In Part One of the entity selection series we discussed the benefits of a Limited Liability Company for organizing your business venture. In this edition, we will discuss the benefits of a standard corporation (a “Subchapter C” corporation under the federal tax law, as distinguished from an S-Corp). When selecting an operating entity, an entrepreneur should be mindful of the following legal benefits and notable operating complexities of a Corporation. The information here is necessarily high level, but gives a broad overview to help illustrate the differences between a Corporation and an LLC. Note that this discussion focuses on a corporation with only a handful of stockholders prior to an equity financing that layer on additional governance requirements of the type we have previously discussed.
Formality & Management Structure
Corporations are in many ways the easiest and cheapest entity to form. Incorporating a Corporation is fairly straightforward and requires an incorporator(s) (who does not have to be a stockholder) to file a Certificate (or Articles) of Incorporation (“Certificate”) in the selected state of incorporation. The Certificate establishes the company’s existence and, depending on the state of incorporation, the Certificate will indicate the name of the corporation, address, purpose and authority (usually very broadly written to include any activity allowed to a corporation under applicable law), limits on director liability, and the initial authorized shares of the corporation. Generally, the initial Certificate will authorize only common stock and the Corporation will later make changes to it to authorize preferred stock terms when an equity financing is done.
As part of the incorporation process, usually the incorporator(s) will appoint the initial board of directors (natural humans, at least 18 years of age). The composition of the initial board tends to be a number of the founders of the corporation. The corporation’s shareholders will elect/re-elect directors on an annual basis. The board is responsible for the management of the company and the oversight of major company decisions. While overseeing the company, the directors owe their shareholder’s fiduciary duties of care and loyalty, which vary somewhat from state to state. Generally speaking, directors should make decisions that are in the best interest of the corporation and its shareholders, but under some states’ laws on fiduciary duty, the board is permitted to consider the effect of a decision on other constituencies (such as employees, creditors, the community, etc.).
Either the incorporator or the initial board will adopt bylaws for the corporation, which are internal rules that govern many aspects of the Corporation (voting and meeting procedures, officer positions, etc.). Both the initial Certificate and the initial bylaws of the Corporation are generally standard, widely available documents (though use caution – forms of unknown provenance may not have all the provisions in them that should be there).
The board may and usually does delegate the day to day functions of management to officers of the company. Under law, some officers are required (President, Secretary, Treasurer, or equivalents) and may include a Chief Executive Officer, Treasurer, Secretary, Chief Financial Officer, Chief Operations Officer, etc. Required officers’ roles will usually be described broadly in the bylaws, but are subject to refinement by the board of directors.
In accordance with most state statutes, the directors and shareholders must hold separate annual formal meetings that abide by quorum requirements and voting thresholds. Specific actions require board and/or shareholder approval under the authority of either the company’s corporate Certificate, state statute, or in the course of executing certain financing agreements. For example mergers, acquisitions, dissolutions, and/or amendments to the Certificate (for instance, to authorize additional shares) will usually require the approval of both the board and the shareholders. Other decisions, such as the appointment of officers only require board approval. Typically, in order to approve actions, a quorum of the board or shareholders (majority of the directors or a majority of the shareholders) will need to be established at a meeting. Once quorum has been established at the board or shareholder level, an action usually requires the approval of the majority of the directors or shareholders, unless stated otherwise in the bylaws, Certificate, or certain financing agreements. As previously discussed, many boards (and shareholders) act by written consent as often as by meeting, which involves a slightly different analysis.
Additionally, corporations tend to have an annual filing requirement in the state of incorporation, such as Delaware’s annual report and franchise tax obligations. Lastly, corporations must maintain a formal book of minutes as evidence that statutory requirements and bylaws were adhered to when taking corporate actions.
If you are a growth company with outside equity investment, you’re likely to end up with a multi-tiered equity structure, comprised of common stock and preferred stock, which will have terms of the type we have previously discussed.
Generally, the corporate form provides shareholders a shield from personal liability beyond the amount invested in the Corporation for the shares. There are circumstances in which that corporate shield can be “pierced” and the shareholders held liable that are beyond the scope of this post, but which are usually the result of undercapitalized corporations engaged in quasi-fraudulent behavior.
Directors and shareholders may be held personally liable for their own torts, personal guarantees, or to the corporation or other shareholders for breach of fiduciary duties.
Unlike pass through entities taxed as partnerships (including LLCs that have not elected to be taxed as corporations), Corporations have a corporate level income tax, and then shareholders are subject to tax on any distributions from the Corporation (the so called “double tax”).
Capital Raising Considerations and Corporations
Corporations are the preferred entity of choice for outside investment. Many investors will not invest in entities that are not structured as a Corporation either because of the impact of the pass through taxation or because there is a familiarity in the corporate context with the laws and court decisions, documents, and principles surrounding Corporations that sophisticated investors have grown accustomed to when making investments that do not apply as readily to pass through entities such as LLCs.
One last consideration, among many, is that it is easier to award equity incentive compensation through Corporations rather than through LLCs or partnerships. Drafting similar equity compensation plans into LLCs or similar entities as a profits interest can be complex and costly. Most investors want to see that the company is incentivizing its employees and the investor sometimes will help fund an equity incentive pool when making an investment. Incentivizing employees to create value within the company, theoretically, will allow investors to see a greater return on their investment.