42-1

Organization and Financial Structure of

Corporations

PA ET RHC 42

Our business is company creation.

Ann Winblad, venture capitalist, quoted in Fortune magazine (Sellen and Daniels, Oct. 1999)

42-2

Learning Objectives

• Appreciate the risk of liability for corporate promoters

• Understand the process for incorporating a business

• Know the appropriate sources for financing a business

• Explain share-transfer restrictions

42-3

• Each state has enacted laws detailing how a corporation may be created

• A promoter of a corporation incorporates the business, organizes initial management team, and raises initial capital

• A promoter may be the person who originated the idea for the firm or may be a professional hired to undertake incorporation activities

Overview

42-4

• A promoter will be liable for contracts made during the preincorporation period unless the corporation adopts the contracts made by the promoter (adoption) and the third party agrees to substitute the corporation for the promoter (novation)– Like agency ratification, may be express or

implied– Contracts adopted typically: employment

and real property lease or purchase

Preincorporation Contracts

42-5

• Facts:– SmithStearn Yachts, Inc., (Smithstearn) a

Delaware corporation providing luxury yachting services in Connecticut, agreed to a contract with Gyrographic Communications, Inc., a California company, for marketing and promotional services to SmithStearn

– SmithStearn sued Gyrographic, which argued that it had made a contract with SmithStearn Yachts, LLC, not a corporation

SmithStearn Yachts, Inc. v. Gyrographic Comm., Inc.

42-6

• Legal Analysis & Holding:– A corporation generally is not bound by

contracts entered into on its behalf prior to its existence, but it can acquire rights and subject itself to duties for preincorporation matters

– SmithStearn Yachts, Inc. was formed after execution of the agreement, but received benefit of the services pursuant to the agreement and thus ratified the contract

SmithStearn Yachts, Inc. v. Gyrographic Comm., Inc.

42-7

• Legal Analysis & Holding:– Gyrographic developedg letterheads, business

cards, and other marketing material for SmithStearn Yachts, Inc., and SmithStearn Yachts, Inc. made payments to Gyrographic

– SmithStearn Yachts, Inc. is a proper party

SmithStearn Yachts, Inc. v. Gyrographic Comm., Inc.

42-8

• Preincorporation share subscriptions are contracts in which a prospective shareholder offers to buy a specific number of shares in a new corporation at a stated price

• Under the Model Business Corporation Act (MBCA), a prospective shareholder may not revoke a preincorporation subscription for a six-month period

Share Subscriptions

42-9

• A promoter is not an agent of the proposed corporation or investors since they did not appoint the promoter, but a promoter owes a fiduciary duty to the corporation and to its prospective investors– No self-dealing, duty of loyalty, etc.

• A corporation may compensate a promoter with shares

Promoter Duties

42-10

• A U.S. business may incorporate in any state• Fees, taxes, and laws vary from state to state

– See, e.g., Texas corporations section:• www.sos.state.tx.us/corp/index.shtml

Incorporation

Stock Certificate of a Texas

Corporation

42-11

1. Prepare articles of incorporation2. Sign and authenticate articles by one or

more incorporators3. File articles with secretary of state, pay

fees4. Receive copy of articles of incorporation

stamped “Filed” by secretary of state, along with fee receipt

5. Hold organizational meeting for purpose of adopting bylaws, electing officers, and transacting other business

Steps in Incorporation

42-12

• The articles of incorporation (or charter) is the basic document stating the rights and responsibilities of a corporation, its management, and its shareholders– Must add extension to name indicating

corporate form: Inc., Corp., Co., Ltd.– Must include other specifics, such as number of

shares authorized, initial registered office and agent’s name, name and address of each incorporator

– See Fig. 1

Incorporation Details

42-13

• Other provisions (not inconsistent with law) may be added to articles of incorporation or included within corporate bylaws– See Fig. 2

• To retain corporate status, a corporation must file an annual report with secretary of state of the state of incorporation and pay an annual franchise fee or tax

Incorporation Details

42-14

• Sometimes, an attempt to incorporate fails

– One consequence is that the corporate shield does not exist to protect shareholders, officers, and directors from personal liability

– Another possibility is that a party to a contract involving a defective corporation may claim nonexistence of the corporation to avoid a contract made in the name of the corporation

Defective Incorporation

42-15

• De jure corporation: exists when promoters and incorporators substantially comply with each mandatory (shall, must) requirement to incorporate the business

• The validity of a de jure (by law) corporation cannot be attacked except by the state of incorporation due to noncompliance with state corporation laws

De Jure Corporation

42-16

• De facto corporation: exists when promoters fail to comply with all of the mandatory requirements, yet comply with most of the mandatory provisions

• Validity of a de facto corporation could be attacked by a third party, or itself, or the state of incorporation, but may be treated by as a corporation under the judicial doctrine of corporation by estoppel

De Facto Corporation

42-17

• Under the MBCA, filing the articles of incorporation is conclusive proof that the corporation exists

• MBCA imposes joint and several liability for a purported corporation’s contracts and torts on managers and shareholders who both (1) participate in operational decisions of the business and (2) know the corporation does not exist

The MBCA

42-18

Christmas Lumber Co., Inc. v. Valiga

• Facts: – Contractor (Waddell) and Valiga entered home

construction contract, which fell through– Contractor had purchased construction

materials from plaintiff (through Graves) and in 1990, plaintiff filed suit against Valiga and contractor

– 1992: Valiga filed separate suit against Waddell and Graves, claiming defective incorporation

– Suits consolidated; trial court found Waddell and Graves liable as partners to Valiga

42-19

• Legal Reasoning & Holding: – Waddell said he didn’t know incorporation failed– Evidence: Waddell testified he and Graves were

“partners,” the two entered a joint venture agreement, and they shared contractor’s fee

– Conclusion: Waddell and Graves were partners– Judgment for Valiga affirmed

Christmas Lumber Co., Inc. v. Valiga

42-20

• A non-profit corporation incorporates in same way as a profit corporation, but must declare whether it is a: – public benefit corporation, mutual

benefit corporation, or religious corporation

• Nonprofit corporation’s articles must also state whether it will have members

Non-Profit Incorporation

42-21

• For-profit corporations are financed by:– Sale of securities: shares, debentures,

bonds, and long-term notes payable– Short-term financing (e.g., inventory

financing)– Bank loans

Financing Corporations

42-22

• Equity securities, better known as stock or shares, create an ownership relationship, thus stockholders or shareholders own a corporation

• State laws permit corporations to issue classes of shares with specific rights: – Common – Preferred

Equity Securities

42-23

• Claims for dividend payments or asset distribution on liquidation are subordinate to creditor or preferred shareholder claims

• However, common shareholders have the exclusive right to elect corporate directors and exclusive claim to corporate earnings and assets that exceed the claims of creditors and other shareholders

Common Shareholders

42-24

• Preferred shareholders generally receive liquidation and dividend preferences over common shareholders

• A corporation may have several classes of preferred shares with specific rights related to dividend payments, asset distribution upon liquidation, voting, stock redemption, and stock conversion

Preferred Shareholders

42-25

• Authorized shares are shares a corporation is permitted to issue by its articles of incorporation– A corporation may not issue more shares

than authorized

• Issued shares have been sold to shareholders

• Outstanding shares are currently held by shareholders

Share Types

42-26

• A board of directors may issue options for purchasing the corporation’s shares– Issued to top-level managers as an

incentive

• Warrants are options evidenced by certificates

• Rights are short-term certificated options that are usually transferable– Used to give present security holders an

option to subscribe to more shares

Options, Warrants, & Rights

42-27

• Corporations may borrow money to operate by issuing debt securities, such as bonds, debentures, and notes payable

• Debt securities create a debtor–creditor relationship between the corporation and the security holder

Debt Securities

42-28

• Debentures are long-term, unsecured debt securities with a 10 to 30 years term– Having an indenture, or a contract stating the

rights of the debenture holder

• Bonds are long-term, secured debt securities– Identical to debentures except that bonds are

secured by collateral

• Notes generally have less than a five year term and may secured or unsecured

Debt Securities

42-29

• MBCA permits shares to be issued in return for any tangible or intangible property or benefit to the corporation, including cash, promissory notes, contracts for services to be performed for the corporation, services performed for the corporation, and securities of the corporation or another corporation

Consideration for Shares

42-30

• The board must issue shares for an adequate dollar amount of consideration

• Par value is an arbitrary dollar amount that may be assigned to shares by the articles of incorporation– Does not reflect fair market value, but is

the minimum amount of consideration for which the shares may be issued

Consideration for Shares

42-31

• Under the terms of a share subscription, a prospective shareholder promises to buy a specific number of shares at a stated price– Generally in writing, though not required

• A share certificate may not be issued to a share subscriber until the share price has been fully paid

Share Subscriptions

42-32

• Share certificates are registered with the corporation in name of a specific person

• Indorsement of a share certificate on back by the registered owner and delivery of the certificate to another person transfers ownership of the shares

• Under the UCC, a corporation owes a duty to register transfer of any registered shares, provided it has proper indorsement

Transfer of Shares

42-33

• Shares in a publicly held corporation are freely transferable, but often close corporations (less than 50 shareholders) restrict transfer to ensure control

• Four categories of transfer restrictions: (1) rights of first refusal and option agreements, (2) buy-and-sell agreements, (3) consent restraints, and (4) provisions disqualifying purchasers

Transferability & Restrictions

42-34

• Court enforced a poorly drafted buy-sell agreement in which the shareholders were to agree from time to time on the price to be paid for the shares, but failed to do so

Coyle v. Schwartz

42-35

Test Your Knowledge

• True=A, False = B– A promoter is always liable for contracts

made during the preincorporation period.– A U.S. business may incorporate in any

state.– A de facto corporation exists when

promoters and incorporators actually comply with each mandatory requirement to incorporate

– Warrants are stock options evidenced by certificates.

42-36

• True=A, False = B– Preferred shareholders have exclusive

right to elect corporate directors and the exclusive right to dividend payments.

– For-profit corporations are financed only by issuing securities in the form of shares.

– The MBCA permits shares to be issued in return for any tangible or intangible property or benefit to the corporation.

Test Your Knowledge

42-37

• Multiple Choice– Which of the following is not a debt

security: a) Stockb) Bond c) Debentured) Notee) none of the above

Test Your Knowledge

42-38

• Multiple Choice– The Steel Inc. Board of Directors plans

to issue dividends this year. Which of the following is false?

a) Preferred shareholders receive their dividends before common shareholders

b) Creditors receive their dividends before common shareholders

c) Common shareholders receive their dividends before either creditors or preferred shareholders

Test Your Knowledge

42-39

Thought Question

• Do you believe that a company’s stock price reflects a company’s value or success in (a) the marketplace, and (b) society?