Recorded Webinar: Delaware Corporation Basics
This webinar was recorded August 5, 2020.
Speakers: Brett Melson, Jarrod Melson
Moderator: Michael Kupfer
Transcript
Jump to section:
- Delaware Corporation Basics
- Sources of Law Governing Corporations
- Advantages and Disadvantages of Corporations
- Features of Corporations
- Key Corporation Documents
- Audience Q&A
Delaware Corporation Basics
Brett: Today, our goal is really to give you an overview of the corporation as an entity -- what is it? -- and secondly, some key terms. Trying to give you familiarity with basic things you're going to hear about in forming a company, things you'll hear about in getting advice and researching what a corporation is and how it operates.
Why Delaware
So we're going to start with, why do clients incorporate in Delaware? The biggest and the main reason is the sophisticated law structure. This Delaware corporate law structure, general corporation law was enacted all the way back in 1899, so it's got quite a bit of history that goes behind it.
Jarrod: That's right, Brett. The Legislature is advised by very preeminent corporate lawyers, and they're very receptive to that advice. And as such, Delaware tends to be not only a stable, solid place where new laws are passed. It's also a place of experimentation where -- Delaware is pushing the boundaries on incorporating FinTech into the corporate structures and corporate operations. It's got a blockchain initiative currently underway to incorporate blockchain technology into share ledgers. So, it's as strong as it has been traditionally, but yet it's pushing the boundaries simultaneously.
In addition to the statutory law, you have a large body of case law in Delaware. Over the years, very sophisticated jurists from the Chancery Court, which is our specialized business entity court here in Delaware, have developed a huge body of case law in virtually every element of the operation and governance of a corporation.
This body of case law grants people forming in Delaware a predictability and the ability to structure their terms with some certainty, that they know what is permissible. You've got so many examples from the cases that you can draw upon that it really helps to guide your actions, and those of attorneys, in structuring and operating corporations.
Brett: Jarrod, you mentioned the case law in Delaware. One thing that we should point out as well is the importance of the Chancery Court --- not just the importance of the Chancery Court, but a little bit about who is in this Chancery Court, the actual individuals that are appointed to the court itself.
Jarrod: The Chancery Court judges, and all of Delaware's jurists are very experienced in corporate law, and the wall of business entities, all the way up to the Supreme Court. But the Chancery's in particular are preeminent corporate attorneys, generally sourced from Delaware from some of the largest global firms in the world, but people with immense, deep and rich experience in everything regarding corporations, from litigating these kinds of disputes in the Chancery Court to transactional work, in structuring corporations and their businesses.
Brett: So they've got a wealth of knowledge that they bring to the court. So it's not being presided over by people that might not have the knowledge involved for some of the complexities involved with the cases that are brought forth.
Jarrod: That's right. And some of the other states that are trying to make themselves corporate domiciles, you see someone who might be handling an ordinary business dispute, a judge that might be handling business dispute suddenly handling a fiduciary duty case, with very little background or context, or the sort of richness of experience that the Chancery Court judges would have.
Now again, one of Delaware's key advantages, it's not only business friendly, but it also has a great deal of investor protections built into it. It's a proper balance between a pro business environment and investor protection.
The Business Judgement Rule
Possibly the key way that you can see the pro business side is the business judgment rule, which is, in looking at a corporate dispute in the dispute governing the internal governance of a corporation, the judges of the Chancery Court assume that the corporate officers and directors have acted in conformity with their fiduciary duties until that assumption is reversed by evidence presented by the plaintiffs, the shareTolders oftentimes.
They have to make what's called a prima facie case, overturning this presumption that the directors and officers acted in accordance with their obligations. And this is because Delaware understands that the judge is not in a good place to second guess the judgment of business people operating in the market -- they're not here to be armchair quarterback after the fact.
And they know that many times someone who makes a wrong decision still made a well-reasoned decision that should be respected. So, oftentimes the business judgment rule looks at process rather than the outcome.
Brett: So they're going to look at the case of the whole and then go ahead and make a verdict on everything that's presented to them. And if they acted within the best interest of the entity itself, even though, like we said, with perhaps a poor decision.
Jarrod: Yeah. To put in broad strokes, definitely. There's a lot of complexity in these cases, but generally, the Delaware courts are hesitant to second guess business people who are operating under the constraints of oftentimes little time, deadlines -- they recognize that these people can do so much -- and as long as they follow a proper process, disclosed all conflicts, and has taken steps to mitigate those conflicts, Delaware generally is loath to second get those businesses.
Brett: And that's why 67.8% of all Fortune 500 companies are incorporated in Delaware. 89% of all companies engaging in the IPO in 2019 were Delaware entities. I mean, some of these names -- Uber, Lyft, Pinterest, Slack Technologies -- all had IPO's. They're all Delaware entities. So you've got some strength there when it comes to name recognition, for sure.
Jarrod: That's right. And that's both from a practical and an optics perspective. The high net worth in institutional investors that back these companies that ultimately go public, and the investment banks that help them go public, prefer Delaware companies both for the sophistication of Delaware's law but also simply for the fact that they know Delaware law. They know how to predict and plan ahead of time how they can engage in a compliant transaction and a compliant IPO.
Brett: And we hear quite a bit from clients that may have formed a company, for instance, in Colorado or California, and now they're looking to go ahead and bring on investors in the company, and all of a sudden these investors are mandating that this transfers into a Delaware entity. So we've seen that many times throughout the years.
Jarrod: Definitely, there's a lot less certainty when dealing with other jurisdictions. There was a case in Nevada recently that is just seen as a complete debacle for their attempts to sort of catch up with Delaware as business domicile. These judges, who don't have the familiarity with business governance cases make these wildly odd decisions and come out with these wildly odd results in cases before them.
And the investors are watching. Investment banks, the investors, and the brokers are all watching these things, and they prefer the certainty that Delaware law provides.
Sources of Law Governing Corporations
I'd like to go into first the sources of law of governing corporations. What bodies of law govern aspects of the formation, existence, and business operations. First, you have the state law. You have the Delaware general corporation law. That's the key law that governs every aspect of a Delaware corporation's existence.
You also have the state law of jurisdictions where the corporation does business. So if your office is in California, even if you're a Delaware company, you may be subject to certain California requirements. For instance, California has come out with requirements that a certain number of women and persons of underrepresented communities be on the board. Essentially, that will go to be about 40% will have to be women or underrepresented communities.
And even if you're not a California company, if you are doing business in California, have a place of business there, you have to abide by these requirements.
Brett: So even though it's a Delaware entity, governed under the Delaware general corporate law structure, since the entity is actually physically operating in California, and foreign-qualified, meaning, it's a Delaware entity formed in Delaware, but physically operating in California, foreign qualifies it to operate there, it still has to follow through with a particular rule such as that, which boils back down to the state law of jurisdiction where it does the business.
Jarrod: There are limits to that, however. Still, the Delaware general corporation law is the governing law for these companies. However, there are certain laws that do apply to companies doing business, say, in California. Just as there are for, say, companies selling over the Internet, which can subject to certain laws of all 50 states, like information, security measures and things like that.
But primarily what we're dealing with, and what a corporation and its directors and officers will deal with, is the Delaware General Corporation Law.
Now, federal law will also affect the operations of corporation. For instance, capital raising is governed by SEC regulations -- laws administered by the SEC and the regulations they've adopted.
Brett: The capital raising is selling the shares of stock and bringing on investors. That's what you're referring to.
Jarrod: That's right. That is primarily all federal law. It's the Securities Act of 1933, and the Securities Exchange Act of 1934.
Much of the federal law, however, is only applicable to public companies. Once companies reach a certain size and begin "reporting" under the Securities Exchange Act of 1934, that's when you see a number of the substantive and reporting provisions of federal law applying. Similarly, you'll see stock exchange regulations applying to public companies that are traded on those exchanges.
So there's a large body of overlapping different sources of law. But again, primarily the law that's most important for Delaware corporations is the Delaware General Corporation law, the DGCL, as we'll be referring to it here.
Advantages and Disadvantages of Corporations
What are the advantages of the corporate form? Why a corporation over an LLC? We talked about some of them.
Brett: Currently, last year, for instance, 73% of the new formations in Delaware were LLC, so why would you want to go with the corporation versus the LLC? The LLC is easy to operate – no minutes, meetings, bylaws; it doesn't have shares of stock.
Jarrod: The same things that make it easy to operate are in some ways the way that make it ill-suited for public companies. The DGCL provides a framework of law that limits the flexibility one has to vary the terms of the corporation.
See, an LLC is a creature of contract. Essentially, you could have any terms that you want. You can amend or modify the fiduciary duties governing management. You can create an entirely new set of fiduciary duties. You can arrange your terms in an LLC in any way you want.
But in some ways, that is difficult, particularly for a company that's looking to go public. Because the DGCL creates certain bedrock rights and obligations that people can count on. They don't need to understand what the terms of every provision of an operating agreement says in an LLC. Instead, they know that there are certain parameters that a corporation cannot go outside of, and how it structures itself and how it acts.
Brett: The checks and balances are there. You know what to expect, more or less, with a corporation. When it comes to being a shareholder, you know what to expect from the officers, and also you know what's expected of the directors as well.
Jarrod: That's correct. And this limited flexibility, in fact, often is a benefit. Because each LLC case -- a judge has to look at an LLC as contract, but each one is different, the wording is different, the terms are not uniform from one LLC to another, quite often.
Whereas a corporation, there are certain principles that apply regardless of how things are stated, how things are worded, there certain bedrock portions of law that can't be wavered.
See, for instance, fiduciary duties. You cannot waive certain aspects of the fiduciary duty in a corporation, while you can in an LLC.
There are certain terms you just cannot adopt in a corporation. Because, while the DGCL allows for some flexibility, it does not allow you to completely whole-cloth, throw out the statute as you can with an LLC, if you so choose.
Brett: So, more like a freedom of the contract, more or less, is not there with a corporation, so they have these rules to abide by.
Jarrod: That's right. And that gives comfort to some investors, particularly retail investors. At the point where a company goes public, they're buying and selling shares of stock with certain understandings imposed by the DGCL.
One of the other aspects of a corporation that make it both attractive and unattractive, depending on your perspective, is the default C-corp taxation. Now, a C corporation is not a type of corporation, it's simply a tax status, and it's the default tax status for a general corporation in Delaware and everywhere. It effectively means that it's double taxation.
Brett: And this is taxation from the IRS. So, by default, this is going to be taxed as a C corporation unless additional applications are made with the IRS to change this taxation.
Jarrod: That's right. Unless you elect otherwise, the C Corp Taxation is what you'll get. And that's effectively double taxation. The company will pay corporate income tax at about 21%, subject to any deductions or reductions, and then, after the corporation pays its tax, the shareholders that receive distributions, which are generally for dividends in a corporation. Then, they must pay tax on those dividends, which can either be at their ordinary income rates, or at 0%, 15%, or 20% for certain qualified dividends, where they're treated rather like capital gains.
Brett: Now, the C Corporation or the C-taxation, it doesn't limit who can invest within the company like other taxation methods might for the corporation.
Jarrod: That's right. The C Corporation status really doesn't affect your operations. Whereas the alternative, there is a pass-through option for corporations, or S Corp status, S Corporation.
In an S corporation, you're able to elect S corporation status, and it's much like the pass-through given to an LLC, though with certain small differences. Essentially, the shareholders will take into account the items of income gain or loss from the company, rather than the company paying taxes itself. However, this comes with a great deal of additional requirements. For an S corporation, for instance, you cannot have more than 100 shareholders. Your shareholders have to be individual natural persons rather than entities, except for the case of certain tax exempt entities trusts and estates.
Brett: So, your pool of potential investors is a lot less.
Jarrod: That's right. And an S Corp is really much more meant for a closely held family sort of business, rather than one that's a high growth business, your traditional start up that's going to either go public or be sold, hopefully relatively quickly.
Brett: The tax status is not necessarily written in stone. Entities can change from C to S as needed.
Jarrod: That's right. It's important to note that the C Corp and S Corp are not types of corporations. Many people often refer to them as a different type. But really, it's just a tax classification that you can elect.
C Corporations can become S corporations, with some difficulty. S Corporations can become C corporations much more easily because there's less constraint on your operations, your investors, things like that.
Features of Corporations
Now, what are the bedrock features of corporations? What are some of the core elements of what a corporation is?
A corporation originally, which is referred to as a nexus of contracts with the government and with shareholders and with the entity itself. A corporation has legal personhood, meaning it can sue, it can be sued, it can hold assets. It can declare bankruptcy.
It can do all these things on its own behalf as if it were a person. And after the court case in Citizens United, corporate personhood took on a much more urgent nature, as we were able to say that corporations can now have rights to political spending like a person would. So truly, a corporation is a legal person in many respects.
Limited Liability
One of the key elements of a corporation is limited liability, meaning no person is liable for the debts or obligations of the corporation, ordinarily. Now, there are many instances where this may not apply, and persons can be held liable for the debts and obligations of the company. For instance, a director who calls improper dividends. If the board called improper dividends in a negligent or willful manner, they can be held personally liable for returning those distributions to the company.
Similarly, there's a concept called piercing the corporate veil. Piercing is when the personhood of the company is essentially removed, and the individual shareholders underneath, the owners of the corporation become liable for its debts and obligations. That occurs primarily when corporate formalities are not respected. When, for instance, the bank account of the company is comingled with the money of other entities, or some of the owners, or even the founder. Or where, for instance, minutes aren't kept, meetings aren't held, decisions aren't documented pursuant to resolutions. So that's one of the reasons that it is so important to mind the corporate formalities of calling meetings.
Brett: These meetings and the formalities that you mentioned -- the minutes, the meetings, the bylaws -- these are all internal matters within the company itself. They're not filed with the state of Delaware. But it's crucial to keep them current and on file at all times in the company itself, to not allow for the piercing of that corporate veil.
Jarrod: That's right. Really, when piercing would come up in litigation, when the company is sued, during discovery, the records and internal governance documentation will be requested by the plaintiff, and they'll be able to say -- listen, this company is really just the alter ego of the owners, it's not being run as a separate entity with its own goals and objectives. Rather, it's really just a shell to effectively hide behind liability.
Brett: So, it's important to have a business life and a personal life as well. If it's in the name of the company, it's done in the name of a corporation itself. And make sure not to comingle funds.
Jarrod: That's true. And the assets of the corporation have to be truly the assets of the corporation. The bank account has to be inviolate. You can't take it out to pay for personal expenses. And as long as all that is met, then the liability of a shareholder is limited to the amount of his or her investment.
Corporation Management
The next item I'd like to discuss is the general management of a corporation. Corporate management is under the control and direction of the board of directors. Corporations have to have at least one director, but there is no maximum number of directors set by the DGCL. As a practical matter, however, the larger the company, the larger the number of directors, particularly given that the board can operate through committees -- smaller groups of directors that are responsible for certain decisions, certain areas of the company's life or oversight of the business.
And the board may also include board observers. Many times, an investor will have a board observer who may not have a vote but is eligible to participate in the discussions.
So, the core concept here to remember is that corporate management is vested with the board.
Now, the directors may but need not be officers or shareholders themselves.
Brett: So, one person can be the entire company. We don't need to bring in outside individuals that you might not necessarily want there in the first place.
So, Jarrod could be the shareholder. Jarrod could be the only officer and the director as well. But if you'd like, you could bring on another director or officer as well, and still stay the only shareholder.
Jarrod: That's correct. Yes, directors don't have to have any other involvement with the company than being directors. And in many cases it's wise to have a minority of independent directors. Independent directors are particularly useful when you're looking to affect a transaction in which other directors have a conflict.
For instance, if I own Company B and I want to enter into a contract with Company A, of which I'm also a director, an independent director without that conflict could cleanse the transaction of any appearance of wrongdoing by signing off on it, him or herself.
This is particularly important in public companies where conflicts have to be dealt with by independent directors. Exchange requirements and SEC regulations often require a certain number of independent directors in order to lift a company or to keep a company public.
And the Delaware General Corporate Law has often pointed to the action by independent directors as again, cleansing a conflict, and making a transaction that might otherwise be dubious, have been properly authorized by the board.
So, the board delegates the day to day management to officers.
Generally, an executive officer is necessary. A President, a CEO, and a secretary are necessary to take action and to record action, respectively. That's what most people start off with. You really have to have a president and a secretary. It's also very wise to have a treasurer, too, someone that handles the financial matters.
And the reason you have these different people -- if you can, of course, you don't need to have them all -- but it's so that, for instance, the secretary can sign off on the ability of the CEO to sign a document. You've got internal checks. You pass a resolution where the secretary has a certificate he signs, saying, okay, the CEO has signatory authority over this, this, and this.
And without those separate persons, you're really just passing paper from one hand to the other, which again, is fine, but raising some issues.
Now, the authority given to an officer is delineated generally in the bylaws. They may or may not have a separate employment agreement, which may describe the scope of their duties, but there need not be a separate employment agreement. And the officers may be, but need not be, either directors also or shareholders.
Another feature of the officers' role is that they often become shareholders through their compensation. Oftentimes they'll receive a salary, but also equity compensation, whether in the form of restricted stock, or options, warrants, or other forms of compensation through ownership that vests over time.
Brett: You don't necessarily need to have a salary for these officers. They could receive stock options for instance.
Jarrod: That's right. And early in a startup's existence, oftentimes, that is where the main compensation is. You're gambling on future success, essentially taking what might be worth a stock at the moment, but in the future, certainly, hopefully it will have a value.
Michael: So, Jarrod, I know the next topic you're going to talk about is corporate taxation, and as you get into it, one of the questions that came in was somebody was asking about the potential benefits of changing from a C Corp to an S Corp. I don't know if that'll tie into what you're talking about here, but just keep that in mind and if there's something you can direct to as for example of that, that would be helpful.
Corporate Taxation
Jarrod: Sure. We talked a fairly in depth already, well, for an overview of corporate taxation. And it's really difficult to say. It depends on the circumstances when it would be beneficial to shift from a C Corp to an S Corp.
Generally, again, an S Corp is a smaller company where pass through treatment makes sense. Oftentimes, you sort of have to look at the nature of the income that's coming in, the way the gains and losses are most efficiently allocated. And C Corp status is the predominant status for a company that intends for high growth for moving forward. Whereas if you're running a store, a mom and pop operation, an S Corp might be an option for you.
Brett: If you're not looking to bring on different investors, if you're wanting to stay relatively tight knit, if you're not going to be bringing on shareholders that are outside the US, if you were to consult with your tax professional, they might say, yeah, that S election might be the way to go for this particular situation.
Jarrod: Yes, it's very possible. But it very much does depend on the facts and circumstances of a given business, what makes sense from a tax perspective for that entity, for its plans, and for its current situation, versus what it intends in the future.
Double Taxation of Corporations
We've talked a great deal, as I mentioned, about the double taxation of corporations, where the corporate income tax rate of 21%, and then shareholders are taxed on dividends.
Now, profit from the sale of shares, rather than distributions as dividends, are subject to either short term or long term capital gains tax. So there is a benefit in selling corporate shares after holding them for a year, when you get the long term capital gains. If you sell them prior to that year, you will get short term capital gains, which is fundamentally just ordinary income rates.
So corporate taxation is something that's particularly facts-and-circumstance specific. And I recommend that people consult with accountants or at least an attorney familiar with corporate taxation and really can study their particular circumstances.
As a comparison to pass through, we talked a bit about the pass through of LLC taxation. In an LLC, the income or loss flows through to the members, as does the character of the income to the LLC -- capital gains, ordinary income, etc. -- and members take LLC items of loss and gain onto their own taxes.
This is in contrast to the double taxation of corporations. But, like the S Corp, the S Corp is a similar form of pass through. Although, as you see here on my slide, there are quite a few restrictions that make the S Corp impracticable for many companies.
Brett: So, for instance, the taxation for an LLC is traditionally that of a partnership if there's more than two members. Whereas one person is taxed more or less just like that of a sole proprietorship. Whereas the corporation offers that pass through tax status.
But one thing that is interesting as well, is that the LLC can go ahead and elect for that Sub Chapter S tax status with the IRS. Why would an LLC opt to go for that taxation?
Jarrod: You know, oddly enough, yes, the check-the-box requirements the IRS has for taxation now, allow a great deal flexibility in, for instance, the corporation electing pass through treatment, an LLC, while pass through entity is a default, electing pass through treatment under S Corp status. The S Corp status in LLC differentiation has to do with the extent to which the character of the income passes through. It's a bit outside of the scope of this discussion here, but there are some instances where an LLC may elect to be taxed as a corporation or taxed an S Corp.
Perhaps the best way I think at looking at some of the key elements of a corporation are to look at the main corporate documents, and what do each of them generally contain, and what can they contain?
Key Corporation Documents
The key corporate governing documents are the certificate of incorporation, also known as the charter, and the bylaws.
Certificate of Incorporation
Brett: Now, that Certificate Incorporation, that's going to be the only document filed with Delaware Division of Corporations, Secretary of State's office. It's like the birth certificate of the company, or like you refer to it as the charter. Whereas the bylaws, they're kept on file in the company itself, not provided, not traditionally part of public record for a corporation.
Jarrod: That's right. And the certificate of incorporation, as you said, is filed publicly and publicly available. It can contain very little information, or it can contain a great deal. It really depends on where the founders and the corporate board and director and officers really want to put those provisions. Because the certificate of incorporation is more difficult to amend, and it is the chief governing document of the corporation.
So if anything in the bylaws runs counter to the certificate of incorporation, the certificate of incorporation will govern. And any conflict between anything except the DGCL, the certificate of incorporation will govern.
Brett: If there needs to be changes to the certificate of incorporation, they're not written in stone. They can always change. We can always file amendments to change something or to restate the certificate of incorporation to include whatever may come up in the future.
I know a lot of clients, when initially forming the company, are going to have a lot of uncertainties and worried about perhaps doing something wrong. Or -- oh, what about this name? Am I stuck with it? -- oh, no, we can always change the name by filing an amendment.
The same goes with the bylaws. Those governing internal documents and bylaws can be updated, modified, changed as needed.
Related: Jarrod & Brett’s Webinar on Making Changes to Your Company
Jarrod: That's right, yeah. Many times a company as a startup will start off with a very basic certificate of incorporation. And that's what I'm going to be looking at today when I talk about the key terms that may be in that certificate.
As they grow and develop and the company matures, it can certainly amend its certificate however it needs to. Generally, an amendment of certificate of incorporation requires a resolution of the directors be passed, recommending the change, and then that a majority of shareholders of each class of shares entitled to vote, votes in favor of that amendment.
Now, the certificate itself can contain provisions that affect how it itself can be amended. So for instance, the certificate might say that a majority of each class has to vote in favor of the amendment. Or it could say that all of the classes are treated as a single class for purposes of this vote, and therefore each individual class doesn't need to have a majority in favor, but the overall body of shareholders have to be in favor, those at least able to vote.
Now, even in non-voting shares, certain amendments to the certificate of incorporation has to have the approval of even non-voting shares if it adversely affect them in certain specific ways.
The two things to primarily remember are that is publicly filed and that it can be amended. The bylaws are sort of the nuts and bolts of the corporation. They build upon what's in the certificate of incorporation and talk about the real details, the mechanics of how these things work as we'll discuss in a moment.
There are some other potential agreements that can govern the operations and internal workings of the corporation. For instance, the investor rights agreement often talks about what happens to a certain class of shares in the event of the initial public offering, what happens if the company wants to take certain actions, what veto rights to these specific class of shares have.
So initially, a corporation's documentation can be very simple. But particularly as high net worth and sophisticated investors come in, they're going to demand certain rights, certain privileges and certain powers. And those are often documented in either the investor rights agreement or the shareholder agreement.
The shareholder agreement is actually an agreement among the shareholders where you can wave statutory rights by agreement. So it's the shareholders coming together outside of the corporation and saying, here's what we're agreeing upon and how the corporation is going to be run.
So, for instance, the shareholders may agree that shareholder 1 will have the ability will point two directors out of seven. Something like that. You come to these very specialized points. Or -- how are we going to vote in the case of X event? It may have tag-along-and-drag-along rights, which is the rights of a majority shareholder to force a minority shareholder to sell, or inversely, a tag along right is the rights of a minority shareholder to tag along in the case the majority shareholder sells his shares.
So that's really where the workings among shareholders are hashed out. But the key main documents for our purposes here are the certificate and the bylaws. The rest of them are much more complex and involve very specific situations, and very specific negotiated terms.
Now the certificate of incorporation, as I said, is the highest governing document, also referred to as the Charter.
I'm literally just going to go down through here, and go look at what the forms Delaware puts out requires. What are the basic elements it requires? And I'm using these documents to illustrate the different points that come up in terms of corporate structuring and corporate governance.
So, for instance, the corporate name, even. The name requires a pre-formation search.
Brett, I know you handle that quite a bit for...
Brett: No. They can do the search within a matter of seconds, and it comes back with the results. We're able to search the Delaware Division of Corporations database. You can do that on our website quickly and easily, or live chat, or call us.
Jarrod: And that's to prevent the same name from being used twice.
Brett: That's correct. If the name is not available, if a client were to submit the filing on their own, it's going to get rejected, it's going to be wasted time, frustration. So, yes, it's going to clear the name and make sure it's available to be able to be used within the state of Delaware.
Jarrod: Excellent.
The second point raised in the certificate of incorporation is one has to list the registered agent, and registered office.
We at Harvard are a registered agent, and we provide a registered office at our address. The registered agent effectively serves as the corporate locus in Delaware. It's the site that connects the company to Delaware if it doesn't otherwise have an office in the state.
Brett: And it's required by the state of Delaware.
Jarrod: That's right.
Brett: The registration is going to accept a service of process, which hopefully the company doesn't receive. If there's any notices from the division of corporations such as the annual franchise tax notice, which is traditionally the only tax paid to Delaware if not physically operating here, that's going to come to the agent, and we're going to forward that along immediately. If it does receive the service of process, our team's going to email and call and notify the company immediately so they can act on it. But it is a requirement. Our fee is $50 a year. It's guaranteed never to go up.
Corporate Statement of Purpose
Jarrod: The next item in the certificate of incorporation is the corporate statement of purpose. Most people nowadays put in a general statement of purpose, usually something akin to "any action or business that's permitted for a corporation under the DGCL." The broad provision is certainly wise because you want to avoid what's called an ultra vires claim.
Ultra vires simply means "beyond the power." And if you have too specific, for instance, a business purpose, someone could claim that you've gone beyond the power of the corporation by entering into a different line of business. For instance, if you're a mining company, and it states as much in your certificate of incorporation, suddenly you start opening retail stores selling clothing, investors or even creditors might come and say -- wait, this is outside of the powers of the company as stated. You stated the corporate purpose is mining, and now you're selling clothing.
Now, that doesn't make the action invalid under Delaware law, but it does allow stockholders to bring a lawsuit in the company's name, against the directors and officers, or against the company itself, as being outside of what the company can do.
The purpose statement is most important in the new form of public benefit corporation that Delaware has passed. And again, this is something I'm just touching on. We're going to do another webinar on public benefit corporations.
But essentially, the purpose clause is most important in a public benefit corporation because there, you have to list the public benefit purpose for which you're forming the company.
So, for instance, this might be providing low income students with high nutritional food in schools. That would be in addition to the more broad statement of -- we're engaging in whatever business is legitimate for a corporation under the DGCL.
Brett: So for the PBC, the statement is more of, it's going to be staining its public benefit that it's going to be giving to society. So therefore, shareholders that are going to be investing within that public benefit corporation know that -- hey, this is part of what the company's intended purpose is.
Jarrod: Yes, they know the social benefit that the company is seeking to provide. And even there, it's important to...
My recommendation, and my practical point, is always to include the general statement, giving the broadest power to the company, and then including a second specific statements saying what the company's current anticipated plan is, one that's broad enough to encompass their intended operations, but not too broad so as to be meaningless.
Brett: So, next we're off to the initial shareholders, or the directors. Neither the shareholder or the initial director needs to be listed or filed with the division of corporations. We tend to rarely see a client list a director's name on the certificate of incorporation filed to create the company.
If we let the director's name, we also then have to provide the director's address. That's a requirement with the state of Delaware. And then any updates to that requires subsequent amendments, which are a couple hundred dollars each time. So that's not something that we typically see clients include.
Jarrod: That's right. Clients typically want to take advantage of the privacy that Delaware offers in having very little membership and operational information out there. Of course, once you're a public company, you're filing giant reporting statements with the SEC and the exchanges. But until that point, while you're still privately held, Delaware very much respects the privacy of companies.
Par Value and Share Classes
The next item in the certificate of incorporation deals with share classes and par value.
Par value is a largely outdated concept. But it's something that we do get questions about and something that is generally dealt with in the certificate of incorporation. Par value is usually a very small number, and it is thousandths of a cent, and it is the lowest amount for which shares may be sold.
In the past, it had much more meaning. Now it's only really purpose is for calculation of franchise tax. Brett deals quite a bit with the franchise tax. And it's a key element in calculating what you have to pay the state of Delaware.
Brett: We also see a par value for new startups, maybe if they're going with 1000 shares, it might be a penny. 10 million shares, we might see clients with five zeroes and a one -- 0.000001 -- for the par value. Just really the amount, like Jarrod mentioned, that the stock can't be sold for less than. It can be sold for more or less whatever the market will bear, whatever someone's willing to pay.
Jarrod: That's right. And next, we're getting into the share classes now. So you have to set out what are the authorized shares, and what are the different share classes Initially. Authorized shares are the maximum number of shares that the corporation is authorized to issue. The share classes are, of those authorized shares how the shares divided up.
The key ways to divide shares are common versus preferred. Common shares generally have one vote per share. They generally entitle the person to their prorata share of the distributions based on the number of common shares held relative to all those outstanding.
But you can create series of common shares with different rights and obligations.
Brett: So these different series, for instance, could have different voting rights. So a particular series could help keep control within a company and offer 10 votes for every one share of stock that you own.
Jarrod: That's right. And there you start getting into more of a preferred concept. The common stock generally tends to be all the same common share. But the preferred stock, especially, will have different rights built into it. And there's myriad rights that can be built in here. I mean, there could be very complex rights that someone can negotiate for and can get from a company, and all of that will be built into the certificate of incorporation and reflected in other documentation.
The preferred stock may have different rights in terms of dividends. It may have preference in dividends, meaning it has to receive its dividends first before common stock received dividends. It may have, as Brett mentioned, different voting rights.
For instance, Facebook, Snap, and many of those companies have a dual class structure, where the founders and insiders may have 20 votes for every one vote held by a public shareholder.
Preferred stock may have certain veto rights over key actions. It may have anti-dilution protection, meaning that if more stock is offered, the preferred stockholders have a right to purchase stock to effectively keep their percentage interest in the company.
And then all other types of preferences. I mean, really, preferred stock can vary in its terms in any way imaginable, subject to certain limitations, of course, under the DGCL, that are mainly intuitive.
What you also see is blank check preferred stock, which is something I often included, when I was in private practice. Blank check preferred is a class of preferred stock without any set terms. You would say that it's Preferred Series One stock. And then at a later date the board could set the terms of that series of stock and issue it. It essentially allows you to have stock in your pocket waiting to be issued such that you don't have to amend the certificate of incorporation. It gives the directors the ability to offer future investors another series of stock without the current shareholders having the ability to either approve or disapprove of an amendment offering a new preferred class.
Brett: So that's going to actually be listed on the certificate of incorporation. When the founders are creating the company, they're mentioning the blank check preferred. So therefore, it's on the books, it's reported, it's listed on the certificate. Everyone knows it's there.
Jarrod: That's right. And it would have to account for a portion of the authorized shares -- total authorized shares.
Brett: It's a powerful tool.
Jarrod: That's right. If you think of authorized shares as the ocean, the different sub classes are, you know, buckets of water in there. The authorized shares is the entirety of all shares, and the different classes -- Series, Preferred, Common -- all of those are sub portions of that authorized total.
Certificated vs. Un-Certificated Shares
The next item we get into on a related point in terms of shares is whether shares are certificated or un-certificated. This generally can be stated in the certificate of incorporation, but it need not be.
If you're silent on the issue, then it's assumed that you're able to issue certificated or un-certificated shares.
What does certificated mean? It means -- is a share represented by an actual piece of paper with the company's name on it and a whole bunch of other formalities and fancy drawings.
In the past, certificated shares were very common. But when you think about the modern day, I mean, in trading shares, you would literally have to exchange pieces of paper, or your broker more likely would. With un-certificated shares, it's all done on digital ledgers.
And one of the things Delaware has done is allowed and encouraged un-certificated shares in order to allow you to trade shares through new technology, such as documenting the trades through blockchain. Un-certificated shares can be documented through a blockchain-enabled stock ledger. that allows you to keep an immutable, efficient and accurate record of your shareholders.
One of the most difficult parts of just the processes of being a corporate secretary, for instance, is having these lost, damaged, mutilated, destroyed share certificates. How do you then reissue them? How much time is spent reissuing them?
It's far easier to have un-certificated shares simply held in a ledger format.
The next item is exculpation of directors. You'll often see in the certificate of incorporation, while it's optional, it's very common, you'll see a statement that a director will not be held for monetary liability for a violation of fiduciary duty.
What that means, essentially is, while an overly broad statement, essentially, the Delaware General Corporation Law allows you to remove monetary liability of directors for violations of the duty of care. So, criminal conduct is not included, and also any willful misconduct is not included. But in the sense that if someone is, for instance, negligent in their information gathering and making a decision, they didn't take in enough information or seek out enough to make an informed decision, a director can be removed from monetary liability for that omission. And most certificates will have that provision in there.
You can alter the scope of it in the bylaws later on and provide different conditions on the exculpation. But usually exculpation is the rule because it's management friendly, and above all, who's creating these companies, but their management?
Indemnification
And lastly, is indemnification. You often see indemnification in the certificate of incorporation, although it can be in the bylaws. Usually it's the mechanics that are in the bylaws. But the actual fact of indemnification is in the certificate of incorporation.
Indemnification means that the company will pay the fees, expenses, costs, judgments, attorney fees, any sort of cost or loss or other fee incurred in litigating or fighting a case brought against that person, arising out of their action as a director or an officer.
And certain indemnification is mandatory. If a director or officer is successful on the merits of his or her case, that's a mandatory indemnification. The company has to pay their legal fees and costs.
Permissive indemnification comes in anything but a successful context from the merits.
Oftentimes there are certain limitations on it, the boundaries. For instance, to be successful on the merit, you have to indemnify that officer or director. But you cannot indemnify an officer or director if they act in bad faith, or for a derivative suit brought by the company against that officer or director. But everything between that is permissible.
Now, this is a cost to the company. So what does the company often do? Oftentimes, it will go out and buy what's called D&O (Directors & Officers) insurance. That effectively stands in and pays the legal costs, expenses, or other costs incurred by an officer or director that the company can't cover, either because of loss of assets or because it's not permitted under the Delaware General Corporate Law.
Michael:Jarrod, before you move on, there is a question we just got that's relevant to what you're talking about with the certificate of incorporation.
Somebody wants to know -- if there's no mention in the certificate of certificated or un-certificated shares, can it be regulated in the bylaws?
Jarrod: Yes, it most definitely can be put in the bylaws. Generally, silence on the matter on the certificate is treated as the company being able to issue either certificated or un-certificated, which would be stated at the time that the resolution is passed issuing those shares. So, yes, silence is permissive in that regard.
But I do generally prefer to specify. If I know they're going to be all un-certificated, I will say that. Because really, there's no reason I see to justify certificated shares in this day and age.
The last thing I wanted to talk about on this point on indemnification is advancement. So, the company is going to pay your legal fees, your costs, your judgments, your investigation costs.
Well, that's all well and good, but they may be hundreds of thousands of dollars by the end of the action against you. And so, how do you get that money, it doesn't help you if it's only after the fact.
A company will often advance those amounts to the officer or director as they're incurred. This is something that is permitted but not required. There's no right to be advanced your indemnification expenses for your judgments or costs. But it's very commonly done, and usually there is a required undertaking, where the person must say they will pay back any amounts advanced to them if it's ultimately determined that they were not entitled to that amount.
So you say, “okay, well, who decides whether you're entitled to indemnification or advancement?” Oftentimes you liken it to a judgment. You'll say, for instance – “the person will only be not entitled to advancement if there's an adverse decision by a court of competent jurisdiction.” In other words, a judge says, "you acted in bad faith."
Oftentimes, however, you could make the board, a committee of the board, or even a vote of the shareholders determine whether indemnification applies and whether advancement applies.
There will often be a separate contract as well. A director will require a separate contract where the company agrees contractually to indemnify that director. Now, why would you do that? Well, it gives you a contractual right as well of the right in the governing documents.
Contractual rights can be more easily and more quickly asserted, and also you can take what is previously permissive indemnification in the company's certificate and make it mandatory from a contractual standpoint. It gives the director a lot more comfort that after they have acted, that they're going to get the indemnification they were promised.
Also, the bylaws are affected with the mechanics of the points we discussed. The bylaws essentially discuss how are meetings called. How are director meetings called? How are shareholder meetings called? How are they conducted? How are the votes taken? What is the quorum for a board to actually, effectively take action? What is the notice required before a meeting can be given? One of the key elements is -- can action be taken by written consent?
So effectively, in your corporation, if you allow written consent in the certificate of incorporation, you say "shareholders may act by written consent," then instead of having to call a meeting, you can simply email let's say, 51% of the shareholders. They sign this consent, and the action is being taken, so long as you have the percentage of shareholders that would be required to take the action at the a meeting.
So this is a much faster, much easier way than having shareholders take action, then having to call an official meeting with 30 to 60 days notice, taking votes, accepting proxies. It can often be done in a day. And it's something that I've relied upon greatly in my practice to get things done very quickly in a corporation.
The directors can also act by written consent when they don't need to have a meeting of directors. This means that if the directors unanimously agree on a certain topic, you can simply accept signed sheets saying that they agree on a given resolution and that action is effectively taken.
That's a key advantage that applies unless it's otherwise prohibited in the certificate of incorporation. So, I like to say, "expressly in the certificate," but you can do it so long as it's not expressly prohibited in that document.
Audience Q&A
Michael: Alright. And with that, I think we're done with the content of the presentation. So let's jump into some of these questions that we have. I know we have some good ones lined up.
Earlier, when you were talking about par value, someone asked about increasing the shares of their company from 50 million to 100 million, and also increasing the par value. So, they were asking about how that would affect the franchise tax, essentially. I know it can get a little bit complicated, but maybe, Brett, you would address that?
Brett: When you file the amendment to increase the shares of stock, there's a formula that the state of Delaware uses. A rule of thumb is, the number of shares of stock, multiplied by the par value. If it's less in 75,000, there's going to be no additional filing fees to file the certificate of amendment, besides the state of Delaware's traditional filing fees.
The franchise tax on a corporation with 50 million shares to 100 million shares, they're going to get a franchise tax bill initially of a hundred-and-some thousand dollars, and they'll be required to provide certain figures to recalculate that tax. And we've got a franchise tax team that'll work with you to ask about the gross assets of the company for that calendar year, and they'll ask about the number of issued shares. And once we have that information, we'll be able to recalculate the tax.
It's going to be a minimum of $400 franchise tax, and a $50 report fee to the State of Delaware. So, the least amount that you'll be able to pay is $450. It could be drastically higher, depending upon the assets and issued shares in the company. But come franchise tax time, our team will work with them to ensure they're paying the least amount of taxes the company is obligated to pay.
Jarrod: I hi
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