws also identify the positions for officers. Most organizations have at least three officers as follows:
(1) President – runs the company
(2) Chief Financial Officer (Treasurer) – manages the financial affairs
(3) Secretary – maintains the legal documents and the corporate records
The board of directors appoint officers and task them with certain responsibilities. The by-laws set the limits for the officers and their respective functions.
As an example, in a small government contractor operation, the by-laws restrict the President from signing contracts with any customer with a total dollar value in excess of $2 Million. Contracts of $2 Million or more require board endorsement. Similar rules are usually put in place for the following:
(A) Acquisition of fixed assets in excess of a certain dollar amount
(B) Authorization of payment in excess of set sum
(C) Borrowing money via long-term loans
(D) Assigning collateral for debt
(E) Authorizing dividends or distributions
(F) Extending credit to any single customer or affiliate group in excess of a set amount
(G) Allowing changes to the stockholder/shares status including changes to the charter
The by-laws identify the frequency of electing the board and appointing officers. The by-laws also establish other terms and conditions of operations including:
* The function or mission of the company;
* The voting powers of classes of stock/shareholders in accordance with the articles of incorporation;
* Issuance of other forms of equity (stock, treasury stock, convertible notes/stock etc.) via a change in the articles of incorporation;
* Emergency appointment to a vacancy created by a retired/terminated director;
* Frequency of meetings;
* Notification procedures;
* And other critical facets of running a corporation.
The by-laws also direct the board to establish corporate resolutions that address major operational issues including:
* Employee Qualifications
* Benefit Programs
* Accounting Methods/Tax Reporting
* Hiring of Upper Level Managers/Consultants
– Human Resources Director – Legal Team
– Controller – Outside Accountants
– Operations Officer – Engineers
– Outside Accountants
* Policies and Procedures
* Lawsuits/Federal Compliance
Overall the by-laws set the tone of operations and establishes power within the corporate organization for the effective functioning of the entity. The real power rests with the shareholders and they too have an agreement as to each other.
A stock certificate is the official document recognizing ownership of a company. When the charter is granted, the state allows the company to issue a set amount of shares as established in the initial application for formation. The company in turn sells the share for cash or some form of value (property, services, intangibles etc.). The stock sold is referred to as ‘outstanding’. Not all shares may be sold at the initial offering.
In publicly traded companies there are typically thousands of stockholders of the company. In effect it is very difficult or impossible for any one single individual to own a majority of shares. However, one or more individuals may influence and thereby control the company. In the large corporate publicly traded environment there are no rules to prevent the sale of stock.
But in small business, freely traded shares is frowned upon and outright dangerous. To prevent this and establish some rules related to the transfer of stock or property, the stockholders create an agreement. The stockholders agreement sets the terms for stock held by shareholders. These terms include but are not limited to the following:
A) Restrictions on the transfer of stock;
B) Restrictions on voluntary lifetime transfers of stock;
C) Closing and payment procedures for transfer;
D) Tag along rights;
E) Pledging and encumbering stock;
F) Transfer of stock by gift;
G) Restriction for involuntary transfer;
H) Setting fair market value of stock;
I) Death of a stockholder;
J) Drag along limits and rights
K) Protection of proprietary and confidential information;
L) Termination, dissolution and winding up of company affairs;
M) Duties as an officer, director, trustee or agent of the company while a stockholder;
N) Notification process;
O) Resolution process for disputes and remedies.
Rules may be created to address any concerns the founders or subsequent stockholders may have.
To effectuate the agreement for all new stockholders, small closely held businesses require new parties to sign a joinder agreement binding them to the stockholders agreement. The stockholders agreement binds the stockholders to the mission of the company and prevents manipulation for control of the entity.
Whenever a change is required, the shareholders on the board meet to initiate and formalize changes. These changes are often stated in the form of a resolution.
The secretary keeps the minutes and a log of resolutions. These resolutions act as guiding principles or major changes like Acts of Congress. Resolutions are statements of action or endorsement and are created and approved by the board of directors. Resolutions include:
* Opening bank accounts with certain institutions;
* Authorization to borrow money;
* Changing the equity structure;
* Approving the payment of dividends/distributions;
* Setting policies and making changes to existing policies;
* Adding or eliminating officer/management positions;
* Amending the by-laws;
* Endorsing certain contracts (building, customer agreements, consulting etc.);
* Approving mergers, acquisitions or sale of divisions or the company;
* Declaring bankruptcy or insolvency
A resolution is required for anything not delegated to the day-to-day operation administered by the corporate president or his delegated staff.
The by-laws set the rules related to creation of resolutions and the levels of approval. Items like amendments to the by-laws or mergers/acquisitions may require shareholder approval. Overall, resolutions are the decisions of the board with regard to its position related to corporate actions.
Summary – Corporate Documents
The corporate documents consist of three sets of forms, rules and an agreement to create a legal entity. These documents identify the ownership, organizational structure and the rules for management. The articles of incorporation are a set of state required forms identifying the name, purpose and ownership of the company. The by-laws involve the details explaining the corporate structure and the rules for changes. The stockholders agreement dictates the terms of ownership between the respective stockholders and how ownership transfer is allowed.
Along with corporate resolutions, ‘rules mandated by the board of directors’, and the existing by-laws, all combined act as the overall governance of the company.
This is the introduction article for this series on corporate documents. Understanding the corporate structure and the underlying documentation provides the necessary legal introduction to the traditional corporation. ACT ON KNOWLEDGE.