Making Changes to Your Delaware Company

By HBS Wednesday, February 26, 2020
This webinar was recorded February 26, 2020.
 
Speakers: Brett Melson, Jarrod Melson
Moderator: Michael Kupfer

Transcript

Jump to section:

Brett: Hello, everyone. Thank you for attending. We're excited to be able to present this to you. We're going to go ahead and kick it off with -- how to change your Delaware company name.


Changing Your Delaware Company Name

Changing the name of a Delaware company is a very straightforward process. We're going to go ahead and check the name of the company to make sure it's available. We're going to prepare a Certificate of Amendment, and that's filed with the state of Delaware.
 
It's quite interesting. Right here on the right hand side, we have an example of one that -- it's quite comical -- we have Brad's Drink. That was the original name of Pepsi. Pepsi then changed their name.
 
So it's not uncommon for a client to go ahead and originally choose a name that no longer suits the needs of the business. So, like we always say, changes can be made to the name, the stock -- the sky is the limit.
 
 
Jarrod: I think, Brett, it's important before we move on, just to note that reserving the name or checking the availability of the name with Delaware is not the same as anyone trademarking, copyrighting or otherwise protecting any intellectual property. And also, it is not checking a name for any purpose outside of the State of Delaware's availability, so for instance, website availability. Often a quieter company could have a name, get it checked in Delaware, but then find out someone has a trademark or for instance a web site using that name is taken.
 
Brett: That's a great point. So we're checking this name against Delaware Division of Corporations and their database only. And if it's available, we're able to move forward with that amendment.
 
So this amendment is just one filing with the state. It's traditionally just a one page document that's submitted the Delaware. The Certificate of Amendment notifies the state of your current name, and then the new name that you wish to use.
 
If this is filed through a registered agent such as ourselves. We traditionally have this faxed, stamped, approved, from the state of Delaware in about 3 to 5 business days, and we're able to email you that document.
 
Once this is complete, it is imperative to write down anybody and everybody that concerns the business. You want to notify them that this name has in fact changed. You want to make sure you notify the IRS, vendors, banks, partners, anybody and everybody that you do business with. And most importantly, it's a great idea to make sure you notify your customers. That way, when checks start coming in, they're coming into the correct name of the company.
 
Jarrod: Brett, while we're on the topic of names, I know there are certain limitations Delaware puts on names, no vulgar terms and whatnot, but with medical and recreational cannabis being as popular as it is as a new business entity, what general restrictions are there with any use of drug-related terms?
 
Brett: Delaware traditionally is not going to allow the use of names that have "marijuana" in the name. If there are names that do somewhat seem like they may be dealing with marijuana, the state may come back and ask for a purpose. They're really looking to make sure that there's no THC involved.
 
So if you're dealing with let's say CBD oil, which doesn't have any sort of THC, that's what Delaware wants to know -- hey, we're dealing with a CBD oil product of this "420 Creations, Inc." that we're wanting to move forward with; we'll strictly deal in CBD and will not have any THC.
 
And as long as there's no THC involved, the state of Delaware is typically A-OK with that.
 
The state of Delaware will not allow us to use words in a company name such "bank" or any variation of the word "bank."
 
Jarrod: That is, unless you're actually registered as a bank.
 
Brett: That's 100% correct.
 
So even words like banc, non-English words for bank, the state of Delaware will not let us move forward with.

Changing Your Business Address

The topic that we're onto is how to change your business address. If you're moving the location of your business, you're going to want to let parties know of the change. One of those important government agencies to notify is the IRS. Clients are going to report this change using form 8822B. This is changing an address or changing information of the responsible party that the IRS has on file. This form is going to notify the IRS of the change and any change to the contact information for the EIN's responsible party that they have on file. So this responsible party is going to be someone with control over the business entity by virtue of the title position or through ownerships.
 
Is there anything you'd like to add on that, Jarrod?
 
Jarrod: That's right, Brett. It generally has to be someone with control over the entity. As you said, title, position or ownership.
 
While you don't have to supply any member or owner information to the state of Delaware or even to us as a registered agent, this is a way in which the IRS does obtain a certain level of ownership information or control information.
 
It's also important to make sure you notify registered agent of this change. One of the main functions of the registered agent is to accept any service process lawsuits served in the company, or notices from the division of corporations.
 
These notices and the service of process, we need to make sure they're going to the correct address and the correct information on file. You're also going to want to make sure you update the banks, the partners, vendors and anyone else that you work with this well. And most importantly, don't forget your customers. Make sure they've checked and mailed to the correct address.
 
And I want to reiterate that point simply, and also state that any contract the business has, you really need to look at that agreement and modify the address on file there. Most contracts provide a designated address for notices, and notices are only effective when provided to that address by certain means, And the counterparty is able to rely on the accuracy of that address and the fact that you're receiving those notices until they received notice otherwise.

Changing Your Delaware Registered Agent

Brett: So, now we're onto how to change your Delaware registered agent. You may not be satisfied with the current registered agent. They may have promised you a fee to begin with. The next thing you know, the fee is up over $200. They just simply might not be providing to you the level of service that you think they should be.
 
Well, Delaware allows you to go ahead and change the agent very quickly. Filing takes about 3 to 5 business days. It's key to make sure that you find a registered agent that's been in existence for a while. With Harvard Business Service is our annual agent fee is $50 a year, guaranteed never to go up to the life of the company. It's been fixed since 1981, and we offer stellar customer service so you know exactly what you're getting.
 
With a change, traditionally, the registered agent is going to go ahead and prepare the document to change the agent. They're going to go ahead and email that to you for signature. The agent makes the filing with the division of corporations to go ahead and enact the change. In about 3 to 5 business days, Delaware is going to go ahead and stamp that document and return it, and the agent in turn will go ahead and email you that document. That's the evidence showing that the agent has been officially changed. It's also a good idea to send a copy of that stamped document to the current registered agent. Even though they're notified through the state of Delaware's computer system, it's not uncommon for them to continue to bill you until they receive that notice.

Converting a Delaware LLC to a Corporation

So now we're off to a very interesting topic -- converting a Delaware LLC to a Delaware corporation. Let's go ahead and start with -- why would somebody want to go ahead and convert their company? Jarrod, this is really in your wheelhouse.
 
Jarrod: Thank you, Brett. There's a number of reasons why someone might want to convert from an LLC to a corporation. The LLC is an extremely flexible business entity. It allows you to do a lot of things that a corporation can't, simply because a corporation is bound by certain rules that can't be waived or modified or bent beyond certain points.
 
In an LLC, of course, you have complete freedom of contract within the bounds of good faith to design your own terms.
 
A lot of times people would say, well, why would I move from freedom of contract to something more rigid? And the reason, oftentimes, is that professional investors, sophisticated investors like venture capitalists and venture capital funds simply won't invest in a Delaware LLC, because it has pass-through tax treatment as its default. Generally, this means that the entity itself is not taxed, but the members have to take in consideration their taxes their distributive share of the gains and losses, the profit and loss of the company. That becomes a nightmare for these sophisticated investors essentially being the entity standing behind an LLC.
 
You could elect corporate taxation with an LLC, but even still, a venture capitalist also will want to know that it has the predictability and at least the protections of corporate law.
 
There's a lot of ambiguity and drafting your own LLC agreements, and the default rules of devil or corporate law give them some predictability. They're accustomed to it, and they know what's involved.
 
Brett: So with the corporation, that would be converting to these three tiers of power -- the officers, the directors, the shareholders. You mentioned these rigid type formalities. Why would they want to go ahead and go to this type of structure? Would it be for those rigid formalities? Or would it also be for say, the ability to go ahead and issue stock to the investors? The shareholders now know exactly what to expect from a Delaware corporation?
 
Jarrod: Well, there's a number of reasons you might do that. First, of course, the tax treatment. If you need entity taxation, and if you want to be tax as a C-corporation, which effectively means the corporation is taxed as entity as opposed to a pass-through like an S corporation.
 
So first, the tax treatment is one reason you might want to be a corporation. Secondly, shareholders are often more comfortable with a corporation because there are those limits to what could be waived. A lot of the things that are ordinarily waived by management are the duties that they owe shareholders. In an LLC, you can entirely eliminate fiduciary duties. However, in a corporation there are times you can remove a director -- you could exculpate, as they say -- a director from liability for certain breaches of duties. But the corporation is still liable. He still owes those duties to shareholders. So a lot of times the rigid formulations give shareholders the comfort that there is bedrock they're standing on.
 
In addition and lastly I think is, an LLC, when you're drafting your own language, it becomes very ambiguous. A judge or even attorneys looking at a corporate document generally know what they're looking at, they know what the terms mean, what formulations are. However, in an LLC, you can essentially draft anything you want and no one particularly knows what was intended by specific words, phrases and provisions.
 
So, it's a matter of predictability, really, in a lot of ways.
 
Brett: Interesting.
 
Delaware does make this conversion filing somewhat simple, somewhat quick, just needs to be done properly. To complete the conversion, you'll need to know how many shares of stock that the entity will need to have. The stock is what's going to show the ownership in the company. We'll need to know if it's going to have 1,500 shares or if it's going to have one million shares, or if it's going to have 10 million shares. And that really brings into play what you expect down the road from this company. Is it going to be bringing aboard investors? What's the ultimate goal?
 
One thing to consider is the Delaware franchise tax. When switching to a corporation, there are fees paid for the right of privilege to have a Delaware corporation, and this franchise tax is based on the number of shares of stock. So once we get over a certain threshold, every year, you're going to need to pay the state of Delaware this tax on March 1st, and it will depend on the number of gross assets and issued shares once we go over the 10,000 share mark. So every year you will need to go ahead and provide Delaware those figures in order to calculate the franchise tax. And at the minimum, the franchise tax is going to be $400 plus a $50 report fee.
 
Jarrod: And it's really important at the outset of forming a corporation or switching to a corporation that you run through different calculations and scenarios for franchise tax purposes.
 
In my past life as a private practice attorney, I would often see clients who formed their own entities, put in certain numbers for the par value and the number of shares, and then they found they were paying an exorbitant franchise tax, particularly with entities with a high book value of assets such as real estate but with very little actual liquid assets or cash.
 
Brett: That being said, if a company just has 1 to 5,000 shares stock, the franchise tax in that annual report is only $225 so it is just a flat fee. So if you don't need more than 5,000 shares of stock to start, many who do tend to stay below that threshold did not occur any additional fees for the entity.
 
Two items. The franchise tax must be filed with Delaware to complete the conversion. We're going to go ahead and file a Certificate of Conversion, more or less officially changes the entity type. And this is also done in conjunction with the certificate of incorporation, more or less creating the actual entity. And then also the franchise tax for the LLC needs to be current.
 
Jarrod: I also want to come back one point on par value before we go further. It's a concept that's largely outdated except for the purposes of the franchise tax. But I would want to note that usually par value is something extremely low. Shares can't be sold for less than the par value. It's often a hundredth or a thousandth of a cent.
 
You can also in Delaware and some other states have no assigned par value. I will argue to my dying day -- and I've been made fun of quite a bit for this -- that having no assigned par value is different than having a zero par value. I can't find an area where that distinction is important, but I will argue it until I die.
 
Brett: Thanks Jarrod.
 
So when converting from a Delaware LLC to a Delaware corporation, you're going to need to go ahead and pay the franchise tax for the prior and the current tax year. So that LLC's franchise tax is $300.
 
So this example up here, we have -- if you convert your LLC to a corporation in 2020, you must pay your $300 tax for 2019 that's traditionally not due until June 1st of 2020. However, that needs to be paid to convert, along with the $300 tax for 2020 which is not due until June 1st of 2021.
 
Now you might think, OK, let's say we were to do this now. Delaware is not going to prorate that 2021 tax, unfortunately. Once we go into one day into 2020, they're going to want their money in order to go ahead and make that conversion so it's the full $300.
 
If you've already paid your franchise tax, so for instance, if you've already paid your franchise tax for the 2019 year, it would only be the 2020 franchise tax that would need to be paid in order to convert from this LLC to the corporation.
 
Jarrod: You know, I think there's one last point for me on converting a Delaware LLC to a Delaware C-corp -- a Delaware Corporation; of course "C-corp" is just a tax status.
 
As I said before, the Delaware LLC is extremely flexible. So in transferring from the Delaware LLC to a Delaware corporation where there are more rigid rules outside of which you simply can't go, you'll need to reassess a lot of the terms of your operating agreement for the LLC. There are provisions, waivers of fiduciary duty, other terms, which simply may not be permitted in the Delaware Corporation. You'll need to look through and consult with an attorney to figure out how to reframe some of the deal terms you've reached with the members, founders, and investors.
 
Brett: And one last note on this topic. For instance, the type of company that would be changing from an LLC to a Delaware corporation -- what would you say is the type of situation that you see? Would this be a fast growth type company? Is that where you would usually see this change being made?
 
Jarrod: That's right, Brett. And I think I should have mentioned this earlier when I was talking about that the investors coming into a company preferring a Delaware corporation.
 
If you own an ice cream shop and you're raising just working capital from investors, they're generally probably not going to care. Or they may prefer a corporation, but it's not nearly as imperative.
 
If you're a fast growth tech company, for instance, if you anticipate fast growth trying to disrupt an industry, you're going to draw a lot of attention from professional investors if you have the right idea.
 
And that's the kind of company that really need to make sure they're a corporation by the time they've left, so, the friends and family around the financing, and they've gone to what is referred to as their first round, their Series A round of venture capital financing.
 
Brett: Great explanation. Thank you.

Converting a Delaware Corporation to an LLC

So now we're going to go to the flip side. We're going to go ahead and talk about how to convert a corporation to an LLC. The process is extremely similar. Instead of filing a certificate of incorporation along with a certificate of conversion, we'll be filing a certificate of formation along with the franchise tax as well.
 
We mentioned some of the reasons why someone would think about going from an LLC to a corporation. Let's switch that around. In your experience, what have you seen from clients when they're looking to make this type of change?
 
Jarrod: I would say it's less common in my 15 years in private practice, to go from a corporation to an LLC. But the reasons you might do it is you simply find that the rules of the corporate form, the bedrock principles that you cannot wave or modify, are simply too restrictive, or that the investors are willing -- your friends and family investors, your members, in the case of the small business -- are willing to take more broad, sort of creatively-defined terms. Or let's say that the agreement you reach with your founder partner is such that you just can't draft and manifest those terms under corporate law. You certainly can in the context of an LLC. In addition, the LLC receives pass-through taxation. It may find halfway through your first three or four years of operation that suddenly the pass-through taxation is much more beneficial, given the way your business has grown and developed.
 
Brett: So if I'm hearing you correctly, it's more or less the freedom contract, the ability to customize this LLC to suit the individual entity needs, is why you would think that a client change to the LLC from a C-corp.
 
Jarrod: That's right. That freedom contract is very attractive. It's one of the main reasons why something -- I forget the precise number -- but around 70% of new formations are LLCs. And since that form has come out, it's seen explosive growth. You get partnership taxation. You get freedom of contract to design your own terms. And also no member has unlimited liability. Everyone has limited liability, even the manager of the entity, unlike a limited partnership for instance.
 
Brett: Very good.

Using the S-Corp Tax Status

Next, we're off to what's known as the S status, nickname S-corp. Who can go and select it? The Subchapter S, the aka S-corp status, is reserved for small business corporations and refers to only the company's federal taxation.
 
So for instance, we can't file an S-corp with the state of Delaware. There simply isn't that type of entity. This is a tax classification on how your corporation or LLC is taxed by the IRS. This tax status is traditionally obtained after the company is formed, and then after the tax ID number is obtained as well. An S-corp doesn't have to pay federal income taxes.
 
Jarrod, you want to go and discuss the benefits of this S tax status?
 
Jarrod: One of the benefits, especially before the LLC came about, is that you could use the corporate form while still receiving similar pass-through taxation that you would get in a partnership or an LLC. Here, you're able to take advantage of the corporate form with its interesting provisions, its protections, its fiduciary duties, its guidance in case law and what can it can't be done, and the predictability of operating as a corporation.
 
An S-corp, there are certain differences between the type of pass-through taxation that it offers, versus the pass-through taxation that an LLC offers, and those are really fine distinctions, but they can be important in tax planning and estate planning purposes.
 
So, for instance, in an LLC, income that is gained in the LLC is that its taxed as capital gains will be passed through, and the member will also be taxed on that income as capital gains. The character of the income flows through.
 
In an S-corp, and one of the advantages of the S-corp, is that distributions from an S-Corp... The nature of the income does not pass through. A corporation is always what's referred to as a blocker. It blocks the character of the income so that the members, when they receive their pass-through distributions, they're considered dividends from the S-Corp, which receive a very favorable tax rate, around 15%.
 
Brett: Okay, so when the shareholders go ahead and receive the distribution.
 
Jarrod: That's right. The issue with pass-through taxation is that you'll often have phantom income, which is why there are distributions.
 
When you have to take the gains and losses of an LLC into account, or an S-Corp, you may be taxed on gains in the LLC that you never actually receive with distributions, and that's what's called phantom income. Phantom Income is also covered by tax distributions, which are made yearly just to allow members to account for the tax burden of the LLC or the S-Corp.
 
Brett: Now, this sounds great for taxation. However, there's some limitations as far as who can go ahead and select it. Some of the limitations out there are going to be a vital part of making a decision.
 
So for instance, what I'm trying to get at here is that non-US clients, for instance, can't be a shareholder, can't be an owner within the company.
 
Jarrod: That's right, Brett. As you mentioned earlier, this is a tax status that's reserved for small businesses. The S-Corp status and the requirements for S-Corp status fundamentally limit the size and the ability of a company to take in a broad number of shareholders and eventually go public. It simply can't be done with an S-Corp. It's limited to fewer than 100 shareholders. It's no non-US persons or entities as shareholders. In fact, no entities at all as shareholders.
 
In an S-Corp, every shareholder has to be a natural person, an individual holding shares in their own name.
 
Brett: So that's really going to limit. You mentioned that it can't be other entities. So a shareholder can't be another fund that wants to go ahead and come into this company. So clients that are looking to raise funds, or funding and different rounds of funding, they're going to steer clear of the S status, and they're going to go with the traditional, what that they call the C-Corp route.
 
Jarrod: That's right.
 
Another point on the S-Corp -- and it's a strange point -- is that an LLC can actually elect S-Corp status in addition to a corporation. Now, an LLC might do that to get that fine distinction that I mentioned earlier about the character of the income. So an LLC, which has its own pass-through taxation as a partnership as a default taxation, would elect S-Corp status. And rather than having the character of the income pass through, it would get that S-Corp sort of eccentricities that the blocker still applies for the character of the income. And again, that's not often important, but it can be for tax planning purposes.
 
A lot of times people hear an LLC electing S-Corp status and think, why would a pass-through entity go through all this and actually subject itself to the limitations of the S-Corp status so it would then get pass-through taxation?
 
But as I said, there's a difference there.
 
Brett: So they would like the taxation aspect that you speak of, but then again, we're coming back around to the LLC's flexibility and its freedom of contract. So that keeps bringing people to it.
 
It's not often that we hear from our clients that want to go ahead and file an LLC with an S election. It does come up. We do have information on our sites and blogs. So it's a topic to hit on. A lot of people think the term "S-Corp" has got to be a corporation. But no, the S status can go ahead and be obtained for the corporation. It could be obtained for the LLC. So the sky's the limit. Changes to be made. Elections can go ahead and be made whether it's the S or the C for both the LLC and the corporation.
 
Jarrod: I would note too, you really need to watch the requirements for S-Corp status. If you fall outside of those and they're not cured within a sufficient time, which I don't recall the top of my head, the time, you will immediately be taxed as a C corporation at some point. And switching from an S-Corp to a C-Corp without planning for it can have extremely bad consequences, in that a corporation, a C-Corp, is double-taxed. It's taxed as an entity, and then the shareholders are taxed on any distributions that are made.
 
Brett: And that's going to segue into the next couple lines here -- how do you go ahead and apply for the Subchapter S tax status? The company is formed, the tax ID number is obtained. What we're going to do after that is filed the form 2553 with the IRS to go ahead and make that election for the corporation. Where for the LLC, we're going to file that 8832 and form 2553.
 
Often, too, that election, maybe something that client is having their accountant assist with. I know clients that we work with, that when they're looking to do this election, they're making sure to send that 2553 form in Certified. So therefore, they know the IRS actually received it when it's mailed in.

Changing a Corporation's Officers

Brett: We're going to go ahead and transition here to -- how to change a corporation's officers. And this is something that will be an internal matter within the company. We're not going to need to know about it as a registered agent. The state doesn't need to know about each and every change. But it's very important that this is done properly.
 
And I know you've had a lot of experience in your private practice time, of updating officers.
 
Jarrod: That's right, Brett. It's very important because you can lead to lawsuits, employment law violations. If you don't terminate an officer correctly, you could cost yourself a great deal of money under employment agreement in how the options are treated, whether there's accelerated vesting of unvested options, whether the person has cashed out. Often that kind of thing will vary based on whether a termination is for cause, whether cause is found and documented.
 
So, let me go through the process here. As Brett said, it's an internal corporate matter. The bylaws generally say how officers are appointed and removed. Generally speaking, however, the board appoints the officers and has the power to remove them. The board can appoint any officers that it finds necessary. There's no requirement that someone have a CEO or a CFO. You do need someone to act as the treasure or CFO in a financial capacity, and you'll definitely want a secretary, someone to help maintain the files, to sign certificates that are required of secretaries. But one person can even hold all these offices if they choose.
 
To effect the removal and replacement of an officer, generally speaking a board would need to review the bylaws for the required process, they would need to review employment and other agreements with officers.
 
For instance, maybe looking for sort of just cause provisions. Can the person be fired with or without cause? What are the effects of firing with cause versus without cause? Also those distinctions are made in executive employment agreements There may be notice periods. There may be all sorts of requirements.
 
The next bullet point here talks about you'll need to review the treatment of vested and unvested options, warrants, and restricted stock that may have been given to that officer. There are agreements that say if they're terminated, under various circumstances, how those unvested options, vested options, and restricted stock will be treated.
 
If it's for cause, for instance, many employment agreements will simply say the person received zero value for those, if it's for cause for something moral turpitude, theft, something like that.
 
However, otherwise, there's often accelerated vesting, means the person's options, which, technically were not theirs to exercise at that point, will suddenly all become exercisable into stock, or restricted stock will have to be cashed out often through a note, a debt obligation that the corporation would issue the employer and would pay out over time. So you need to deal with those other agreements in addition to just the bylaws.
 
Unless the bylaws state otherwise, the board would want to adopt a resolution at a meeting of the board, or, more often and more easily, you need a unanimous written consent of the directors. A board can act by meeting and resolution, or it can act without a meeting simply by a signed consent by all of the board members. Notably, however, certain actions may require only, say, a majority of the board in a resolution and vote. But if you're going for consent, you need the unanimous written consent of directors. That's a corporate law provision that can't be modified. You'll be documenting it with a resolution or consent.
 
And lastly, if you want to replace that officer, you would need a resolution appointing a new officer and approving of the form of employment and other agreements that that person will enter into with the company, as well as granting that person's signatory and other authority.
 
None of this needs to be filed, as you mentioned. There's no need to file a change in officers. You don't file the resolutions or anything.
 
But you will want to make sure, for instance, that if that person is our contact person as registered agent, you change that name and contact information. That's something keep in mind.
 
Brett: The company is required to file an annual report with the Division of Corporations. These are due by March 1st. It will need to go ahead and list the officer and director information. It doesn't need to be reflecting each and every change. It simply needs to be reflecting the information at that particular time the report is filed.
 
Any registered agent is traditionally sending you notice about this annual report that needs to be filed, and also can help you complete that annual report as well.

Changing Directors of a Corporation

Now we're on to the next topic in regards to change of a corporation's directors. So this is not pertaining to an LLC. Since the LLC doesn't have officers, directors, or shareholders it's traditionally going to have the members and managers. This is strictly for corporations.
 
Let's talk about the steps to go ahead and remove or to replace a director in a corporation.
 
Jarrod: At the outset, though, building on your point about LLCs, I will note that many times LLCs will adopt some of the corporate forms in appointing and removing officers. An LLC may still have officers just like a corporation, even though it isn't required to. It's general managed by a manager. But the officers are the people that actually affect the day to day operation of the business.
 
Now, when an LLC takes on those formalities, it can vary them however it wants. It can for instance not require a unanimous consent of directors when using a written consent. It can simply have the normal board quorum and voting requirements.
 
Brett: Whatever is in the LLC agreement.
 
Jarrod: That's right. It's completely flexible. However, the same principles apply. So if you're looking at an LLC... Look to that slide again if you're removing an officer of an LLC.
 
Now, removing the director is far more regimented by corporate law. Because the director is fundamentally responsible for the general oversight of the company. They have a fiduciary duty to oversee the company and to maximize the value the company to shareholders -- fiduciary duty, which is a very high standard.
 
Removing a director can be instigated by the other members of the board or by shareholders. Normally, a director is elected for a term, however, you can provide that the director serves until removed. The only way to remove the director is by a shareholder approval by no less than the affirmative vote or consent of more than 50% of the shares entitled to vote at that time. So you need at least a majority, 50.000001 percent of shares have to vote in favor of removal, and that can't be modified. You can't condition that on cause. You can't change the percentage requirement. Directors cannot be allowed to appoint other directors, except in the instance of a vacancy caused by death or removal or some other unforeseen vacancy on the board.
 
You'd want to consult the bylaws on how the call a shareholder vote. Or, as with the directors' written consent, you can seek a written consent of shareholders. You could approach just those shareholders that represent the majority, and then you simply have to notify the remaining shareholders of the change approved by the majority, either one or more shareholders.
 
Generally you want to adopt a resolution reflecting the removal and approving the tasks that the officers will have to take to implement it -- terminating indemnification agreements, removing the director from any D&O, directors and officers insurance policy, removing access to corporate systems and records and whatnot.
 
The bylaws will address how replacements are selected, where a director is taken prior to the expiration of its term, if there is a term
 
Somehow, share holders elect the new director, and in some cases, the bylaws can provide that the board can appoint a temporary director until the next election, the end of that director's natural term.
 
Again, as with the change in officers, you don't have the file this change with the State of Delaware or your registered agent. It's all done through internal documentation, resolutions, consent, board minutes.
 
As Brett mentioned, the company's annual report will need to list the names and addresses of the current directors and at least one officer. So while you don't have to file changes, you do need to file a snapshot at a certain point, listing the directors and at least one officer.

Changing a Corporation’s Shareholders

Brett: So we're off to -- how to change a corporation's shareholders. The shareholders are more or less the owners of the entity. And this is a very important topic.
 
Jarrod: That's right, Brett. It's an important topic, but it's also very murky. I'm diving in brackish water here. Because what happens... Getting a shareholder out of a corporation, particularly a minority shareholder, is a very touchy subject. It almost, I should say, very frequently leads the lawsuits and disputes.
 
I need to make a distinction at the outset between documenting a change in shareholders, such as through sale of shares, something like that, versus trying to remove a shareholder.
 
When you're trying to remove a shareholder, generally that will be documented and governed by your shareholder agreement, which is an agreement among shareholders to act or not act in a certain way, and it provides penalties, including ways to remove a shareware or force a cash out of a shareholder.
 
For instance, there's something called drag along rights where a majority, if they decide they want to sell a portion of shares or all of the shares and actually merge the company with another entity, they can drag along the minority shareholders to sell their interests at the same price as the majority whether they want to come along or not.
 
Conversely, there's also a tag along right, where where a majority decides to sell shares, the minority investor can sell a proportionate number of those shares, essentially being able to tag along on the coattails of the majority shareholder sale.
 
So, again, the shareholder agreement is where you're going to find how to remove a shareholder generally, perhaps the investor rights agreement. But both of these are not the corporation's documents. These are agreements among the shareholders, and they can provide a wide range of terms. So that's why it's murky. It's difficult to say how to kick out a shareholder because it'll vary.
 
When you're talking about documenting a change in the shareholder, for instance, if the shareholder sells shares to another. Say the shareholder complied with whatever restrictions the corporation has on resale in its bylaws, and it also complied with whatever securities law regulations apply to the resale of shares, then properly drafted bylaws and other documents should mean that you don't need to amend corporate documents. You should be able simply to amend the schedule of shareholders, the shareholders ledger, effectively, that's maintained by a corporation. And that should not require any vote of the shareholders. But again, various things could be provided for these agreements, subject to the corporate law boundaries.
 
Actually, as I mentioned, there's a difference between forcing a shareholder out and documenting a change. You may say -- what if the change is caused by death? What if a shareholder dies? The general provision there you'll find in corporate law and in corporate documents is that person's estate will take on the interest. It may be transferred pursuant to an estate plan, generally not for consideration, not for value, meaning that there's no securities law requirement needed. Usually, corporate documents carve out a transfer for state corporate purposes for many transfer restrictions. So generally when someone dies, it's fairly easy to move their interests to someone else. Or, the estate itself can stand in the shoes of share with the deceased shareholder for economic purposes, but not for purposes of voting or other powers other than receiving distributions.
 
And the same is true about somebody who receives the shares by estate. As I said, it's easy to transfer shares, but that person will only receive economic value until the corporation admits them as a shareholder officially, which generally just requires the completion of a simple form, a share purchase representation, making certain representations to the company.
 
Brett: In regards to any restrictions or transfers with a corporation, we have our close corporation, for instance, which is meant for a small, tight knit group of investors, it does have restrictions on shares of stock, right of first refusal, to help keep those shares of stock within the family itself.
 
Do you mind just talking about that just a little bit?
 
Jarrod: Sure, yeah. The closed corporations are a very special type of Delaware corporation governed by specific provisions in the Delaware General Corporation law that deal solely with closed corporations.
 
And as Brett said, they're meant to be small. I believe the requirement is no more than 30 shareholders. It's a tight knit, family-owned kind of company. And the restrictions on transfer, may be pre-approval of the board. It may be pre-approval of the shareholders. Shareholders will often have a right of first refusal, meaning the shares have to be offered in whole or in part to the other shareholders before they can be sold to a third party. If the other shareholders turn down the right of first refusal, then you can go ahead and sell them to a third party if permitted. And there's other types of restrictions on transfer.
 
Again, without getting into it, because it's a total morass, is getting into the securities law exemption. Consult an attorney and look to that. Any time you hear transfer of shares, think about consulting an attorney because there are federal requirements on the offer and sale of securities and resale of securities.

Changing the Number of Authorized Shares in a Corporation

Brett: We're going to move on to how to change the number of authorized shares in your corporation. This is a relatively straightforward type filing. We file a stock amendment, and the stock amendment doesn't necessarily need to increase shares. It can also go ahead and decrease the number of authorized shares that the company has to issue.
 
You could remove or add classes of stock. A rare type of stock amendment, maybe to modify the par value, that's not traditionally done too often, but it could be done.
 
In order to go ahead and make the stock amendment, the companies are traditionally holding an internal company meeting and having any changes approved by holders of a majority of the stock.
 
How is that typically done?
 
Jarrod: Well, a meeting is certainly a possibility. However, in today's world, getting everyone together in a room, or even getting everyone together on a conference call, all the owners of shares, or at least a quorum, usually a majority or perhaps higher, which is required to take action, is difficult.
 
A lot of times, too, it's very time consuming. There are notice periods that are required by statute. If notice is not properly given, then the shareholder is under no obligation to show up, and the vote really can't go forward.
 
So what you often do is what I said before, where it's shareholder consent. You'll simply go out to the requisite number of shareholders, or all shareholders if you're being particularly democratic, and you'll seek their written consent. They'll sign a consent and it's as good as a vote, without holding a meeting. That's a way you often see this sort of thing done.
 
Brett: The state of Delaware won't need to know anything about the votes. There is a certificate of amendment that's prepared and executed by an officer, and that's then submitted to Delaware division of corporations. They'll stamp it, approve it and have it back in about 3 to 5 business days. And that company now has the new stock structure.
 
Jarrod: That's right, and it can provide... The different classes of stock and have different rights, different privileges relative to other shares. You'll often see in venture capital investments by professional investors a fund. You'll see certain very specific favorable terms that those investors will demand -- a rite of future participation and any offers to keep their percentage ownership, as well as the most favorite nation, meaning, any better terms given to another investor -- except in say, another round, because that would be covered by the ability to participate -- will be given to that shareholder. So they will get the best terms possible.

Changing Members of a Delaware LLC

Brett: The next slide -- how to change the LLC's members.
 
The process is very straightforward. The members are not filed are on record traditionally with the state of Delaware, they don't need to be filed. They're not provided in the annual report. The LLCs don't have an annual report. It has a flat $300-a-year franchise tax. And Delaware doesn't need to know anything about the managers either.
 
So usually the changes is just done internally within this operating agreement or the schedule of the members.
 
If you like to expand on the change?
 
Jarrod: Sure, sure. If in the corporate contact I was in a swamp, now in the Old West, I'm just shooting from the hip. Bullets are flying, jumping on the horse and riding out.
 
Because the LLC is even more a creature of contract. So the terms are very specific to every LLC. Adding or removing members is very -- really, anything under an LLC is very company specific. There are no bound requirements or rules subject to fiduciary duties, and the good faith obligation that applies to any agreement, including an operating agreement.
 
So again, yes, you're right, it's internal, and it's not filed with the state or registered agent.
 
If we're talking about removing a manager, I'll just get on that really quickly. Some LLCs are managed by an external manager.
 
Brett: -- who doesn't have any ownership control. They're just simply a manager within the entity itself.
 
Jarrod: That's right.
 
Oftentimes, the manager will be referenced in the operating agreement and discussed, but the actual terms of the specific manager's engagement will be provided for in a separate agreement.
 
Termination -- stripping a manager of its role or even stripping what's called a managing member, a member who's also a manager of its role -- is again, all involved in the terms of the LLC agreement. And in the case of the external manager, that second agreement, which normally says that it will terminate upon termination of the operating agreement. The two happen hand in hand.
 
Brett: So from what I gathered here, and what we dealt with with clients in the past, it's a great idea from the onset of forming an LLC to make sure you think about these contingency situations -- what could happen with the LLC? When we're starting the LLC, everything's going great. But what if things start to break down between partners?
 
A properly structured LLC agreement is going to spell out what happens if a member wants out of the company. What happens if there's a death involved with one of the members? What happens if there's a disagreement among the members, and how does it get resolved? So it's a great idea to make sure that your agreement is drafted properly.
 
Jarrod: That's right. Under the definition, there used to be no requirement that you had a written operating agreement, but it was a fool that didn't, because...
 
Brett: It could be oral.
 
Jarrod: That's right. It could be back in the day. However, it's such a terrible idea. If you go into court with oral understandings of what was said, what was meant, and what was promised, you're guaranteed to get conflicting interpretations. That's the nature of a dispute. One person thinks their owed something that the other things they do not, or should have a privilege that the other doesn't want to extend. And disagreements without an operating agreement, even though the ever see act, the enabling act for LLC, is done to provide certain default rules if an operating agreement is in place. Those default rules just do not cover every possibility, and they specifically don't cover something like a deadlock in management, except to say you can go to the Chancery Court and effectively have your company dissolved by judicial mandate.
 
Brett: That Chancery Court. You mentioned that. We've not talked about that. That's a court that's specific here to Delaware to help expedite disputes between entities.
 
Jarrod: That's right, those are the corporate law experts, the judges who are corporate business entity law experts. One of the best features of forming in Delaware is you have judges that are experts. They're not handling a basic dispute as their next case. They're not handling a family matter later that week. They only handle business entity cases over and over and over, with increasingly complex cases. Delaware has essentially built up a road map of how to satisfy your fiduciary duties under broad range of circumstances. And because they're drafted by experts, they're internally consistent, with exceptions to an extent, but they're more consistent than you'll find elsewhere.
 
Delaware simply have the cachet value and a certain amount of respect that you don't get with Nevada or Wyoming.

Converting a non-Delaware Company to a Delaware Company

Brett: Alright. So we're off now to converting a non-Delaware company to a Delaware company. This is something that we do hear from clients quite often. They may have formed in California. The idea is all of a sudden starting to take off. And lo and behold, they've gone to try to get investors and the investors are mandating -- hey, in order for us to go ahead and invest with this entity, we're going to need to make sure this is a Delaware company first.
 
So we are able to go ahead and assist with making the change from a non-Delaware company to a Delaware company.
 
And why would per se, a client want to go ahead and become a Delaware corporation when bringing aboard an investor?
 
Jarrod: Well, as I told you, the investors prefer it, and usually the management prefers being a Delaware company. Because there's so many management-friendly terms. And I don't mean to imply that it's a zero sum game where management-friendly means shareholder-unfriendly.
 
But Delaware starts with the business judgment rule, which is a presumption that officers and directors are trying their best and they're exercising their fiduciary duties with due care and loyalty.
 
A shareholder suing these officers or directors has to rebut that presumption before the case can even go forward.
 
So the business judgment rule and other features like that are great protections for management. Really, all the reasons I've mentioned for incorporation apply here/
 
And simply, as I said, the respect value that Delaware holds. If you show up with a registered address that's Reno or Las Vegas, people immediately think go-go dancers and Ponzi schemes involving physical gold, hoarding gold, or something like that. It's just not the same cachet value that Delaware has. Because shareholders want the predictability, the reliability and the quality of judges in case law that you get in Delaware.
 
The conversion process, this again is 3 to 5 business days, it doesn't take too terribly long. There's going to be a filing of paperwork within the current state, which the entity is formed.
 
The next step is filing a certificate of conversion and the certificate of incorporation with the state of Delaware to go ahead and create the entity, and then convert it from the state where it's originally formed to Delaware. So in Delaware, there's two filings that are made that are done at more or less the same time, and that takes 3 to 5 business days.
 
This is outside of the scope of quite what we're talking about but it bears mentioning on this topic is that in some states a switch from non-Delaware company switching into Delaware from another state will require you to terminate the entity in the existing state and form an entity in Delaware. So effectively it's the termination and re-establishment of the company.
 
And because that happens by operation of law, it's meant to be very streamlined. But it can create issues. In effect, you're terminating your former company. You need to make sure your contracts account for that, that counterparties to your contract understand this is merely a termination by operation of changing jurisdictions. So just keep that in mind and pay attention to what the law under jurisdiction says.
 
In many ways, it's meant as a penalty for going to Delaware. You have to terminate your company there and go through some level of inconvenience because you're leaving.
 
Brett: Now we're going to go ahead and talk about the requirements. We won't spend much time on this.
 
Right there, the requirements needed in order to go ahead and make this change for an LLC. Also the requirements for the corporation. Really the hardest question coming up with a number of total authorized shares that you would need for a corporation.
 
Now, this is something interesting -- making multiple changes simultaneously. We've talked about making amendments. We talked about making changes. It's not uncommon for a client to call and need to go ahead and change their name, need to go ahead and file a stock amendment.
 
For instance, I had a gentleman the other day, we weren't his registered agent, he wanted to increase the shares, he didn't like his name. What we did is we went ahead and file an amendment. We filed one document that went ahead and changed the name of the entity with Delaware, increased the shares of stock, and then also appointed Harvard Business Service as the registered agent. So instead of paying three separate amendment fees, we were able to get this done in just one filing. So they were very appreciative of that as well.
 
So a filing service such as ourselves can go ahead and inform you what type of filings can be made all at one time. And it's not uncommon for us to see a client go ahead and change a non-Delaware LLC and then convert into a corporation. So we can make a filing with Delaware to go ahead and change the existing California LLC into a Delaware corporation. So don't be afraid, give us a call, send us an email. We'll be glad to go over what can be done or also, what can't be done.
 
And this really is important. When making changes it's a great idea too to talk to your attorney or tax professional about these type of ramifications that you might face by making an entity change from an LLC to a corporation. What are my tax ramifications going to be? So it's a good idea to spell things out and to know exactly what you're getting into.

Correcting Errors in Your Company

Jarrod: And one last point. We talked about a lot of filings. Let's say you forget to authorize new shares. You issue too many shares. You had a million authorized and you issued 1.1 million.
 
Brett: So you went ahead, and for instance, you only had a million shares the issue but you accidentally issued...
 
Jarrod: That's right.
 
Brett: -- 200,000 shares to many?
 
Jarrod: That's right. And that happens.
 
Delaware has what they call validation, or what I like to call a cure provision, where you can go back and file a corrective action filing.
 
You have to adopt a resolution with the board providing details about the issue, that whatever wasn't filed or whatever wasn't properly documented with filings in the state. If it requires a vote, you need to take that boat and note it in the resolution. You need to notify shareholders if it's something material, that there was a failure to make the filing, if it's a material issue for company that shareholders need to know about. And then you make the corrected filing -- the amendment. You traditionally a certificate of validation, which describes the defective action or whatever action wasn't taken and you state "I'm making the filing after the fact."
 
Now that doesn't necessarily cure issues that come under federal law. It doesn't necessarily prevent shareholders from bringing a lawsuit if there were consequences of not making the filing, but at least for state purposes you still can maintain good standing.
 
Brett: So this isn't backdating a filing. What this does is this is knowledge and error that was made and fixing it as of now, for something that happened in the past.
 
Jarrod: That's right. Never backdate a filing. No. The cover up is worse than the crime, really. Just never backdate.

Audience Q&A

Michael: Alright. Well, thank you, guys. That was a great presentation, and certainly covered a lot of ground.
 
We do have some time if we want to take some questions from the audience. So anyone who's listening needs some clarification or has maybe a change that we haven't gotten to, go ahead and type it in, and we'll see what we can get you for an answer.
 
Let's just start with one quick question -- if you have a corporation, you're going to file an annual report each year with the information in your franchise tax payment. Is there a way that you can make changes to an annual report that's already been filed?
 
Brett: Most definitely. And we have a lot of clients that need to go this route. They may have made an error as far as a current director of an entity. Delaware does allow for the amended annual report. It's going to cost $50 to go ahead and get that filed.
 
A company such as ourselves will go ahead over a small service fee to go ahead and assist and file that amendment with Delaware. Yes, it most definitely can be changed or amended.
 
This isn't necessary at all whatsoever with an LLC. There's no annual report. There's no information to go ahead and update or change. It's just a flat $300 payment.
 
Michael: Alright, great.
 
We had one question just come in asking about transfer of interest in an LLC, and I think this is just clarifying an earlier point.
 
If you're transferring Interest in an LLC, can you just modify the schedule to reflect the change? Is there anything else you need to do?
 
Jarrod: Yes. That is a very important point. A properly drafted LLC agreement should not require a vote and other formalities necessary to modify the operating agreement. And again, modification, the amendment, it's all governed by the terms of the operating agreement itself. But usually you see a vote required for amendments. You should just be able to modify the schedule without changing the operating agreement and without taking those formalities.
 
Michael: Great. One more question. And I think this is the last one that we have. You spoke earlier about the event of a death for shareholder in a corporation, and transferring to the estate. Are there any other statutory thing regarding a director passing away and how that might be replaced?
 
Jarrod: Generally a director that passes away is simply treated as if the person resigned. A replacement could be appointed pursuant to the terms and bylaws. But it's generally just treated as a resignation.
 
You'll need to look to other agreements that director may have had for any terms of fees they might be owned, options they might have. But generally in terms of just a role as director, yes, it's treated as a vacancy.
 
Michael: Alright.
 
I think that'll wrap it up for us today. So thank you both for your time and thank everyone for joining us today. You are, of course, welcome to email us or contact us afterwards if there are questions that you didn't think of, and wed' be happy to get them to you.

*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.

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