The chapter on Articles of Incorporation in Business Transactions Solution (BTS §§ 31:1 et seq.) covers the decisions and procedures relating to the preparation, execution and filing of the articles of incorporation of a general business corporation and amendments to such articles that may be approved by the board of directors and shareholders after the corporation is formed.
If the principals have had an opportunity to consider the structure for internal governance of the corporation, the articles of incorporation may well reflect these decisions and include detailed provisions relating to the powers and actions of the directors; the various rights and preferences of the authorized stock (e.g., terms of preferred shares); and certain matters relating to the shareholders (e.g., preemptive rights, transfer restrictions). See BTS Master Form at § 31:61.
Drafting the articles of incorporation for a corporation with a complex capital structure that includes both common and preferred shares requires a lot of care and attention. The first step is to collect certain general information relating to the preferred stock such as designating the name for each class of stock to be issued (e.g., common stock, preferred stock or class a preferred stock); determining the number of shares to be authorized in each class; determining whether any limitations will be placed on issuance of each class of stock; determining whether stock will be issued in series; determining differences among classes and series relating to rights, preferences, privileges and restrictions of each class or series; determining whether the board of directors will have the right to fix rights, preferences, privileges and restrictions of any class or series; determining whether the board of directors will have the right to increase the size of the issue; and determining whether the board of directors will have the right to issue other classes of preferred stock, junior or senior.
Once these questions have been answered attention should turn to the specific rights, preferences and privileges of each series of preferred stock, making sure that the relative rights of multiple series have been considered and balanced. Issues to consider include dividend rights, including amounts and timing of payments, whether dividends will be cumulative or noncumulative and whether a particular series will have a preference as to dividends over other series; voting rights, particularly the right to votes as a separate class or series on specific matters such as mergers, sales of assets and issuance of new shares; rights on liquidation and dissolution, including preferential rights to liquidating distributions; conversion rights, including mandatory conversion into common stock upon the occurrence of certain events (e.g., initial public offering); and redemption procedures, including the rights of the company to require redemption and/or the rights of shareholders to require the company to redeem their shares. It is customary to also include protection provisions for preferred stock such as restrictions on changing the terms of issued preferred shares with approval of a stated percentage of such shares, prohibitions on the creation of any stock issue on parity with or senior to the outstanding preferred shares, and requirements for obtaining approvals from a stated percentage of preferred shares in order to consummate specific corporate actions.
Common examples of complex capital structure include the following:
- Common shares, typically issued to the founders and employees of a corporation, and an initial series of preferred shares, typically referred to as “Series A”, to investors participating in the corporation’s initial round of outside equity financing and requiring the full range of economic and voting rights described above. See BTS Specialty Form at § 31:149.
- Common shares as above and multiple series of preferred shares (i.e., Series A and Series B) issued in multiple rounds of financing to outside investors. See BTS Specialty Form at § 31:147.
- Common shares as above and an initial series of preferred shares with limited voting rights and no special economic rights, a structure that might be used when investors have purchased convertible notes and demand the voting preferred shares as a means for participating in management control of the corporation until the notes are converted upon closure of a traditional equity financing round. See BTS Specialty Form at § 31:149.70.
- Two classes of common shares with one class being issued to the founders and having super voting rights (i.e., 10 or more votes per share) and the other class with regular voting rights (i.e., one vote per share) being issued to employees and consultants and to outside investor upon conversion of preferred shares that might be issued to them in the future, a structure that is designed to ensure that the founders maintain the right to control key decisions regarding the corporation made at the stockholder level. See BTS Specialty Form at § 31:149.30.
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The Business Transactions Solution chapter on Transfers of Corporate Securities (BTS §§ 38:1 et seq.) covers routine changes in the composition of the ownership group of a corporation which occur as a result of transfers of corporate securities. Each sale and transfer of shares should be memorialized in a stock purchase or transfer agreement that addresses the following key terms:
- The identity of the parties to the agreement (e.g., the seller and the purchaser and perhaps the corporation and/or the remaining owners, when consent of those parties is required), including full names and addresses;
- A description of the specific shares being sold (i.e., the entire interest of the seller in the business or some portion of the interest);
- Desired changes in any shareholders' agreement which are deemed necessary in connection with the admission of the new shareholder (e.g., amendments to reflect the rights of the new shareholder to participate in the management of the business); and
- The purchase price for the shares being purchased and sold, the terms of payment, and the creation of any security interest in favor of the seller in the event that the purchase price is to be paid in installments. Typically, the security takes the form of a security interest in the shares being sold.
In some cases, one or both of the parties may also be required to deliver certifications or legal opinions regarding issues such as their legal status to enter into the agreement; good and clean title to the shares; and the enforceability of the agreement.
A sale and transfer of a large block of securities may be conditioned upon satisfaction of certain conditions. If so, the parties may provide for escrow of a portion of the purchase price and for delay of the closing until the escrow agent has received appropriate evidence that the condition for the transaction has been satisfied. See BTS Specialty Form at § 38:70. Conditions may vary depending on the situation. For example, the sale may be made subject to approval by the corporation's board of directors. See BTS Specialty Form at § 38:71. Or, the transaction may be subject to compliance with a co-sale agreement involving other shareholders, in which case the agreement should include procedures for purchasing shares from other shareholders electing to exercise their co-sale rights. See BTS Specialty Form at § 38:72.
The parties may also include restrictions on the ability of the purchaser to attempt subsequent sales and other transfers of the shares covered by the agreement without complying with the procedures included in the agreement such as a right of first refusal in favor of the corporation that has issued the shares. The issuing corporation is also a party to this agreement in order to enforce its rights with respect to the right of first refusal and the covenants made the purchaser not to transfer the shares in a manner that will violate applicable securities laws and/or impair any public market for the corporation’s securities. See BTS Specialty Form at § 38:71.50.
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The May 2015 Business Counselor update includes new slide deck presentations from recent Business Counselor Institute programs as additional practice materials in several chapters. Specific presentations cover fee arrangements (§ 1:264); conflicts when representing business clients (§ 1:265); admitting owners of non-corporate entities, such as partnership (§ 50:151) and limited liability companies (§ 61:149), and supplier selection and management (§ 82:162). The slide deck presentations were adopted from presentations originally prepared for a teleconference program on the topic that is part of the Business Counselor Institute series offered by Thomson Reuters West LegalEdcenter®. To listen to the programs (not maintained) and learn more about the Business Counselor Institute series, visit the West LegalEdcenter® online at http://westlegaledcenter.com.
The partners of a professional services firm should be sure to establish detailed procedures for the admission of new partners. A full discussion of the procedures for admission of new owners to a partnership or limited liability company is provided in the chapters covering Issuance of Partnership Interests (§ 50:3) and Issuance of LLC Ownership Interests (§ 61:1) in Business Transactions Solutions on Westlaw Next. While most of the procedures discussed in those chapters apply to professional services and limited liability partnerships, it is obviously necessary to take into account the need for new owners to satisfy applicable professional standards and requirements. One method sometimes used to ease the transition to ownership status is an agreement for admission of an associate to a professional partnership that covers the duties and responsibilities of the associate for a specified trial period prior to an agreed date that the association is promoted to partner status. During the trial period the associate may even be allowed to share in the profits of the partnership as part of his or her compensation package. It is typical for the parties to include non-competition provisions that would be applicable following the termination of the associate’s relationship with the partnership. See Specialty Form at § 55:152 of Business Transactions Solutions or contact firstname.lastname@example.org for a complimentary copy.
March 2015 marks the introduction of separate chapters in Business Transactions Solutions on Westlaw Next relating to the admission of new owners to two important non-corporate entities: partnerships (see §§ 50:1 et seq.) and limited liability companies (see §§ 61:1 et seq.). The admission of a new partner or member, whether at the time the entity is formed or during the operation of the business, is a fundamental change that requires the most careful consideration and time. A variety of factors and characteristics should always be considered including the functional skills of the candidate, the type and amount of contributable assets, level of participation, goals and objectives and the chemistry between the candidate and the current owners.
In a small- or medium-sized business, each principal should be able to contribute significant experience in one or more key functional areas. For example, one or more of the owners should have expertise in product development, procurement and manufacturing, marketing and distribution, finance and accounting, strategic planning and personnel. In some cases, one or more of these activities can be outsourced to outside professionals and vendors, including consultants, attorneys, accountants and payroll services. Strategic alliances can also be used to supplement the core skills and resources of the business.
In assessing a potential new owner, the current ownership group should determine if the candidate's functional skills are complementary. Clearly, if the current owners are particularly strong in the marketing area, a preference in recruiting might be given to an engineer or scientist with proven experience in product development or manufacturing processes. On the other hand, a candidate with a marketing background may not add that much to the current mix and may even create conflicts among the ownership group unless he or she can bring a unique set of contacts or ideas to the company.
While functional skills are important in evaluating a new owner, consideration should also be given to the contributions the owner is willing to make to the business. While new owners are often admitted on the basis of their experience without further contribution of assets, new owners are also a good source for working capital, equipment, facilities and intellectual property rights. For example, a new owner may contribute cash for operations and the owner's rights to patents that might be useful in developing new products to be commercialized by the company. A new owner may also be able to contribute needed equipment or arrange for the equipment to be available to the company under a long-term lease on favorable terms.
The current owners should get a clear idea of how much time and effort the new owner candidate is willing and able to devote to the business affairs of the company. While it is anticipated that all of the partners of a general partnership will be actively involved in the day-to-day management of the partnership business, use of a limited partnership or an LLC allows the parties to plan for different levels of participation. At one extreme, there may be owners who do not have the time or functional skills to be actively involved in the business and who are only looking to be silent financial partners. In that situation, the business will be organized as a limited partnership or a manager-managed LLC and these owners will become limited partners or non-managing members, as the case may be. They will generally have the right to receive regular reports on the progress of the business and special voting rights as permitted by statute on fundamental matters relating to the company (e.g., mergers). Assuming that the new owner will be participating at some level in the day-to-day management and operation of the business, the parties must reach agreement regarding the specific duties and obligations of the new owner. This often takes the form of an employment agreement or a detailed description of the agreed services in the partnership or operating agreement.
Each owner has his or her own personal goals and objectives for participating in the management of the business entity. In general, each owner should be dedicated to the overall success of the business, which may be defined by profitability, development of new products and markets, expansion of the workforce and/or increase in the value of the ownership interests. However, specific goals of an owner may conflict with the objectives of the other owners. For example, if one owner is much older than the others and is looking to retire in the near future, he or she may be less inclined to incur business risks that might endanger his or her ability to liquidate his or her interest on retirement. The other owners may want to take on more risky projects that will increase the value of their interests over the long-term. The divergent interests of the owners may lead to conflicts among the group and make it more difficult to manage the business. Similar issues may arise when owners have different levels of separate personal wealth.
Goals and objectives are also important when adding new owners looking for what is nominally a passive investment interest in the business (e.g., limited partners). While a passive investor is generally relying upon the active managers to conduct the business in a proper fashion, passive investors may have specific financial goals and objectives that need to be taken into account. For example, a limited partner may require that a certain amount of cash must be distributed to the limited partner on a regular basis regardless of whether or not the cash might be better used for internal projects in the business. In any event, the goals of the passive investors should be carefully described in the partnership or operating agreement.
The ownership group of a small- to medium-sized business should expect to spend a good amount of time with one another and to share tasks that might be delegated in a larger organization. The intensity of these relationships means that personal chemistry is a very important element in adding new owners. Ideally, new owner candidates will be well known to the other owners, either from past business relationships or from time that the candidate has spent as an employee in the current business organization. In fact, many businesses will not admit new owners without some trial period to make sure that there is a good fit. If that is not possible, and the candidate has no prior working relationship with the other owners, detailed interviews should be conducted and references should be carefully checked.
Traditional analysis of entity selection focused on comparing and contrasting the tax and non-tax characteristics of a limited group of prospective business forms, namely proprietorships, general and limited partnerships and corporations (C and S forms for tax purposes). In recent years, however, the creation and acceptance of new business forms, such as limited liability companies (“LLCs”) and limited liability partnerships (“LLPs”), that can be used to control and limit non-tax liability, and the easing of prior regulations by the Internal Revenue Service (“IRS”) to facilitate entrepreneurial flexibility (i.e., the check-the-box regulations), has dictated a transformation of the analytical process. The preferred sequence for legal and tax professionals at this point is to first identify for clients the four main types of “tax treatment” for businesses and then take the clients through a series of common organizational, operational and exit transactions to determine how the choice of a specific treatment will impact the principals of the business. Once that process is completed, the professional can focus on some of the more subtle issues that must be considered in selecting a specific entity or structure (i.e., if two or more related entities are needed) within a group of entities or structures that offer the desired tax treatment.
As part of this entire process, the legal or tax professional should be able to explain the default rules that apply under the tax laws with respect to classification of business entities and the steps that can be taken to elect a non-default classification by completing and filing Form 8832 (Entity Classification Election) with the IRS. The form must include all of the information requested. Failure to include required information will render the election void.
• A copy of the form must be attached to the entity's federal income tax or information return for the year in which the election is made.
• Where the entity is not required to file a return, a copy of the form must be attached to the return of any direct or indirect owner of the entity.
• Failure to attach a copy of the form will not render an election void, but may subject the non-filing party to penalties.
• The entity may specify an effective date for the election, but the date cannot be more than 75 days before or 12 months after the election is filed.
• Once an election is made, the entity may not change its classification for five years, unless there is a more than 50 percent change in ownership of the entity and the IRS consents to the new election.
• The election must be signed by each member of the entity or by any officer, manager, or owner who is authorized to make the election and who makes a representation under penalty of perjury that he has the authority to make the election.
The power to elect the board of directors is held by the shareholders, and the power to elect all or a majority of the directors is held by those shareholders who own a majority of the outstanding stock of the corporation. Under certain circumstances, the shareholders may wish to allocate voting rights in some manner other than one based upon the ownership of shares. For example, special arrangements might be used in the following instances: shareholders in a closely held corporation may want to ensure that they will serve on the board of directors; a shareholder may wish to reduce his or her ownership interest in the corporation for estate planning purposes while retaining the voting control, at least while the shareholder remains actively involved in the management of the business; and a minority shareholder may be unwilling to invest needed capital without assurances that he or she will have some ability to participate on the board of directors.
Voting arrangements may take a variety of forms, including voting trusts, voting agreements or pooling agreements, and irrevocable proxies. For example, a corporation with two or three shareholders may have a shareholders’ agreement that ensures that shareholders’ actions may not be taken without the consent of the consent of both shareholders, when there are two shareholders, or both of the main shareholders, when there are three shareholders. See Specialty Form at § 11:151.30 of Business Transactions Solution on Westlaw Next. Another variant is a shareholders’ agreement that provides that actions of the board and shareholders will not be effective unless they are approved by one of the shareholders designated as the managing shareholder. See Specialty Form at § 11:151.70 of Business Transactions Solution on Westlaw Next.
Even after a corporation is legally in existence, it is still necessary to “organize” it to do business. Organizing a corporation usually means the election of officers, the subscription and payment of the capital stock, the adoption of bylaws, and such other steps as are necessary to give the legal entity the capacity to transact the legitimate business for which it was created. Most of the organizational steps will generally be taken at an organizational meeting of the board of directors of the new corporation; however, an actual meeting may often be dispensed with if the directors are able, and willing, to take the necessary actions by unanimous written consent. Even if the actions are taken by written consent, you should have a meeting with all of the initial directors, in person or by phone, to briefly go over each of the key steps that are outlined in the consent action. A template you can use to guide your clients through the organizational actions can be found at §9:156 of Business Transactions Solution on Westlaw Next.
In most cases, the founders or key employees of a new corporation will purchase their shares in exchange for a nominal amount of cash or past services rendered to the corporation in connection with its formation or organization. There are, however, situations where a founder or key employee may also contribute his or her rights in technology to be used in a corporation's business. Intangible assets are lawful consideration for shares; however, the parties must carefully describe the transferred technology and assets by reference to the actual and proposed business of the corporation so as to minimize the risk of future disputes regarding ownership of technology that turns out to be key to the success of the corporation.
In some instances the assignment may be done in the context of a broader agreement that includes undertakings and promises from the assignor to provide the corporation with ongoing technical assistance in connection with the transfer and use of the assigned technology.
When you are transmitting a draft of an assignment agreement it should be accompanied by a letter or e-mail that seeks assistance from the founders in describing the assigned technology with specificity and also reminds them to be sure that procedures will be implemented, either in the assignment agreement or elsewhere, to make sure that the transferred technology is fully and efficiently integrated into the company’s development activities (e.g., including undertakings from the assignor to provide all necessary technical assistance for transferring the technology).
In addition, your communication should make it absolutely clear to each founder assigning technology to the new corporation as consideration for his or her shares that the assignment is permanent and irreversible and that he or she will have no rights to use the assigned technology in the event that his or her employment with corporation terminates in the future.
One of the most important documents in the incorporation process is the common stock purchase agreement used to formalize the issuance of shares to a founder of a new corporation and set out various restrictions with respect to transferability of those shares and requirements typically imposed on the founder with respect to his or her continued employment by the corporation as a condition to obtaining the full benefits of share ownership.
Drafting and finalization of such an agreement requires careful consideration of a number of issues, many of which can be quite sensitive to one or more of the founders. For example, a choice may need to be made among various types of consideration for the shares including assignment of intellectual property and other assets. Perhaps most importantly, the founders and their attorneys need to hammer out the procedures for vesting of the founders’ shares based on continued employment with the corporation and decide what other restrictions on transferability of the shares should be included in the agreement.
Once the initial draft of the agreement has been prepared you should forward it to the members of the founding group of the new corporation along with a letter or e-mail that specifically highlights and summarizes the key issues that need to be considered before the agreement is finalized. In addition, given the length and complexity of these agreements you should strongly recommend setting up a time to discuss each of the provisions in person or in a conference call. You should also make sure that your communication includes clear language directing the founders to seek independent legal advice from their own personal attorney regarding the terms of their proposed purchase and ownership of shares in the new corporation.
Finally, you’ll usually need to prepare a few additional documents to complete the issuance of the shares including a stock power, an acknowledgement and statement of decision regarding Section 83(b) election, an election under Section 83(b) of the Internal Revenue Code of 1986, a receipt for consideration for stock and a receipt for share certificate and consent to escrow.
Examples of all of the agreements mentioned above are available for you to view and use in Business Transactions Solutions on Westlaw Next.