If your client is an entrepreneur or a start-up, the first and most important step he or she can take to avoid personal liability for the financial obligations of the business is to form an entity, such as a corporation or limited liability company, to create a corporate shield. Most entrepreneurs appreciate the many benefits of forming a legal entity for the operation of their new business venture, such as shielding themselves from the liabilities of the business and providing a framework for raising start-up capital and working with co-founders, but they are also highly motivated to avoid unnecessary taxes and regulations, and legal fees for that matter, so these days it is not uncommon for a start-up client to wait until after he or she has formed an entity to hire legal counsel. In these cases, the first order of business with the new client is often a determination of whether the right choices were made with regard to form of entity and state of formation and, if not, whether it worth changing.
Unfortunate choices are often made based on the mistaken belief held by many entrepreneurs that it is less expensive to form their new business in a particular state other than the one in which they operate, or that there are lower fees or privacy or tax advantages to organizing their new corporation or LLC in another state, when in reality, in most cases, the differences in state laws will not significantly affect the business in these ways. On the other hand, if a company incorporates in another state, its owners will be increasing their tax and regulatory obligations, given that they will also have to register to do business in the state where they operate and comply with the fees, taxes, and filing requirements of both states going forward, including paying a corporate agent to represent it as its agent for service of process in its state of formation.
For especially risk-adverse clients, including experienced investors such as venture capitalists, Delaware is the most common choice for state of formation, despite the additional cost to a business based elsewhere. This is because the corporate law of the State of Delaware is generally considered to be more sophisticated, comprehensive, well defined and protective than that of other jurisdictions, and because Delaware has developed a business-friendly environment of which there are numerous legal and administrative examples. This is also why Delaware is the most common choice among Fortune 500 companies, regardless of their primary office location. Therefore, for companies that plan to seek venture capital, prepare themselves for acquisition by a publicly held company, or set themselves up for rapid growth with an eye toward going public, Delaware is a great choice.
Once a corporate shield is established, care must be taken to ensure it remains in place. A corporate shield can be pierced through legal action if appropriate formalities are not observed, and an entity can lose its legal status if it neglects compliance matters, such as mandatory filings and payment of taxes. Unfortunately, given that most entrepreneurs are vigorously optimistic, they often experience a general lack of interest in discussing the ways in which the corporate shield may ultimately fail them and devising strategies to ensure that doesn’t happen—unless they have ever been sued or experienced the failure of a prior business, that is, in which case the idea of taking steps to maintain the corporate shield becomes much more interesting.
The regular observance of corporate formalities is an important aspect of maintaining the protections and advantages that the corporate form offers, not the least of which is the corporate shield. Three of the most important areas of corporate formalities are shareholder decision making, director decision making, and the separation of corporate assets from personal assets. It is recommended that corporate clients observe the following formalities in connection with ongoing operations, and if they haven’t been doing these things, help these clients get caught-up and stay current.
The shareholders should take action to elect the board of directors of the corporation annually. The election can occur at an annual meeting of the shareholders or may be taken by shareholder written consent without a meeting, in accordance with the corporation’s bylaws and applicable state corporate laws. In addition, certain specified fundamental changes in the corporation require the consent or approval of the shareholders. The consent or approval can be obtained either through a formal shareholders’ meeting or by written consent. These fundamental changes include amendments of the articles or certificate of incorporation or bylaws, the sale of all—or substantially all—of the corporation’s assets, a merger or consolidation of the corporation with or into any other entity, and a winding up and dissolution of the corporation.
Decisions of more general operating policy and strategy should be considered and authorized by the board of directors of the corporation. Although there is no statutory requirement with respect to how frequently the board of directors should act, it is typical that the board of directors meets at least quarterly. In addition, a specially convened meeting of the board, as authorized by the corporation’s bylaws, may be called if action is required before the next regular meeting of the board. Action by the board may also be taken by the unanimous written consent of the directors in accordance with the corporation’s bylaws and applicable state corporate laws. Board meetings can be held either in person or by telephone conference so long as all of the directors in attendance can hear each other simultaneously.
Matters appropriate for director action include the appointment of officers, the setting of salaries and declaration of bonuses, the appointment of board committees, the opening of corporate bank accounts, and the designation and change of corporate officers authorized as signatories. Additional matters include corporate borrowing, entering into certain kinds of contracts, adopting pension and employee benefit plans, declaring dividends or redeeming shares, amending the bylaws, actions that require a shareholder vote, and issuing and selling shares of the company’s stock or granting options to purchase additional shares.
Failure to observe appropriate formalities in conducting the business of the corporation may lead to the imposition of personal liability where the financial affairs and accounts of the corporation and those of the individuals who control it are confused to the prejudice of creditors, or where there has been an undue diversion of corporate funds or other assets to individual use. In other words, the owners of a corporation may be held personally liable when they fail to observe appropriate corporate formalities, treat the assets of the corporation as their own, and add or withdraw capital from the corporation at will. Whether the company is small or large, it is important to scrupulously keep the corporation’s money separate from the personal funds of shareholders, directors, or employees. A commingling of funds is often seized upon by persons suing a corporation as a reason to disregard the corporate entity, thus enabling the litigants to sue the shareholders for the corporation’s debts.
Legal requirements, such as annual state filings, payment of annual fees, filing of tax returns, and payment of state and federal taxes, are also required to remain in good standing and keep the shield intact.
All of the same is true with regard to limited liability companies, except that LLCs are statutorily relieved from the governance formalities imposed on corporations. However, many LLCs adopt operating agreements with fairly complex governance provisions, which, if adopted, should be observed, and the owners of LLCs are well advised to keep records of member and/or manager decision making, if not to maintain the integrity of the shield, then to protect themselves against possible misinterpretation or failures of memory and mood (the three Ms) with regard to such actions.
It is recommended that counsel give each new corporation or LLC some guidelines for operating as an LLC or corporation, such as those in the “First Correspondence to a Newly Formed Corporation” from Chapter 6 of this author’s book, Advising the Small Business, published by the American Bar Association. It is also suggested that the attorney help with the client’s corporate or LLC recordkeeping and other compliance where possible, or at least provide periodic reminders of formalities and compliance tasks to be completed.