Key Roles in a Corporation: Registered Agents and Incorporators

Registered Agents

Most states require corporations to name a registered agent who resides in the same state that the corporation is formed in.

A registered agent is responsible for receiving legal and other official state communications on behalf of the corporation. Generally,  a business owner can name him or herself as a registered agent; however, there are disadvantages to this route. Contact information for a registered agent must be public information, which results in enormous amounts of spam and junk mail. Moreover, it may not be good news that is being delivered — say if the corporation is facing legal action.

In order to maintain privacy and to avoid having potentially unsettling news delivered to the workplace directly for clients and employees to see, startups generally contract with a third-party registered agent.

Although third-party registered agents provide an in-state mailing address for a corporation, it is important to also establish a second business address for general correspondence, as registered agents typically only accept mail from the state. Generally, all other mail received is returned to the sender.

Registered agents typically also serve as filing agents. That is they file documents with the state on behalf of the corporation.

Incorporators

An incorporator is the single person who initiates a corporation by signing the certificate of incorporation that is filed with the Secretary of State. In a startup setting, the incorporator is generally the founder who is most willing to do the paperwork.

Generally speaking, the incorporator is responsible for electing the initial board of directors, and is able to elect him or herself to the initial board. He or she also establishes the corporation’s bylaws and the number of seats on its board of directors.

Because the role ends here, and the corporation doesn’t yet have any assets at this point, it is not tremendously important who completes these tasks. If, for any reason, other founders are dissatisfied, they are free to form a separate corporation before assets are assigned. In fact, some law firms have been known to use a paralegal as the incorporator.

Taking Stock of the Situation: Issuing Stock and Entering Contracts

Stock is a representation of ownership of a corporation. A person who owns stock, a stockholder, by extension owns part of the corporation itself. However, stockholders generally do not have direct control over the corporation, as they are only able to appoint board members who in turn operate the corporation through the officers.

Structure

It is standard practice for startups to offer one of two varieties of stock — common stock and preferred stock. Preferred stock carries with it certain privileges that common stock does not have. Specifically, preferred stock offers more options in terms of liquidation and dividend preferences, and potentially more.

Classes

A corporation’s stock is divided into classes. Often the initial offering is in a class of “common stock,” and subsequently “preferred stock” is offered in certain situations.

Generally, startups offer common stock to founders and employees, while preferred stock is often reserved for investors.

Series

A corporation can also divide its stock offerings into series. This is fairly common for preferred stock, as it is issued during distinct phases of the fundraising process. The first class of preferred stock is referred to as Series A Preferred Stock.

Requirements to Issue

In order to issue stock, a corporation’s board must first approve the issuance, and the corporation must have stock to issue. So, if the stock is of a particular class or series, the corporation must have enough shares of those varieties to issue.

To identify the number of shares available for issuance, a corporation must first determine the number of authorized shares, which is outlined in the certificate of incorporation. This same practice is true of classes and series of stock. These quantities must also be defined in the certificate of incorporation.

Most startups authorize 10 million shares of common stock when they are first formed.

In the event that a corporation wants to issue more shares than were called for in the certificate of incorporation, that document must be amended prior to the issuance.

Entering Contracts

Contracts are formal agreements between two or more parties that are enforceable by law. A formal contract does not, contrary to popular  belief, have to be written. Oral agreements are binding legally as well; however, as they provide significantly less legal protection than written contracts, corporate lawyers discourage oral agreements.

Formal contracts do not need to be formally drafted by an attorney. In fact, agreements that are made between qualifying representatives from two or more parties are contractually binding. A common example of this is an email chain between a CEO and a vendor, supplier or other interested party.

So who qualifies to enter into a contract on behalf of the corporation? Good question. Boards of startups generally afford this authority to the CEO.

First Steps: When to Become Incorporated

Personal Liability Considerations

In the event that the corporation is sued, the personal assets of interested parties (i.e. founders, investors and the board etc.) are most likely protected.

Good Fences Make Good Partners

When multiple founders are involved in a startup, forming a corporation is a clean way of delineating ownership of assets. This is particularly true of intellectual property.

Equity Ownership

Deciding how equity will be split is a major component of the process. This varies significantly from one startup to the next, but however it looks this is the time to iron it out.

It is common for founders to place temporary restrictions on stock issued to founders in order to maintain a common vision and avoid ownership disputes. These restrictions are often lifted according to a vesting schedule. Vesting motivates founders to work together for a certain period of time, and outlines actions should a founder leave before the agreed upon window of time has passed.

Intellectual Property

Commonly referred to as IP, intellectual property is often the greatest asset of a startup. As such, it is essential that the corporation is able to continue using the property as it sees fit even after the founder or founders responsible for its creation have left the company.

Enables Investment

Investors generally expect stock or a security that will convert to stock in exchange for their financial contribution to the startup. Becoming incorporated allows a company to issue stock, and thus accept third party investments.

Equity Compensation

A key factor in attracting top talent to a startup is the possibility of equity compensation. Becoming incorporated is a fundamental step toward positioning yourself such that you can offer the possibility of great success, which so utterly fuels startups.

Perception

Finally, having a polished exterior image for prospective investors and employees is often viewed as essential to making it to the “next level.”

Laying the Groundwork: Corporations and Boards of Directors

Corporations

In a casual context, person clearly refers to a human being. Legally speaking, it’s not so cut and dried. Person or Legal Person, in a legal context, can also refer to entities people create, which hold rights in and of themselves.

A corporation is one such entity. Legally speaking, a corporation is a person with rights and obligations that are distinct from its creator(s). This brings with it a slew of benefits for stakeholders in the corporation, not the least of which is controlled liability should something go awry.

Although each state has its own procedure for the creation of a corporation, generally speaking, a certificate of incorporation must be filed with the Secretary of State.

How do corporations and companies differ?

“Company” is a catch-all term for any business. Corporations are a variety of company that carry with them specific legal rights that other companies don’t have.

Board of Directors

A governing body made up of a designated number of seats, the board is responsible for making formal decisions on behalf of the corporation. The board can consist of a single member, or any number agreed upon the the founders. It is common for startups to structure their board such that the number of members can be adjusted easily. It is worth noting that the number of directors cannot be greater than the size of the board.

In the event that decisions are made in board meetings, half the board plus one additional member (also referred to as the quorum) is required to be in attendance. Otherwise, the board may give written consent to a given action; however, in this case the decision must be unanimous amongst board members.

Once stock is issued, a defining element of a corporation, stockholders are responsible for selecting board members. For startups, the board generally consists of founders until their Series A financing. At that stage, venture capitalists often join the board as well.

The Steps to Forming a Corp.

In the world of startups, the following are the steps most often taken on the road to incorporation:

Incorporation

  1. A certificate of incorporation first has to be filed with the Secretary of State’s Office.

Post-Incorporation Setup

  1. After the Secretary of State receives the certificate of incorporation, the incorporator creates bylaws for the newly formed corporation. He or she also appoints members to the board of directors.
  2. The board, in turn, appoints officers to oversee the daily operation of the corporation — for startups this generally includes at least a CEO and potentially a CFO, Secretary, and President. However, the CEO/President and the CFO/Secretary are often the same person in a startup.
  3. The founders purchase their shares as outlined in the certificate of incorporation. If the stock options are subject to a vesting schedule, the founders then make 83(b) elections.
  4. The founders then generally bind themselves to confidentiality and intellectual property contracts.

Create Stock Plan

  1. The board of directors establishes, and the stockholders approve a stock plan.

Geographic Variance

Although the term gets tossed around a good bit, startups rarely need to set a shareholder agreement. These are generally reserved for traditional small businesses, although regional differences exist. Legal counsel is more likely to use them in regions where they have traditionally been the standard procedure for the setup of corporations.

Getting Help

This paperwork is tough to complete. In fact, almost everyone uses an attorney or some type of software to aid in the process. Making sure of the value in the help you pursue is key. It is fairly straightforward to see that the paperwork is completed. Any lawyer with experience working with startups will be familiar with the steps outlined above. If you opt to go with software to assist in the process, make certain that it is equipped to handle all of the involved steps in the creation of the corporation. If, for some reason, the software cannot handle each step, the process can be made more complex for the simple fact that you will then have to isolate the document or information that is not provided for and to identify the correct information for its completion out of the stream of the process.

Unfortunately, the quality of legal documents provided for startups is rarely tested, as the majority never require due diligence that comes with acquisition or VC. So, the best course of action is probably through personal recommendations. Give us a holler. We at Bax can help you find the right assistance at the right time.

Slicing the Pie: Allocating Equity and Vesting

Allocation of Equity

When a corporation is formed, its founders have to establish how the equity or value of the corporation’s holdings will be allocated. To this end, founders generally take into account:

  • the respective percentage each founder ought to receive
  • an approximation of the percentage to be held by founders, as opposed to employees and consultants
  • the possibility of a reserve of shares in the event that the startup enters an accelerator program (i.e. Y Combinator) or increasing the number of founders at a later date.

In the event that a corporation elects the standard 10,000,000 authorized shares, the following represents a common breakdown of allocation:

  • 8M shares divided amongst the founders
  • 1M shares for stock offerings to employees and consultants
  • 1M shares set aside for future opportunities

Although the number of authorized shares designated in the certificate of incorporation can be adjusted at any time, it represents an undesirable, and arguably unnecessary expense. As such, it is worth getting this one right the first time.

Vesting

Stock issued to founders is almost always subjected to vesting. This means that even though the founder owns shares, the corporation is able to purchase back (buy out) a founder if he or she is no longer providing services to the company. The number of shares that can be bought back is governed by the number of shares that have not yet vested.

If common stock is subject to vesting, it is called restricted stock. Restricted stock usually vests over a predetermined period of time, referred to as a vesting schedule. This process begins on an established date known as the vesting commencement date.

The “four year vesting with a one year cliff” is far and away the most popular vesting schedule among startups. According to this plan, 25% of one’s holdings vest on the one year anniversary. From that point forward, just over two percent vests each month, so that the total holdings will be vested at the conclusion of the fourth year.

Following this in terms of popularity is the “four year straight line” model. This is essentially the same as above, except that there is no one year waiting period. 1/48th of one’s holdings are vested each month, such that 100% will be vested in four years.

The vesting commencement date is generally the date that shares are issued to founders, but it may be post-dated to credit certain founders for their contributions prior to incorporation. This is referred to as vesting credit.

Vesting is meant to protect the sweat equity of startups. It provides a means by which there is a common financial motivator for the company to maintain focus and to stay intact.

For Solo Founder

Vesting is also common among solo founders. This is generally a preventative measure, in that a future angel investor may require that the founder’s stock is vested before contributing to the startup. In the event that a solo founder didn’t subject his holdings to vesting, there is no guarantee that the investor will offer vesting credit for his or her time spent.

I Got 99 Problems but an 83(b) Ain’t One

By default, the IRS taxes the difference between the purchase price of a founder’s stock holdings and the current market value of those holdings at each step within a vesting schedule as a taxable event. This is burdensome in terms of time and resources, as the full market value of the shares held then needs to be evaluated 48 times over the course of a standard 4 year vesting schedule. It can also become a major tax burden, as the difference between the current value and the purchase price is considered taxable income at each step — even though the income is tied up in stock that cannot be sold freely.

Thankfully, the IRS allows founders to choose an alternative tax structure through an 83(b) election. In this case, there is only one taxable event — the initial purchase of the stock. Because founders generally pay full market value for their shares, and they are taxed according to the difference between FMV and current value, there is generally no taxable income to report.

The 83(b) must be signed and submitted manually. The IRS does not accept electronic signatures. The form must be mailed to the appropriate IRS office within 30 days of the initial issuance of the stock. It is very important to meet this deadline, as there are no easy fixes if it is missed.

The IRS also requires that the 83(b) must be submitted to the company. This can be as simple as emailing the document to co-founders. It is a best practice to maintain a copy of the 83(b) in company records as well.

It will also be to your benefit to collect evidence that the 83(b) has been filed, as future investors will likely need to see proof of its completion.

The following steps outline common legal advice to this end:

  • Send the 83(b) via USPS certified mail
  • Keep the receipt and the return receipt (when it is returned)
  • Include a brief letter and a self addressed, stamped envelope along with a second copy of the 83(b)
    • Ask that the duplicate form be stamped and returned to you as evidence of filing.

How and When Founders Should Capitalize

Founders can structure cash infusions early in a startup’s lifecycle in a variety of ways. And on the face of it, money is money. Most of the startups we work with don’t intuitively sense the importance of forecasting and and planning when it comes to the valuation of their “baby.” But it can make the difference between the life and death of a startup.

There is no “one-size-fits-all” solution to the question of getting your startup up and running — or keeping it that way, for that matter — but making informed choices is what we advocate at Bax. Read on for a breakdown of some of the most common elections.

Common Stock Value

Infusing cash is essential to getting most startups off the ground. To this end, founders are sometimes tempted to ramp up the purchase price of common stock, so that they can basically make the startup a loan through the purchase of common stock.

However, most startup attorneys recommend against this.

It can eat away at the value offered to employees and consultants through common stock offerings, as the core attractant for these folks to equity offerings is the potential increase in full market value of the stock from the time it was issued to the time of sale.

If the value is prematurely inflated as a means of infusing cash into the business, the potential return on common stock holdings is diluted significantly.

However, it is highly advised that a startup issue stock to its founders immediately upon incorporation. Shares are generally sold for a fraction of a penny to founders, which keeps the startup attractive to potential investors and employees while also avoiding potential tax law pitfalls.

Simple Loan

When a startup is in need of immediate capital, founders generally deliver it by way of a simple loan. With this approach, the company is obligated to repay the founder at a later date with nominal interest, and the startup’s equity offerings are still intact.

Seed Investment

As an alternative, certain founders choose to make a seed investment either as a convertible note or safe. This route may carry unintended consequences with future investors, and they may seek to dismantle founder-driven seed investments if it appears too economically favorable for the founders.

Stock Plans: Do They Come Stock?

A stock plan is the standard vehicle for issuing equity to startup employees and consultants. It’s a structured stock delivery and maturation program. At its core, it offers a means for controlled issuances of stock across a variety of situations. With such far-reaching influence, such plans need to be drafted and subsequently adopted by both the board and the stockholders.

Startups generally create a stock plan when they become incorporated — whether they plan to do any hiring immediately or not. This approach offers significant simplification of the process, and thereby a significant savings to the corporation over time..

Three Key Benefits of Stock Plans:

  • Significant potential for tax breaks.
  • Dramatically reduces the due diligence required beyond the initial offering,
    • translates into significant savings of time and resources.
  • The reduction in required due diligence also applies in acquisition.

The stock plan outlines the total number of shares a startup can issue. This election will then stand indefinitely unless it is overwritten with the approval of both the board and the stockholders. The fledgling corporation is then bound to retaining enough shares available for issuance — commonly referred to as an “option pool” or a “stock option pool.”

Finally, as a matter of practical formality, a stock plan’s name begins with the year in which it was created — i.e. 2018 Stock Plan. This lays the foundation for a self-organizing system should a large number of future stock plans be adopted.

Fully-Diluted Capitalization

A startup’s pre-money valuation, the determination of its worth prior to investments, is used to set the price of stock issued to investors. This process establishes the percentage of the corporation that a prospective investor will purchase for a given investment.

Capitalization — in this context — denotes the capital structure of the corporation. For capitalization to be considered diluted, the relative degree of ownership of the corporation (denoted by stock ownership) is reduced at each additional stock issuance. Taken a step further, the term fully-diluted implies that all obligations associated with the issuance of stock have been fulfilled.

As such, a startup’s fully-diluted capitalization generally implies:

  • preferred stock holdings have been converted to common stock;
  • outstanding options, warrants, and other securities with a right to acquire shares have been exercised; and
  • any shares reserved for issuance under a stock plan have been issued.

That said, there is no one overarching definition of fully-diluted capitalization. For example, shares that have been earmarked for issuance under a stock plan can be temporarily set aside from a fully-diluted capitalization.

This is common practice in the event that the calculation is being performed in preparation for an acquisition, as startups rarely issue equity post-acquisition.

Conversely, such shares are nearly always included in a fully-diluted capitalization in the context of equity compensation. Moreover, certain definitions call for the inclusion of convertible notes or safes, which will eventually convert into stock.