Incorporation is the act of creating an artificial legal entity (usually a business entity—a company, a partnership, an LLC, etc.), that serves to fulfill the objectives of the persons establishing (organizing) it.
The Objectives of Incorporation
Whether incorporation is worthwhile, and the choice of the appropriate type of corporation (a company, a partnership, an LLC, etc.), depend on the purpose of the incorporation. The decision to incorporate should be based on many considerations, deriving from both the requirements of the members wanting to incorporate, and the legal and business environment, which may at times change, thus changing the considerations underlying the incorporation. The following issues may be listed among the considerations in favor of incorporating:
The main advantage of incorporation for business and economic purposes is that it creates a separate legal entity which allows a separation between the acts of the corporation and the acts of the organs (either entities or individuals) composing the same, thus protecting such persons with limited liability. This principle, known as the "separate legal entity principle," determines that the corporation is a separate legal entity from its shareholders and, in principle, an act or undertaking performed by the corporation is not a personal act or undertaking by any of its members, who are therefore not personally liable for the consequences of such act or undertaking. In other words, as long as the employees, directors, and shareholders do not deviate from the rules fixed in the relevant laws of the state of incorporation, they will not be legally liable for the actions and debts of the corporation. Limited liability enables business initiatives that would not otherwise have been undertaken due to the risk involved in them, since private individuals would refrain from jeopardizing all of their personal property, and would seek risk-free investments. When liability is limited, the shareholders or partners risk only the part of the capital they invest in the venture, and not all of their capital. Several types of corporations allow the liability of members to be limited (such as a limited company and a limited partnership), the nature of which will be discussed below.
Separation between management and control—
Managing a business through a corporation allows the management to be concentrated in the hands of a group of skilled managers, while dispersing its equity among many persons or entities.
The existence of the corporation (if it is a company) is independent of the existence of its member shareholders. Thus, the death or retirement of any of the members does not terminate the life of the incorporated business, and prior undertakings may continue to be fulfilled and future actions planned.
Separation between the property of the company and the shares—
Managing a business through a corporation facilitates complex actions such as the sale of shares in a corporation, as opposed to the sale of the corporation's assets individually. When the corporation is the owner of the rights and/or property that is to be transferred, a simple transaction of a share transfer suffices to overcome such procedural and substantive difficulties.
Instrument for raising capital—
The existence of the corporation enables the raising of capital by a variety of methods, such as the issuance of bonds and debentures, as well as public offerings and private placements, discussed below.
The tax paid by a corporation may be lower than the tax levied on individuals, and there are certain tax benefits that are available only to corporations.
Simplicity and certainty—
In short, incorporation creates a simple and efficient mechanism for realizing the business objectives of the company and the entrepreneurs. Corporate mechanisms should be simple and clear to the company's entrepreneurs, to investors, and to third parties dealing with the company. The business and legal environment should allow decision-makers to make correct business decisions with the knowledge of the legal consequences of such decisions, without fearing later intervention by the courts.
Types of Corporations
Among the many possible forms of incorporation available to ventures, this discussion will focus on the three that are most common at present: "ordinary" corporations, limited partnerships, and LLCs (Limited Liability Company). The manner and form of incorporation are determined according to the laws of the country and state of incorporation. However, there are certain principles in corporate law that are common to all countries belonging to the Anglo-American jurisprudence, including the United States.
A corporation is an artificial legal entity created to facilitate the incorporation of persons into a single, business-oriented economic body. As aforesaid, a corporation is a legal entity that is separate from its shareholders, who enjoy the protection afforded by the separate legal entity principle. The most common of these forms is the C Corp company, whose definition is derived from the arrangement whereby the liability of each member at the time of dissolution of the company is limited to the amount invested by him (or which he undertook to invest) in purchasing the company's shares. The term LLC (Limited Liability Company) is used to describe another type of corporation, to be discussed below.
A partnership is a legal entity characterized by the fact that its members are personally liable to third parties, in addition to the liability imposed on the partnership itself. However, there are situations in which a partner is interested in limiting his liability (a limited partner). Such a partnership is a "limited partnership," since the liability of each of its limited partners is limited to the amount he invested, or undertook to invest, in the partnership. A limited partnership will include at least one general partner, who is liable for all its liabilities, and at least one partner who is liable for the capital he invested in the partnership (the limited partner). In practice, the general partner is usually incorporated as a limited company, thus limiting his liability as well. The main difference between a partnership and a company is that the partners are the ones who are levied with the tax on the partnership's profits, according to their share in it, and the partnership itself is not taxed separately (as distinguished from a company, which is levied with corporate tax). In other words, the partnership's profits or losses are personally prorated to the partners. The fact that general and limited partners operate together in a joint business framework creates significant differences between the partners' rights. Naturally, the limited partner will not be liable for the partnership's debts, but will also take no part in its daily management, whereas the general partner enjoys superior rights in the management of the partnership, but is also liable for its debts. The relevant laws are derived from this principle. For instance, a limited partner shall not participate in the management of the partnership's business, and is not authorized to bind it (and if he does participate in its management, he shall be liable for all its liabilities, as if he were a general partner).
LLC (Limited Liability Company)—
An LLC is a corporation deemed as a partnership for tax purposes: The company's profits or losses are attributed directly to its shareholders (or "members," in the language of the law), and the company itself is not subject to tax. In contrast with a partnership, the members do not forfeit their limited liability if they participate in the management of an LLC. All the affairs of an LLC are regulated in an operating agreement or LLC agreement (in the absence of which, the law provides a default). Due to various restrictions imposed on LLCs, it is not a common form of incorporation for startups, whose entrepreneurs do not invest the majority of their money in the venture. The following are the main restrictions imposed on LLCs: restrictions on the acceptance of new members, which restrictions hinder the allotment of options to employees; restrictions on the lifetime of an LLC; the inability of an LLC to go public; and tax restrictions imposed on the conversion of an LLC into an ordinary corporation (a process that is required before an IPO). As a result of these restrictions, the use of LLCs in the venture capital industry is chiefly popular as a tool enabling shareholders in the company to decrease their tax liability, or as an investment vehicle (such as a venture capital fund), that allows the members to limit their legal liability, while enjoying the tax benefits of a partnership.
The incorporation of a company is usually preceded by the actions of entrepreneurs/founders, who lay its business and financial foundations. Once these foundations are in place and the founders want to incorporate, they have to decide upon certain fundamental principles which determine the legal and business elements of the company and are expressed in its incorporation documents.
Normative Documents (required by law)—
The incorporation documents are the cornerstone of the incorporation of every company and in the United States include the Certificate of Incorporation and the Bylaws (for a more detailed discussion of incorporation, see the section, "Incorporation in Delaware"). The company's documents of incorporation constitute the normative framework that regulates the company's life and activities. Along with the documents of incorporation (see above), some companies have agreements among the shareholders (Shareholders Agreement or Founders Agreement). Alongside, and sometimes above, these agreements and documents are the laws applicable in the state of incorporation. The laws of the state of incorporation contain normative provisions that supersede any contractual agreement (and the documents of incorporation are essentially contractual arrangements), as well as other provisions that take effect when the parties have not fixed contractual arrangements of their own. In addition, the laws of the state of incorporation set forth procedural rules with respect to incorporation.
The company's documents of incorporation contain the company's name, objectives, details of the company's equity, and details with respect to the limitation of liability. In addition, the founders may fix in the documents of incorporation the rights and obligations of the shareholders and of the company, various provisions pertaining to management, and any other matter which the shareholders deem fit to include in the documents. As aforesaid, the documents of incorporation and the agreements among the shareholders include, besides the mandatory technical details, provisions with respect to the relationship between the founders, and provisions governing work procedures and various mechanisms for resolving problems in the company (for documents of incorporation in Delaware, see the subsection, "Organizing and Managing a Delaware Corporation").
A Shareholders Agreement is a contract between the entrepreneurs (who may later be joined by other shareholders or investors) which regulates the contractual relationship between the shareholders. A Shareholders Agreement binds only the parties who signed it, in contrast to the organizational/incorporation documents that also bind shareholders who are not direct parties to them (in other words, who have not signed them), and sometimes also other entities which come into contact with the company (which is why they are usually filed with the authorities and are open to the public). Common provisions in Shareholders Agreements deal with the following issues: the composition of the company's equity, types of allotted shares, the composition of the Board of Directors, methods for appointing directors, the proceedings of the Board of Directors, signatory rights, matters required to be resolved by a special majority, a list of the rights attached to the shares, restrictions on the allotment and transfer of shares in the company, voting mechanisms and agreements, the company's activities and lines of business, confidentiality, and non-competition. Although these issues are often also regulated in the corporate bylaws, their inclusion in the Shareholders Agreement awards each shareholder a private cause of action to claim the fulfillment of such provisions from any other shareholder who is a party to the agreement.
The Corporate Organs
As mentioned above, the company is an intangible legal entity. It lacks the means to realize the company's policy and objectives or execute the wishes of its members. The company's organs are bodies or persons whose main duty is to serve as a medium through which the company can function. Modern corporate law recognizes three main organs: the shareholders (the General Meeting), who appoint the members of the Board of Directors and are required to approve acts of crucial significance to the existence of the corporation (such as mergers or dissolution); the Board of Directors, which directs the company's policy; and the company's managers, who translate the policy into practical action and run the company on a daily basis. It is important to understand that, although the powers of the various organs are fixed in the laws of the state of incorporation, such laws (as is the case in the state of Delaware) generally allow the organs to modify the balance of power among them. For instance, although the most important authority of the General Meeting is to appoint and terminate directors, the shareholders may decide upon other methods for the direct appointment of directors by the shareholders. Another example is when venture capitalists demand and receive the right to appoint a director or directors even though their holdings are insufficient to elect directors at an ordinary meeting.
Shareholders (the General Meeting)—
Shareholders who have voting powers (these are almost always the holders of ordinary shares, and in certain cases also of other types of shares) are entitled to participate in the General Meeting. Since shareholders have property rights in the company, they are entitled to control decisions pertaining to their property. Therefore, the General Meeting is defined as the company's primary body, responsible for appointing and terminating directors, changing the company's bylaws, and approving acts and transactions that require approval, either by law or the bylaws, including vital decisions such as the dissolution, sale, or merger of the company. In order to control the company's actions and policy, the shareholders convene for a General Meeting once a year. In special cases, a general or extraordinary General Meeting may be convened more frequently. In startups, it is customary to receive the shareholders' written consent as an alternative to holding meetings.
The Board of Directors—
Except for certain issues that are subject to the authority of the General Meeting, the management of the company is—according to the law in most countries—entrusted to the Board of Directors (with the General Meeting usually being authorized, as aforesaid, to appoint and terminate the directors). The following actions may be listed among the areas of responsibility of the Board of Directors: appointment and termination of managers/officers; outlining the company's action plans and the principles for their financing; examining the company's financial condition and the amount of credit it may undertake; determining the organizational structure and the compensation policy; preparing and approving the financial statements; reporting to the General Meeting on the condition of the company; and deciding to issue shares and convertible securities (within the framework of the company's equity). In order to adopt its resolutions and control the company's actions, the Board of Directors convenes periodically, at a frequency that changes in accordance with the character of the company and the issues on the agenda. In startups, this frequency is relatively high (about once a month). In many cases, meetings of the Board of Directors are held by telephone, and resolutions may also be adopted in writing.
It is generally the case that the involvement of the company's General Meeting and Board of Directors in the daily running of the company is limited. A company cannot be managed by a body that convenes once a month (or less), and is not involved in the company on a daily basis. Therefore, modern companies operate mainly through professional managers, who are responsible for the daily management of the company's affairs, within the framework of the policy determined by the Board of Directors and subject to its directives. These managers are referred to as "executives," and among them are the General Manager or Chief Executive Officer (CEO), the various senior executives such as the Chief Financial Officer (CFO), the Chief Operating Officer (COO), and the Chief Technology Officer (CTO), as well as other principal officers. The second line of management of the company is occupied by other managers, who are not executives. In startups, these are usually the Vice Presidents (VPs).
During its incorporation and thereafter, the company issues securities which award their holders certain rights toward the company and toward the other shareholders, in consideration for which it raises money. A security is an instrument that awards its holder an expectation or right to a future stream of payments, sometimes in addition to other legal rights (such as a voting right). In fact, it is a "standardized" contract that is also characterized by property rights. The basic types of securities are shares, preferred shares, and bonds.
A share is a personal property right that comprises a bundle of rights. These rights include the right to declared dividends and to assets upon dissolution, as well as the right to vote at the company's meetings.
A company's capital stock is divided into several types. In this context, the following principle terms should be mentioned: authorized (or registered) share capital is the capital that the General Meeting has authorized to be issued; issued share capital is the share capital sold to investors; and outstanding share capital is the share capital held by investors. The outstanding share capital is smaller than the issued share capital when the company buys back from the shareholders some of the shares it has issued. The re-purchased shares are called treasury stocks. Equity capital is an accounting term referring to the balance-sheet value of the company's assets, less/minus its liabilities.
According to traditional corporate law, a preferred share is a cluster of contractual rights, the most common of which is the priority in the receipt of dividends (both ordinary and upon dissolution). Preferred Shares are usually cumulative (in other words, if a dividend is passed in a certain year, the right for priority is reserved until the payment of a dividend, for all the years in which no dividend was paid) and non-participating (in other words, the holders of preferred shares are not entitled to partake in dividends together with the holders of ordinary shares after they receive their preferred dividend). Preferred shares may be voting shares (in other words, they may confer on their holders a voting right) or may be awarded without an attached voting right.
Investors in startups are usually issued preferred shares that are convertible into ordinary shares, either at the investor's discretion or upon the occurrence of pre-determined events. Such shares are always voting shares, and they customarily entail priority upon liquidation or upon events deemed as liquidation, as well as other rights such as protection against dilution and a right to veto resolutions of the company. (See the section in Chapter 8 for the rights attached to convertible preferred shares received by venture capitalists.)
An option is a right to buy (call option) or sell (put option) a certain asset, for the exercise price, in a pre-determined period. When the option holder wants to exercise it, he pays the exercise price to the issuer of the option and receives title to the asset.
As far as startups are concerned, this is usually a right to buy a new share that is issued to the holder of the exercised option. This type of option is referred to as a warrant, mainly in order to distinguish it from other options that are based on monetary clearing, rather than by the issuance of new stocks. Such options are allotted to investors in many rounds of financing, as well as to the employees of the company.
These are securities that oblige the issuer to pay the holder pre-determined amounts on pre-fixed dates, or upon the occurrence of certain events. An issuance of a bond (or debenture) is, in fact, a loan that is taken from the buyer of the bond.
The basic distinction is between a straight bond, on which interest is payable on pre-determined dates, and a zero coupon, on which no interest is paid but which is sold at a price lower than its par value. A bond can be secured (when the payment of the debt is guaranteed by certain assets that serve as collateral) or unsecured. The quality of the collateral, coupled with the anticipated stability of the business issuing the bond, determine the risk involved in the bond, and hence its price. Bonds issued by startups often include an option to convert the bonds into shares according to a pre-determined conversion ratio (convertible bonds).