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Corporate Governance Insights

 
 

Corporations

What is a corporation actually? Why do I need all that paperwork when forming a corporation or giving equity?

Corporations are mini-republics, but founded on the principal of one share, one vote. When thinking about structuring your corporation, you should primarily be thinking about 3 kinds of roles:

  • Shareholders

  • Directors

  • Officers

In most start-ups the founder(s) will occupy all three roles. And, even well after a corporation is formed and successful, owners may wish to occupy more than one role.

Shares in a corporation fall into 4 (but really 3) classifications: (i) authorized, (ii), issued, (iii) outstanding, and (iv) treasury. These are the terms to think about to determine who owns what percentage of the corporation and who is or will be diluted.

Further, corporations can put all kinds of restrictions and grant all kinds of rights to its stock. On one hand, a corporation may want to grant stock with many restrictions, such as when incentivizing employees and contractors. On the other hand, investors may (and frequently do) demand certain rights and privileges greater than the founders.

Founders should have at least some familiarity with all these facets of their corporation to plan ahead and be able to assess good deals from bad ones.

LLCs

In legal terms, Limited Liability Companies are very much the new kids on the block, having only be made in American law in the 70’s, whereas the corporation has been around since the 1600s.

For many starting out, an LLC makes a lot of sense. It has:

  • Flow-thru taxation (not always a good thing),

  • It’s easier to form and understand (at least initially), and

  • Much cheaper in legal and maintenance costs.

However, that ease, flexibility, and recentness create another sort of problem—the LLC is too flexible.

Because the LLC is almost entirely governed by its main governing document (the operating agreement) and the operating agreement can just be whatever the owners want it to be:

  • It’s harder for investors to know what they are truly getting, and

  • Every decision needs to be carefully thought through to ensure it doesn’t have unanticipated consequences.

As such, many investors may insist that before they invest, the company switch from an LLC to a Corporation.

Founders should strongly consider these issues when deciding between an LLC and a corporation. If you are looking to bootstrap for a while with the same close group of people, the LLC typically makes more sense in the short to mid-term. But, if you are looking for investors, or thinking of using a lot of incentive equity, while using an LLC isn’t an absolute bar to those things, it will make them more difficult.

Fundraising

So you found someone willing to give you money now in exchange for your giving them more money later. Is that debt or equity though? What actually is the difference between debt and equity?

In short, there a lot of ways to structure investments. Founders need to be familiar with the basics such as:

  • Lines of Credit

  • Convertible Notes and Simple Agreements for Future Equity (SAFEs)

  • Priced Rounds (Friends and Family, Seed, Series A are not as well defined as you may think)

  • Preferred Shares

  • Common Shares

  • Incentive Equity

  • Stock Options

Each one of these, and more, need to be carefully considered as to their risks and rewards in any situation. Also, and very importantly for start-up owners is to keep track of all these instruments as they issue them.

Lastly, just to make it all worse, Section 409A (non-qualified deferred compensation) of the tax code as well as various securities rules create requirements and significant penalties for using these instruments incorrectly.