Entrepreneur’s Guide to Corporations and How They Work
Three Types of Small Business Sale
Every entrepreneur should have a basic understanding of how corporations work. If you do, you should normally have little or no difficulty deciding whether you should adopt the corporate format or in maintaining your existing corporation simply and inexpensively.
Here are some explanations and guidelines that will help you.
How Corporations Work: Shareholders, Directors, and Officers
Think of a corporation as being akin to a centuries-old algorithm that is so thoroughly debugged that it can adapt itself as easily to the simple needs of a one-person corporation as it can to the complex needs of multi-national enterprises.
The goal is to facilitate capital formation by offering limited-liability protection to investors who put up risk capital.
This can be a founder who puts up his own money to fund a small business. It can be VCs who invest in a startup in hopes of getting a 10x return within a few years. It can be public investors who buy stock through a publicly-traded exchange.
In any case, while the corporate law affords limited-liability protection to shareholders generally, it has special rules that facilitate comparatively simple maintenance for closely held corporations.
Before we can understand how those rules work, we need to understand how shareholders, directors, and officers relate to one another within the corporate context.
In a closely held corporation, as in others, shareholders own the entity. But they do not manage it directly, other than by electing the board of directors. The broad idea behind limited liability is that there needs to be a sharp distinction between those who own and those who manage the affairs of the corporation.
Shareholders elect the directors and thereby ultimately control the company. Besides electing the directors, shareholders need to approve important actions generally affecting their ownership interests or otherwise deemed fundamental — for example, increasing the number of authorized shares, amending the corporation’s charter document, approving a merger or acquisition, or authorizing a dissolution. Apart from a few such fundamental areas, shareholders do not normally vote on corporate matters. They leave the most important management decisions to the board.
Under law, the board is responsible for all major decisions of a corporation that are material or “out of the ordinary course of business.” Let us call these “high-level” management decisions and let us distinguish them from the day-to-day management conducted by corporate officers. Where a high-level decision is involved, the action requires the approval of the board if it is to be properly authorized.
Of course, one can easily imagine issues about exactly where the line between high-level and day-to-day management decisions should be drawn. Corporations are creatures of state law, and your state law may differ from that of other states. Check with a good business lawyer in your area if you need to understand which types of actions require board approval.
Here are some obvious cases. If your corporation decides to issue stock in exchange for a capital contribution, this needs board approval. Grant of options? Needs board approval. Material building lease? Needs board approval. Bank line? Needs board approval. Appointing a corporate officer? Needs board approval. Acquiring a company? Needs board approval. Dissolving your company? Needs board approval.
In contrast, corporate officers deal with day-to-day management of the corporation’s business. These too can be very important decisions, as one can derive even from the titles of corporate officers. Company president’s, after all, do important things. The point, though, is that such actions are operational in nature and need no special documentation as would an action of the board of directors.
To recap, then: (1) shareholders own but don’t manage; (2) directors do high-level management; and (3) officers run day-to-day operations.
It is imperative that entrepreneurs in a closely held corporation keep the above distinctions in mind. If you do, there will be no confusion of roles. You will know, for example, that shareholders do not vote to appoint officers, that the company president cannot just go sign for a building lease without board approval, that an individual board member cannot act to sign a contract for the company, that the company cannot sell substantially all of its assets without both shareholder and board approval, and so on. Always check with a lawyer when there is any doubt. But there are clear lines of division, and it is critical to observe these in administering the affairs of a corporation.
Given this division of functions, here are some general guidelines on how to administer the affairs of a corporation.
Treat the Corporation as a Legal Person
A corporation is a legal “person,” albeit an artificial one. What does this mean?
A person has rights. So too does a corporation. You can enter into a contract as an individual. So too can a corporation. You can buy and sell property. So too can a corporation. You can sue and be sued, as can a corporation. If a law says that you must file a fictitious business name statement (dba) as a prerequisite to doing business under any name other than your exact name, then such a law applies to a corporation as well.
Let us use this last example to illustrate the point of a corporation being a person.
If John Smith as an individual seeks to do business as “Smith Enterprises,” he will need to apply individually for a dba to use that name. If John Smith’s corporation, J. Smith, Inc., seeks to do business as “Smith Enterprises,” then the entity will need to apply for the dba. What does this mean logistically for John Smith? It means that, when he goes down to make the application, he will list the corporation as the applicant and will sign it at the end, not as an individual, but as an agent for the corporation. Thus, for example, he will sign it as “J. Smith, Inc., by John Smith, President.” The “person” applying is not John Smith the individual but rather J. Smith, Inc. the corporation. In making the application, J. Smith, Inc., a legal person, acts through its agent, the president of the corporation, John Smith.
Use Consents to Document the Actions of Shareholders and Directors
How exactly do you document the fact that a corporation is acting through its agents?
In a public company context, there is great formality associated with board and shareholder meetings. Formal notices are sent out. Meetings are handled with strict protocol. Motions are made and seconded, discussion is had, formal votes are taken and recorded by a corporate secretary. Minutes are taken and formally approved.
In a closely held context, corporate actions are normally documented in much simpler fashion.
Indeed, now that we understand the general division of functions, we can see some remarkable things about how corporations work: specifically, that many apparently complex steps can be dramatically simplified.
Here is how this works. In most states, such as California, a corporation can legally exist and function even if it has only one shareholder. That same shareholder can appoint himself as the sole member of the corporation’s board of directors. And that one-man board can similarly appoint that same individual to each of the officer positions. The result: one individual fills all the roles and does everything, just as in the case of a sole proprietor.
Does this single-person corporation still have to honor the rules relating to the corporate division of functions as outlined above? Absolutely. The sole individual in that corporation functions in three different capacities: as a shareholder, as a director, and as an officer. In acting for the corporation, that individual must always bear in mind the role in which he is acting. If the corporation needs to enter into a building lease, then he must approve it in his role as sole director and must also give himself authority to physically sign it in his role as president. If his company is being acquired, he must approve the deal as a shareholder and as a director for the acquisition to be valid. And so on. Legally, what do have here? We have two legal “persons,” one an artificial person that can act only through agents and another an individual who acts on its behalf as an agent. As an agent, that individual wears at least three hats, one as shareholder, another as director, and another as officer. Though he practically can function much as a sole proprietor would, he must be careful to honor the division of functions that corporate law requires.
But how can this individual “meet” with himself to approve those items requiring shareholder or director approval. There is no mystery to this. No one can possibly “meet” with himself, unless he wears a straight jacket. But there is no need to go into convulsions over this because the corporate law makes simple provision for how approvals are done at the shareholder and director level. And this brings us to yet another radically simplifying feature that is woven into the genius of corporate law.
If you consider the division of functions set out above, you will see a hierarchy, with the shareholders on top dealing with the most fundamental actions, the directors immediately below dealing with the high-level management functions, and the officers just below them dealing with the day-to-day management. At each level, how do we know that the “person” known as the corporation has been authorized to act. We know this when any action besides day-to-day activity has been “approved” at the level required – shareholder or board or both. How do we know that such approvals have been properly given? There are two ways: first, by a vote at a meeting; second, by what is called a corporate “consent.”
The meeting is the part most of us are familiar with. The shareholders of ABC Corp. are required to approve an impending merger already negotiated by its officers under the direction of its board. A notice goes out as required by law giving at least a set number of minimum days advance warning that a meeting will occur. The shareholders show up and conduct a formal meeting. The meeting is chaired, motions are made and seconded, votes are taken, and minutes are recorded. In those minutes will be recorded various actions that were thus authorized, which appear in the form of corporate resolutions. For example, “The shareholders of ABC Corp., by unanimous vote, approved the following: RESOLVED, that ABC Corp. is hereby authorized to merge with Voracious, Inc. on the terms and conditions set forth in that certain Merger Agreement attached as Exhibit A.” These minutes are duly recorded by the corporate secretary and we thus know that the corporation’s shareholders have “acted” to authorize the action. The action of the shareholders has been properly documented.
In this example, there would also be an accompanying meeting of the board of directors, which also could be held by the notice-meeting-minute format. The resolutions adopted at the board meeting would also add something like the following: “RESOLVED FURTHER that the President of ABC Corp. is hereby authorized to sign the Merger Agreement on behalf of the company.” Again, in this way, we know that the board – acting as agents for the artificial person known as ABC Corp. – has authorized the corporation to act, and we thus know that the merger (in this instance) is a proper and lawful act of the corporation. The action of the board has been properly documented.
These are the sort of corporate formalities of which we always hear. And, indeed, if every corporate action required them always to be done with that level of formality, then the corporation would become administratively burdensome as a vehicle by which a typical small, closely held corporation could do business. It could function, and many small corporations do function in this way, but this aspect of it would often be regarded by its principals as a serious negative.
This is where the corporate “consent,” when combined with the normal division of corporate functions, saves the day for the closely held corporation. Recall that day-to-day operations are done by the corporate officers – these require no form of special corporate approval beyond what is routinely set out in a corporation’s bylaws defining the roles and duties of the corporate officers. That is, all such actions by the officers have a standing approval as set out once for all, so to speak, in the bylaws. Thus, the officers can go about with their conduct of normal company business without needing to get special documentation for any of their actions. These are all proper corporate actions that occur without special documentation.
Now let us consider our hierarchy again. If the day-to-day actions of officers do not need special documentation, and if that constitutes 99% of what the corporation typically does, there is no administrative burden whatever associated with such activity. About the only thing that differs, practically, between what such officers do in this way and what a sole proprietor does is that the officers must always remember to use the block-signature format to ensure that it is the corporation and not an officer individually that enters into contracts or makes applications or otherwise acts by signing.
That takes care of the overwhelming bulk of the corporation’s activities, whether it is 99% or some other ratio to the whole – no special documentation required. The corporate consent takes care of the rest for most situations in any closely held corporation where the principals are not feuding. Consents are simple documents (often “one-pagers”) that simply set forth each of the resolutions to be adopted and bracket them with simple language saying who is adopting them, plus signatures for the adopters. If it is a shareholder consent, it will say something like, “The undersigned, holding the number of shares set forth opposite their names below, hereby approve by this consent the following resolutions . . .,” with the resolutions then set out similar to the format described above for meetings (“RESOLVED that . . .”). The shareholders then sign the consent. No meeting required.
Board consents work in a similar way as far as the mechanics go. The consent describes the action being approved by setting forth the appropriate resolutions. The directors then sign. No meeting required.
There are a few important caveats to note here. First, the consent procedures may vary from state to state and local law always needs to be consulted concerning their requirements and validity for varying situations. Next, the rules for approval will sometimes be slightly different for what it takes to approve an action using a consent versus what it takes to approve it at a meeting. For example, under the law of most states, such as California and Delaware, a board consent is not valid unless it is approved unanimously by the directors. If unanimity is not possible, then the board will need to hold a formal meeting, where a majority of the directors can approve the action. This is just another way of saying that, when matters are in conflict, something so important as board approval needs to be obtained in a more formal way that, among other things, lets the dissenting directors know that an action has been approved. Otherwise, there might be great confusion among even the directors themselves concerning whether some action had or had not been approved. The same principle applies to shareholder consents but in a slightly different way: in the case of shareholder consents, a consent may legitimately be adopted approving the action by whatever percentage of the voting shares would otherwise be required to approve it at a meeting but the signing of such a consent by the requisite number needs to be followed in fairly short order by a notice sent to the other shareholders telling them of its adoption. All of this is another way of saying that the corporate consent is a highly useful administrative tool for closely held corporations but cannot be used without regard to the rights of dissenters in the company.
There is also another important caveat that explains why corporate lawyers promote the idea of having regular meetings of the directors and of the shareholders. This serves a very good purpose. Since small companies tend to be lax in paying attention to their legal affairs, periodic meetings with the lawyer promote discipline. The very process forces the entrepreneur to pay attention to important legal issues that might otherwise be neglected.
In other words, in answer to the question, “should our corporate management meet periodically with our business lawyer to make sure we do things right,” the answer is yes. It is “yes,” however, not for legal reasons as such but rather for prudential reasons. Regular meetings promote legal discipline and accountability and should be held for that purpose. In a closely held context, however, they are not necessarily required to comply with corporate formalities (as long as consents are properly used).
Now let us summarize. We have set out the theory and the hedges and qualifications for how corporate administration works. But look again at our hierarchy: if 99% of corporate activity needs no special documentation and if we are a closely held corporation whose management is acting in unison, then even the small remaining percentage of authorizations needing special documentation can be done by consent. In this situation, no formal meetings are required.
Returning to the one-person case, we also see why it is unnecessary for that person to “meet” with himself. Nor is it necessary for that person to go about documenting all manner of corporate activity when only a relatively few fundamental or “high-level” items even require such documentation. Thus, standing back from our common impression of corporate formalities in a public company context, we can see that such formalities can be managed without any undue burden at all by you if you just understand how it all works. Again, legally, we have two persons, one real and one artificial, with the real person wearing three hats. As long as he understands the roles in the corporate division of function, the practical result is his having the ability to function perfectly legitimately as a corporation with not much more practical burden than would apply if he were functioning as a sole proprietor.
The handling of annual meetings is really no different for a typical closely held corporation. During the annual meeting of shareholders, the shareholders must act to elect the following year’s board and to approve the prior year’s financials. If there is no dissent, this can normally readily be done by consent. During the annual meeting of directors, the newly appointed board will act to appoint the next year’s officers. Again, absent dissent, a consent can accomplish this. All in all, the annual meetings can be done with little or no hassle in most cases involving closely held corporations.
The above discussion readily suggests why the door to the corporate world is easily accessible to a huge universe of small companies without any great difficulty.
Keep Things Separate
This brings us to the most important step in corporate administration: keep your personal things separate from your corporate business.
You are dealing with two separate persons, legally speaking — you and the corporation.
Don’t commingle personal assets with corporate assets. The assets belong to two different persons. If you fail to keep the assets separate, the law may well see your corporation as being your mere alter ego – hence, you may be liable for its actions.
Don’t raid corporate funds as if they were there to pay your personal bills. If you work for the corporation, document your salary and bonuses. If you pay yourself a dividend, document it as a dividend.
If your corporation uses space in a building that you own, have it sign a lease agreement for that space.
If you loan money to your corporation, or borrow from it, document the transaction with a loan.
Remember, the corporation is a legal person. If you transact business with it in any way, you should treat it as a separate person.
When it comes tax time, the corporation, just like any other person, needs to file all appropriate returns. Make sure you arrange for this.
Keeping your corporation separate is not complex. It does require that you as an entrepreneur always bear in mind the separate legal existence of the corporation and that you treat and document things accordingly.
Pay Attention to Routine Aspects of Maintenance
Every state has its routine requirements for corporate maintenance. California requires that every corporation periodically file a so-called Statement of Information to let the state (and the world) know who its management is.
If the corporation issues stock, applicable securities law exemptions must be complied with. Sometimes this involves filing some form or other with the state.
None of these items tends to be complex in a closely-held corporation.
Corporate administration is straight-forward and easy for most small corporations. Don’t be intimidated by the corporate format. It has a logic to it. It has clear procedures for complying with corporate formalities that are neither complex nor expensive. As an entrepreneur, you need to understand these things. This will enable you to make smarter decisions as well as to limit your legal expense in being able better to manage your lawyer’s activities in this area.