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The HBS Blog offers insight on Delaware corporations and LLCs as well as information about entrepreneurship, start-ups and general business topics.

101: Delaware Blank Check Preferred Stock
By Rick Bell Tuesday, September 27, 2016

The Directors’ Trump Card For Attracting Early Investors, Maintaining or Gaining Control, Rewarding Key Participants, Going Public And Avoiding Bankruptcy

 

Every Delaware General Corporation must have one class of common stock, but it can also have a second class of stock (or more) with customized terms for the different classes. The most popular second class of stock is called preferred stock because it can contain terms, negotiated between the Board of Directors and the recipient, that are preferred over the rights of common stockholders.

 

Delaware’s brand of preferred stock is so powerful and flexible as a business tool that the top U.S. and international corporate lawyers refer to it as Delaware blank check preferred stock.

 

If you’re thinking of starting a business, raising capital and going public, or if your company is ready to go public, you should be aware of the power this type of stock offers.

 

delaware blank check preferred stock

Why would anyone want more than one class of stock in a Delaware corporation?

 

Common stock has two fundamental characteristics that are written in the Delaware General Corporation Law, and they are mandatory.

 

The first is that every share of common stock carries one vote. If you own 100 shares, you have 100 votes to cast on all matters presented for votes at stockholder meetings.

 

The second is the right to your pro-rata share of any dividends issued by the Directors to the common stockholders. If the total dividend is $1,000,000 and you own ten percent of the total outstanding shares of common stock, you’re entitled to 10% of the $1,000,000. You cannot get cheated on those two issues.

 

After all, common stockholders own the company. They have invested their money in the company and they have a keen interest in their share of the profit. If the company does not profit, the shareholders receive nothing. If the company does profit, the Board of Directors decides where the profit is to be spent, invested and/or distributed.

 

A stockholder's dividend is a distribution of profits. If the Board of Directors saves and/or invests all the profit with the best of intentions, and does not regularly declare a dividend, the stockholder has little recourse.

 

If the Board of Directors decides not to declare a dividend, the shareholders do not get a share of the profit. In the case of Apple, until recently, shareholders did not get a dividend but they did get an extreme increase in the valuation of their stock, so everyone was happy.

 

In other cases, like Wal-Mart, the shareholders have been given a distribution of profit in the form of a dividend for many consecutive years, and that dividend has increased every year. Neither of these examples is more right or wrong than the other; it’s just how it works. The same is true for any Delaware General Corporation.

 

All entrepreneurs admit there are extreme challenges that can occur in the life of a company, and often it is wise to make deals with new investors, the founder or creditors that are made on better terms than those that the common stockholders typically get. Delaware blank check preferred stock can do all this and more.

 

In fact, owners of Delaware blank check preferred stock can get dividends before common shareholders and, unlike common shareholders, can be guaranteed a security interest in the company’s assets, equipment and Intellectual Property. If properly stated, they can even be guaranteed a percentage of gross sales before any money is directed towards paying bills or paying dividends to common shareholders. (ergo the subtitle: The Trump card)

 

blank check preferred stock

 

 

How does an inspired entrepreneur obtain this silver sword?

There are three situations to consider:

 

  1. If you have not yet formed a Delaware corporation to pursue your vision, be sure to specify it when you initially form your company. This is the time when it’s least expensive to obtain. You don’t need to outline the specific terms of the preferred stock when you form the company, just the number of shares and a nominal par value. You will specify the terms for each series of your blank checks as you use them. You just want to declare the Preferred Stock in the beginning so you can utilize it later.
  2. If you already own a Delaware General Corporation with only one class of stock, then your Board of Directors, with shareholder approval, can authorize a second class of preferred stock. If you can’t get your Board to approve it, or if you can’t get your stockholders to approve it, you’re effectively blocked and powerless. Once the shareholders approve the authorization of the stock, the Board is free to negotiate the terms to attract capital, to inspire top people or to create strategic alliances using the blank check preferred stock as a form of currency.
  3. If you own a corporation in any state other than Delaware, you may want to consider forming a Delaware General Corporation, authorizing both common and blank check preferred stock and then merging your current company into your new Delaware General Corporation. It’s a little expensive, but it could still be worth it if your vision is long-term.

 

Now here’s the best part: the total number of shares of preferred stock that your Certificate of Incorporation authorizes may be split into any number of different series of the preferred stock, with each series having its own separate terms.

 

For example, let’s say the company has 1,000,000 shares of common stock and 100,000 shares of preferred stock. The Board can designate that the preferred stock be split into any number of distinct series, giving you, literally, not just one blank check but as many as you want, numbered one through whatever number you choose.

 

How do I use these blank checks?

 

I’m going to enumerate some specific examples of how Delaware blank check preferred stock has been used to attract investors, maintain or gain control, reward key participants, go public and avoid bankruptcy, as they relate to the rights of each series of preferred stock, but first, some general legal knowledge is appropriate.

 

Stock ownership comes with certain rights. You can’t avoid giving common shareholders the two basic rights I described above. At the same time, you cannot give common shareholders any special rights like a guaranteed dividend, a guaranteed percentage of the profit or a security interest in the company’s assets. The Delaware law guarantees them two particular rights and doesn’t leave a lot of room for changing those rights.

 

The rights of a preferred stockholder, on the other hand, can be negotiated before the stock is issued. These are the three most notable rights that are important in the negotiations:

 

  • Voting rights: Common shareholders get one vote per share, but the Board can give one or more series of the preferred stock super voting power, such as two votes per share, or ten or 100 or 1,000 votes per share. Why do this?

Let’s say the company is trying to attract more capital from a key shareholder who already owns a big percentage of the common stock and the Board doesn’t want him to take control. The Board can create a series of preferred stock with no voting rights but a guaranteed 10% dividend paid quarterly. Your investor might be enticed to invest more money but give up any increased voting rights in order to get a guaranteed return on his investment.

Or let’s say you are raising capital and you’ve sold 45% of your stock. Once you sell more than 50% of the company, you lose control. So what do you do? Bring out a series of preferred stock designated as Founder’s Stock, in which the 10,000 shares have 100 votes per share. Have the Board of Directors issue the whole 10,000 shares to you. Now you can sell more of the common stock to investors and still keep control of the company.

These maneuvers are sophisticated tricks and should be undertaken with the assistance of a very good corporate lawyer.

 

  • Dividend Rights: Common stockholders have the right to a share of the profits only if the company has profits and if the Board of Directors declares a dividend. Preferred stockholders, however, can be guaranteed a certain dividend per share ($1.00 per share, for example) or a dividend based on a business calculation that suits the deal (x% of increase in net profits, for example).

These dividends can be guaranteed, cumulative and convertible to common stock if the deal makers agree and a good lawyer drafts it correctly. If properly stated, preferred dividends can be paid before the common stockholders see any return.

 

  • Security Rights: Preferred stockholders can hold a security interest in a company-owned asset. This can include a patent, real estate, a major piece of equipment, the company’s website or any other company asset.

In a typical example, the company is desperate for an influx of cash. Bankruptcy is the next step if a deal isn’t put together in time to save the company. No one will buy the common stock if they fear a company is going out of business.

However, someone might invest if you gave him/her a security interest in the assets that will revert to him/her if the company declares bankruptcy. I hope you never need to use this technique, but if you find yourself in that position, you’ll be glad you have a Delaware corporation with blank check preferred stock.

 

If you’re about to form your Delaware General Corporation and expect to sell stock in the company to raise money, it would be a good idea to consider getting the preferred stock right from the start by including it in the Certificate of Incorporation. This way, you won’t need the shareholders' approval to authorize it when you need it.

 

The Directors will be able to issue the stock in the best interests of the company without the necessity of shareholder approval. If you already run a Delaware General Corporation, you will need shareholder approval to amend the Certificate of Incorporation, authorizing the preferred shares.

 

If you control the Board and the common stock now, you might be well-advised to consider authorizing a preferred class of stock at your next shareholder meeting so when you need it, it will be there.

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Podcasts We Love: Entrepreneur on Fire
By Veselin Ganev Monday, September 26, 2016

entrepreneur on fire

Entrepreneur on Fire is a top-ranked business podcast in which John Lee Dumas, its founder, interviews some of the most successful and inspiring entrepreneurs of our time. 

 

It is one of the most frequently published podcasts, with episodes being published almost every day.

 

According to Mr. Dumas, the goal of Entrepreneur on Fire is to inspire entrepreneurs by illustrating others’ failures, successes and Eureka moments, which may then give them the courage they need in order to take the entrepreneurial leap.

 

I listened to Episode 1416, “Why the Only Move that Matters Is Your Next One,” featuring guest speaker Jenny Blake.

 

Jenny is the author of Life After College  and the just-released Pivot: The Only Move That Matters Is Your Next One. She is also a popular career coach and business strategist who helps other people organize their brains, avoid burnout and build a sustainable, successful career.

 

The podcast episode opens with Jenny sharing her personal story about how she ended up where she is now, professionally; she describes her personal struggles with work, including a lack of interest and burnout at her previous jobs.

 

During that time, she helped a start-up establish itself, and then moved on to work for Google for five and a half years. She describes how she often felt bored, despite working for top companies, which in turn made her feel guilty.

 

Eventually she experienced a crisis of confidence in what she was doing. Later in the episode she also talks about one of the biggest fears any entrepreneur faces—running out of money—and the ways to overcome this rational fear.

 

Ultimately, says Jenny Blake, you should be focused on finding yourself and discovering what you are really good at rather than what others are doing, or think you should be doing.

 

For instance, Jenny Blake found that she thrives in situations where she can facilitate learning, so she crafted a job for herself that includes career coaching, speaking engagements, writing books, running an online course and producing her own podcast.

 

pivot by jenny blake

Jenny goes on to share that her worst entrepreneurial moment was the realization that she had lost confidence in herself and didn’t know if she was cut out to be an entrepreneur.

 

As she explains, she was concentrating too much on the negative side of things—the things she didn’t know, the things she couldn’t do and the things she didn’t understand.

 

Her advice to everyone was to shift your thought process by going back to when everything had been working and concentrate on those things by leveraging all the knowledge, connections and experiences you have already had.

 

This podcast episode of “Entrepreneur on Fire” is about half an hour long, and will offer insight into how to get comfortable with yourself and your career, and what corrective action to take if you feel there is something in your professional life that needs to change.  

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What Is the Delaware Court of Chancery?
By Jeremy Reed Tuesday, September 20, 2016

What Is the Delaware Court of Chancery?

The Delaware Court of Chancery has a long history deciding on equity and fairness between parties.

 

The tiny coastal state of Delaware is widely recognized as the best state in which to form a company, not only in the United States but throughout the world. One of the key reasons for this is the Delaware Court of Chancery.

 

More than half of the companies listed on the New York Stock Exchange and NASDAQ call Delaware home, as do 65% of the Fortune 500 companies.

 

 

The Delaware Court of Chancery is a major feature of the “Delaware Advantage,” and certainly a significant part of why so many companies choose to incorporate in Delaware. The Delaware Court of Chancery is widely recognized as the preeminent forum in which to settle disputes that involve fairness decisions involving Delaware corporations, LLCs and other business entities.

 

The Delaware Court of Chancery is a non-jury trial court that serves as Delaware's court of original and exclusive equity jurisdiction, and adjudicates a wide variety of cases involving trusts, real property, guardianships, civil rights and commercial litigation.

 

The court was first established in 1792 and is based on the English model of a Chancery Court. In old English law the King was the final maker of laws, but the Chancellor would hear and decide cases where there were no laws, or remedy at law.

 

A noteworthy aspect of a Court of Chancery is the equitable expertise that is implemented by judges rather than a jury. One Chancellor will hear your case and make the rulings, unlike the U.S. Supreme Court where the case is heard by all nine (currently eight) Justices and a decision is voted upon.

 

This is a significant aspect, because the Chancellors are skilled and experienced in corporate law; thus there is no need to educate an uninformed jury on the intricacies of Delaware corporate law, which saves time and thus legal fees.

 

Litigants can therefore rely on fair and unbiased decisions based on the law rather than public opinion. Chancellors rely on more than two hundred years of case law (history) in making their rulings. This tends to make the decisions of the Chancellors more predictable than decisions made by juries, and makes businesses more confident of a decision based on law and precedent rather than emotions and prejudices.

 

Corporations of all sizes are formed in Delaware because business owners understand that the Chancellors on the Court of Chancery are using the business judgement rule.

 

The Delaware Business judgment rule directs the Court to respect the good-faith decisions of the company’s Directors, even when the outcome of their decision may not have been the best in hindsight. Directors are charged with making informed, independent decisions with care and loyalty and the absence of self-dealing.

 

Sometimes those decisions are questioned by shareholders. When shareholders sue the Board of Directors the case is called a “derivative suit” which makes up the majority of the high-profile cases brought to the Court of Chancery.

 

The Delaware Court of Chancery consists of five justices; the head of the Court of Chancery is known as the Chancellor while the other four are called Vice Chancellors. The Chancellors must be extremely learned in the law, although there is no requirement to have practiced as a lawyer. They must be residents of the state of Delaware.

 

All Chancellors are nominated by the Governor of Delaware and confirmed by the Delaware Senate. They serve 12-year terms. In addition to the Chancellors, there are two Masters in Chancery that are chosen by the Chancellor. All Chancellors and Masters must be members of the Delaware Bar Association in good standing.

 

The current Delaware Court of Chancery is comprised of:

  • Chancellor Andre G Bouchard
  • Vice Chancellors J. Travis Laster
  • Vice Chancellor Sam Glasscock III
  • Vice Chancellor Tamika Montgomery-Reeves
  • Vice Chancellor Joseph R. Sights III
  • Master in Chancery Kim E. Ayvazian
  • Master in Chancery Morgan Zurn

 

 

Sources:

https://www.scu.edu/ethics/focus-areas/business-ethics/resources/history-and-role-of-the-delaware-court-of-chancery/

http://www.courts.delaware.gov/chancery/history.aspx

http://www.courts.delaware.gov/chancery/judges.aspx

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How to Fix Business Mistakes in a Delaware Corporation
By Brett Melson Monday, September 19, 2016

how to fix business mistakes in a delaware corporation

Entrepreneurs are primarily concerned with running a successful company-- on a daily basis, they make myriad decisions and face constant pressure related to the operation of the company.

 

Often, particularly early on in a company’s existence, taking formal steps to document and track corporate actions and decisions is an afterthought, given the pace at which decisions are made and actions are taken.

 

Drafting corporate resolutions, recording meeting minutes and tracking stock available for issuance is sometimes seen as a distraction from the company’s primary focus of pursuing its business plan and achieving its goals.

 

Such a mindset, however, can ultimately prove damaging to a business’s growth and future.  Mistakes or failures to monitor corporate actions can come back to haunt a company at the most inopportune times, such as when it is looking to bring aboard investors.

 

Take for example, a company that has issued stock to its founders and employees without documenting these grants through corporate resolutions, only to find that it has issued more shares than permitted under the company’s Certificate of Incorporation.

 

Such an issue is a red flag for both investors and lenders, both of whom view adherence to formalities as a sign of a company’s overall commitment to detail.

 

All is not lost, however, because under Section 204 of the Delaware General Corporation Law  a company can retroactively ratify mistakes through action that, prior to the adoption of Section 204 of the Delaware General Corporate Law in 2013, would have been deemed invalid as well as a financial and logistical mess to correct.

fix corporate mistakes

Elaborating on our example, assume that a company is authorized to issue 2 million shares of stock under its Certificate of Incorporation but has inadvertently issued 2.1 million shares.

 

What would Section 204 require as a corrective action for the issuance of these 100,000 shares of unauthorized stock that was issued to the shareholders?

 

  1. Board Resolution:  The Board of Directors must adopt a resolution providing details about the invalid shares, and then ratify and approve the shares.

 

  1. Potential Vote:  If the invalid shares would have required a shareholder vote (which, in our example, would be the case, as a stock amendment of the Certificate of Incorporation would be required), then the company traditionally would submit the ratifying corporate resolution to a vote of the current shareholders as well as the shareholders at the time of the defective action.

 

  1. Potential Notice:  If the invalid shares would not have required a shareholder vote, then notice of the ratifying resolution is typically sent to all current shareholders as well as those persons who were shareholders at the time of the defective action.

 

  1. Corrective Filing:  If the invalid shares would have required a filing to be made (which would be the case in our example (an amended Certificate of Incorporation)), the company would traditionally file a certificate of validation with the state of Delaware describing the defective action and making the required filing after the fact.

 

If the above actions are done in compliance with Section 204, the defective action is approved by the state of Delaware and, in our example, the 100,000 formerly invalid shares would be deemed valid stock and the amended Certificate of Incorporation would govern.

 

Section 204 is not the only means by which a Delaware company can give authorization to correct prior mistakes, but it is a formal means with which to deal with serious problems, such as the breach of a company’s Certificate of Incorporation, per our example.  

 

This is unique to the state of Delaware and yet another example of how Delaware keeps the Delaware corporate law structure on the cutting edge.  

 

A company reviewing its past or current compliance with corporate formalities should seek the assistance of counsel to ensure that any corporate clean-up is documented appropriately.

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Business Dissolution: Two Ways to Go About It
By Amy Fountain Tuesday, September 13, 2016

close a company

 

 

How to Close a Delaware Company

 

When a Delaware company is no longer viable, there are two options available to the company owner in order to complete a business dissolution.

 

One approach is to file the proper cancellation (for an LLC) or dissolution (for a corporation) documents with the state of Delaware to formally close the company.

 

Just as formation documents are filed with the Secretary of State’s office to create a Delaware company, official documents must also be filed to legally close the company.

 

An alternative route is to have the acting Registered Agent resign upon the entity. While this course of action is not the same as filing a formal certificate, it will put the company into a forfeit status. An entity in a forfeit status is considered an inactive company by the state of Delaware.

 

However, the resignation process actually takes a couple of months to complete; it does not occur right away like a cancellation/dissolution.  These steps must be taken before the Registered Agent is formally resigned from the company:

 

  • First, the current Registered Agent must provide the entity with a notice of its intent to resign. This notification informs the entity the Registered Agent is pursuing the resignation, which will put the company into a forfeit status.

 

  • The Registered Agent must wait 30 days after this notice has been sent to the company before taking any action. This time period basically gives the company the option to request that the Registered Agent not proceed with the resignation filing. 

 

  • If there is no action from the entity, the Registered Agent can then submit the resignation filing to the state of Delaware.

 

At this point, the state of Delaware gives the entity another 30 days to rename the former Registered Agent as its current Registered Agent for the entity or to find a new Registered Agent to act on its behalf. 

 

Again, if no action is taken, then the entity will become officially forfeit and will lose its good standing status.

 

During the approximate 60-day waiting period, the entity can potentially still receive notices for payments due, such as the annual Franchise Tax Fee. Until the entity is actually resigned upon and in a forfeit status, the Franchise Tax notices will continue to be generated by the state of Delaware.

business dissolution

People often assume—incorrectly—that if their company is in the resignation phase they will not have to pay that company’s Franchise Tax Fee. The Franchise Tax Fee is automatically imposed on the entity by the state of Delaware at the beginning of each new year. 

 

Regardless of whether the entity has conducted any business, it will generate a Franchise Tax Fee. If the entity is resigned upon and the Franchise Tax Fees are not paid, the assessment stays with the entity.

 

Therefore, if the entity is restored at a later date, the outstanding Franchise Tax Fees must be paid at the time of a renewal filing. However, no new Franchise Tax fees are imposed on an entity that is in a forfeit status.

 

All possible options and subsequent consequences should be reviewed by the company’s responsible parties to determine the best course of action for the entity.

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