United States: Basics Of Forming The Closely Held Corporation

You and your partner have decided to set up a business together. You've wisely decided to incorporate, knowing that in this uncertain and litigious society conducting business as a corporation will potentially limit your liability to outsiders. We offer a preliminary guide to the issues you should consider when forming a closely-held corporation. We caution that this is a general discussion and the owners must tailor the corporation, and the governing documents, to their own needs and circumstances.

A closely-held corporation can be any corporation that is not publicly owned, but the term is generally used to apply to corporations with a limited number of shareholders, none of whom are institutions. Many states have specific statutes that apply only to closely-held corporations.

This article is limited in scope, and is not intended to be all-inclusive. We do not address tax issues nor do we address whether the corporation is the most suitable vehicle to conduct business in the circumstances in which the business owners may find themselves. THE PRIMARY REASON FOR INCORPORATING IS TO LIMIT THE LIABILITY OF THE BUSINESS OWNERS. You can now achieve this result with other forms of entities, particularly limited liability companies. The formation of a business entity has serious legal and financial consequences, and you should always seek the advice of competent counsel and accountants.

When forming the corporation you must first select the state in which the company will be incorporated. You can choose to incorporate in any state you desire. You are not required to incorporate in the state where the business will be conducted, nor must you conduct business in the state of incorporation, although a corporation must have a registered agent in that state. On the other hand, a company must qualify as a foreign corporation in each state (other than its state of incorporation) in which it conducts business. State laws vary on the issue of what constitutes doing business, but it is wise to qualify to do business in any state where the company will carry on substantial activities. For one thing, almost every state requires a company to be qualified to sue in its courts.

If a corporation has only one office, the simplest approach is to incorporate in the state where the office is located. You will thus avoid the need to qualify, file tax returns, pay franchise fees and hire an agent in another state. Even the most basic companies will generally save at least $1,000 annually.

Companies often consider Delaware as an alternative state for incorporation. This is due to the well-established body of corporate law that has developed there, along with courts familiar with corporate issues, and to a generally favorable attitude toward management. This latter factor is not an issue in a closely-held corporation where the shareholders are also the managers of the company.

Many factors go into selecting the corporate name. From the standpoint of corporate formation, the first issue is the availability of the name. If the desired name conflicts with another name on file with the Secretary of State's office, it will be rejected. A company can clear a name in advance, and in most states the company is permitted to reserve a name for a period of time, usually a few months.

Most states require the company to use a word such as "corporation," "incorporated" or "limited" to reflect its corporate status. States often prohibit use of certain words, mainly to avoid misleading the public as to the corporation's purpose. Words such as "doctor" or "insurance" or "bank" and their equivalents are examples of words that are often prohibited by law, as well as words that suggest a state division or charitable purpose, unless the business is engaged in such pursuits (which will require special approvals). To find out what words are prohibited in the state of incorporation, you must review that state's statutes.

The Secretary of State's acceptance of a name for filing signifies only that the name does not conflict with another name on file in that state and that the company can block others from using the same corporate name in that state. The name may still violate someone else's rights to use the name as a trademark, and the filing does not give the company any rights to that name in other states. In other words, obtaining a corporate name gives limited protection, is separate and apart from trademark rights, and other means must be used to determine if others have rights in the name or if the company can prevent others from using its or a similar name.

If the corporation uses a name other than its formal corporate name in commerce, then most states will require you to file a certificate reflecting that assumed name. The assumed name may not include "corporation" or words of similar import. The assumed name may be entirely different from the corporate name or merely a shortened version of the corporate name. For example, if the Acme Widget and Tool Company, Ltd. conducts business as the Acme Widget Company, many states will require that it file an assumed name certificate.

The certificate or articles of incorporation must state the number of shares the corporation will be authorized to issue. The company does not have to issue all the shares that are authorized, and it is wise not to issue all shares, saving shares for additional investors. For a simple corporation you need to authorize only a few shares, particularly as the articles can always be amended to add shares later on. Many states base their incorporation and annual franchise fees on the amount of authorized capital (being the product of the number of authorized shares times par value), so you should avoid the temptation to authorize large numbers of shares.

You may want to authorize a greater number of shares if the company contemplates adding additional investors, issuing stock to employees or issuing stock options.

The company must give the shares a "stated" value which is either a fixed par value or "no par" value. This is not a major consideration; it is primarily for accounting purposes, distinguishing stated capital from capital surplus, which in turn generally affects issues such as payments of dividends and retention of capital. As previously noted, states will calculate filing fees based on the product of authorized shares and par value, so it is best to keep par value low. A lower par value allows more shares to be authorized for the minimum filing fee. "No par value" shares are assigned a modest value under the state statutes for purposes of calculating filing fees.

The corporation can create different classes of shares, although this is not common in closely-held corporations. The corporation may want to create special classes, for example, if certain shareholders are to be given special voting rights or preferential treatment for payment of dividends or upon liquidation. Corporations that file an election under Subchapter S of the Internal Revenue Code, and thus become a pass-through entity for tax purposes, are subject to numerous restrictions, one of which is that they may not have different classes of stock. If the corporation creates different classes of stock, each member within the class must be treated equally. This is a basic principle of corporate law and bears repeating: each shareholder holding the same class of shares must be afforded the same rights as all others in that class. For example, each shareholder must be afforded a pro rata share of dividends and equal voting rights.

Corporations may be formed for any lawful purposes. The certificate of incorporation should actually state that it is being formed for all lawful purposes. If you form a corporation for certain special purposes (such as educational, charitable, etc.), you will require approvals of the appropriate state agency and/or the courts. If the certificate sets out a limited purpose without catch-all language, then the corporation may only act in furtherance of that stated purpose. It is almost always advisable to include a broad catch-all purposes clause.

Debt is a loan to the company. The company repays the debt to the lender under the terms of the loan agreement, and in a liquidation the debt is paid off before the equity-holders receive anything. A debtholder does not share in the upside potential of the company.

Equity is an ownership interest in the company. An equity owner is entitled to dividends, if declared by the directors of the company, but the company may pay dividends only out of - and to the extent there is - surplus. An equity owner shares in the upside potential of the company, but can lose the equity investment if the company folds up.

The owners of the company are given considerable leeway in allocating their initial contributions between debt and equity, that is, between loans to the company and purchase price for shares. These allocations do raise serious legal and accounting issues, however, and it is strongly recommended that you seek professional advice.

Because financing arrangements are usually a matter of agreement between the lender and the company, debt and equity can be combined, and often are in very creative ways. The most common combination is convertible debt, which is a loan that can be converted to equity under circumstances specified in the instrument. Preferred stock also shares some of the characteristics of a loan, particularly if it is entitled to a preferred annual dividend in a fixed amount, but being equity, preferred stock also shares in the company's upside potential.

In closely-held corporations where the shareholders are active in the management of the company, the company will usually pay its income to the officer-shareholders as salary, after deducting what it needs to retain for operations. Payment of salary, being a deduction, results in the monies being taxed only once, to the recipient. In contrast, monies paid out to the shareholders as dividends are not a deduction to the corporation, so that dividends are taxed both to the company and to the shareholder. The IRS scrutinizes these situations to make sure that any compensation to shareholder-employees is not excessive.

All shareholders must pay for their shares, either in cash, tangible or intangible property or in services rendered to the company. Some states prohibit companies from issuing shares in exchange for the promise of future services. Most states also bar issuance of shares in exchange for a promise to pay for them (i.e., with promissory notes). The directors or shareholders are given considerable leeway in determining what value to ascribe to each shareholder's contribution to capital. This allows for flexibility in dividing up the company's shares, as the directors could ascribe a higher value to property of apparently limited value and the contributing party is then allocated a larger interest in the corporation.

Although it is beyond the scope of this article, note that tax problems can arise if the owners make their contributions to the corporation at different times. Suffice it to say that all of the owners should try to make their contributions to capital in exchange for original issue shares within a few weeks of each other, if at all possible.

The shareholders are the owners of the corporation. Their functions are to elect directors and to vote on major corporate changes: merger or consolidation of the company, liquidation, a change in capitalization and any other events that would fundamentally change the business or structure of the corporation. Shareholders do not have the right to manage the corporation, merely to elect directors and change directors when appropriate. In closely-held corporations, however, this distinction is often blurred, mainly because the shareholders and directors and officers are often the same group of people. That is not to say that the distinction is not important; control of the board of directors is crucial to the determination of business direction of the company.

The company must give notice of meetings of shareholders, with the length of notice specified in the state statute and in the by-laws. In most states, shareholders may consent to action without a meeting if the consent is in writing, although many states require unanimous consent if no meeting is held.

The directors are responsible for the oversight of the corporation's management and affairs. Directors also elect the officers.

In some states, the company must have at least three directors unless there are less than three shareholders in which case the number of directors may be as few as the number of shareholders. Other states require only one director. The by-laws can fix other requirements for directors, and often closely-held companies will require directors to be shareholders.

The board may hold regular meetings without notice if the date and time are fixed; otherwise notice must be given, but usually only 48 hours' notice is required. Meetings may be held by telephonic conferencing. Directors may consent to actions without a meeting if the consent is in writing, although in most states written consent must be unanimous.

The officers are responsible for the day-to-day management of the company. In some states, the company must have at least two different people fill the offices (generally, a president and secretary) in all events. Other states require two officers unless there is only one shareholder, in which case one person may hold all offices.

In a closely held company, the shareholders will usually elect themselves as officers and run the company without regard to formalities. They use their official positions only in formal situations. The president is responsible for the management of the company, overseeing all operations; the treasurer or chief financial officer (CFO) is responsible for the financial affairs and reporting requirements of the company and the secretary is responsible for maintaining corporate records and issuance of notices. A company can have as many vice presidents, assistants and other officers as it so chooses. The company's by-laws should set forth the scope of the duties for each office.

The first step you must take to form the corporation is to file the articles or certificate of incorporation with the Secretary of State, with the necessary filing fees. Each state prescribes the required contents of the certificate. Usually, the certificate must include the name, the authorized shares (and a description of any special rights of each class), the duration of the corporation (usually perpetual), the purposes of the corporation, the designation of an agent for service of process and the location where the Secretary of State sends service of process. Some states also require that the initial directors be named. The company can add other provisions to its certificate, such as special voting requirements and indemnification of officers and directors. The certificate may be signed by any adult individual, including the attorney for the corporation, in the capacity of incorporator.

Once you have filed the certificate of incorporation and obtained the proof of filing, you must then prepare the organizing minutes. The usual course is to prepare a statement of the incorporator electing directors to serve until the first meeting of shareholders, allowing the corporation to operate. Next, the company will hold the first meeting of shareholders and directors. The shareholders and directors ratify the actions of the incorporator and approve the by-laws. The minutes of these meetings can be adopted either by written consent of all shareholders and directors or at a meeting of the shareholders and directors. The shareholders also elect the new directors and the directors, in turn, elect officers, ratify the issuance of stock and authorize the bank accounts.

The company must also prepare by-laws. These are the company's operating guidelines, setting forth the rules by which the corporation is to be governed. They should contain such provisions as rules for holding shareholders meetings (dates, location, notice, retention of shareholder lists and voting records), rules for directors meetings, number and qualification of directors, description of offices, retention of corporate records, and method for amending the by-laws. It is important that you conduct corporate business in conformity with the by-laws; any action taken by the corporation that does not conform is improper, although the shareholders and directors can ratify actions after the fact.

The secretary or attorney for the closely-held corporation should order a pre-packaged corporate kit, which will contain stock certificates and stock ledgers. The kit will also come with a corporate seal. Many states still require a corporate seal to solemnize documents, and it is a good idea to seal the stock certificates to validate the certificates.

Next, the secretary should prepare and issue the share certificates. If any restrictions are imposed on the shares under a shareholder agreement (see below), they must be typed on the shares themselves. The secretary must keep a record of all shares issued. This will avoid disputes later on, and, in the event the company is sold or an outside investor buys a stake, that party will insist on an accurate list of all shareholders.

The company will need to take numerous additional steps to start up its business, but one that you should take right away is to order a tax-identification number from the IRS. For one thing, banks must have a tax-identification number to open an account. If the corporation has hired accountants, they should take care of obtaining the number.

In addition to following the proper procedures for forming the corporation, the owners must make sure that they follow proper procedures for maintaining the corporation. These include filing tax returns and franchise reports in each state in which the corporation conducts business, holding annual meetings of shareholders and directors and updating the minute books and other corporate records. Addressing these simple procedures every year will prevent headaches and much greater costs later on.

Following the above steps will enable you and your partners to form and organize a corporation. But that may be only the first step in setting up a working and long-lasting business arrangement. Whenever there is more than one shareholder shareholders are well advised to prepare a shareholder agreement to address the management and affairs of the company.

A shareholder agreement is a contract among shareholders and, as such, can cover any corporate matter the shareholders so choose. Being the owners of the company, the shareholders are agreeing how their shares should be voted and what restrictions should be placed on their shares. Most shareholder agreements address the following topics.

Corporate management: the shareholders usually consent to the election of the shareholders, or their nominees, as directors and officers. Alternatively, the agreement sets forth the number of seats on the board allocated to each shareholder. In addition, the shareholder agreement can set out any company actions that will require supermajorities or unanimous consent of the shareholders.

Restriction on transfers of shares:

1. The shareholder agreement usually will provide rights of first refusal or first negotiation to enable the remaining shareholders to buy out shares of a departing shareholder and retain control over the corporation, or control who will join them as new shareholders.
2. You should also address the right to transfer shares to family members as this is often a point of contention. The shareholder agreement may provide whether the spouse or children of a shareholder will be allowed to take over the shares of a deceased shareholder, and whether a shareholder may transfer shares to family members for other reasons, such as estate planning.
3. The shareholders are well advised to consider what happens when one shareholder leaves the company, dies or becomes disabled, and what rights or obligations to buy back the shares will arise.
4. Finally, shareholders should consider whether there are circumstances under which they want to provide for "put" rights or demand-purchase rights which enable a shareholder to buy out other shareholders or to force the buy out of his or her shares.

The most difficult decision facing the shareholders in all of these situations is how to value the buy-back of shares. There are any number of ways to value the shares, and each has its advantages and disadvantages. Often, buy-outs are funded with the purchase of key-person life insurance to cover purchases on death. Following are the most common valuation methods:

1. Book value: The value of the assets on the books of the corporation is often a good measure of the company's worth, but may understate the value of service companies or companies whose assets are intangible and not properly valued on the books of the company, and may overstate the value of companies with fixed assets that have not been adequately depreciated.
2. Certificated value: The shareholders agree on a value, and agree to revise the value each year. While this method is certainly fair, based on agreement of the parties, the shareholders often forget to re-value the shares, leaving them with an outdated valuation.
3. Shotgun buy-out: There are various mechanisms whose underlying principle is to have one shareholder name his price, and if the shareholder to whom the offer is made thinks that is too high a price, then the offeree shareholder can turn around and choose to sell his or her shares at that price.
4. Appraised value: This method allows an outside expert to value the company. The drawbacks of this method are the cost and time it takes to reach a value. The shareholders will have to agree on a method for selecting an appraiser; they should also consider whether they will grant the right to challenge the appraised value.
5. Multiple of sales or earnings: Companies are often valued based on sales or earnings over a period of time, and this can be a fast and easy method for the shareholders to use. Concerns for the shareholders are the selection of a proper multiple and making sure that a long enough period is chosen to ensure that the parties have a proper financial picture of the company. You will probably not want to use this method in a start-up situation where the company has no earnings and little sales, but you could use it after a minimum period of operation, perhaps three years.

Employment agreements for shareholders: The shareholders should consider whether they wish to provide for employment of the shareholders as officers and employees of the company. This can be accomplished either under the shareholder agreement or by separate employment agreements. Most states permit employees to be terminated at will, and an employment agreement gives the employee an established term of employment. You can also provide for rights of the parties on termination. It may seem strange to allow for termination if the employees are shareholders, but employment agreements are particularly useful if one of the shareholders is contributing cash and financing and the other is contributing the services. You will also find employment agreements useful for establishing employee benefits and share options that are not appropriately included in a shareholder agreement.

If you pay close attention to the formalities of establishing and operating a corporation, then you will be well on the way to avoiding problems in the event of audit by the IRS, in the event of disputes among shareholders or in the event of a lawsuit in order to preserve the limited liability protections of the corporate form. We have provided a general guide to the issues that can and do arise in the formation of a corporation, and the founders are well advised to seek counsel to make sure that the legal foundations of their business are secure.