Forming a Corporation: Legal Documents You Can’t Do Without – Part 2

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In our last article, we discussed the formative documents that all startups must have. Our intent now is to provide some suggestions as to their substance.

In getting your corporation up and running, you’ll want to create restrictions on the freedom of shareholders to dispose of their shares in the company. You can control the valuation of the shares, for instance, by drafting it into the shareholders’ agreement. This can be important because a potential shareholder might be willing to pay considerably more per share for 51% of the company than she would for a corresponding 10% of that same entity because majority ownership provides that individual with much greater control of the corporation’s actions.

It’s important also to regulate raising new capital to avoid diluting the power of existing shareholders. This can involve creating what are known as preemption rights for shareholders.

For example, XYZ Corporation has a total of 100 shares. One shareholder owns 10%, and another shareholder owns 60%. Depending on the corporate documents, the holder of 60%, as a majority stakeholder, could decide unilaterally to create and sell another, second 100 shares, causing the 10% shareholder’s stake in the company, as well as his voting ability, (should minority shareholders be permitted voting rights), to suddenly drop to 5%. To prevent this, you can create preemptive rights, that would allow the minority shareholder to purchase the number of those new shares according to his current percentage. In this case, he would have a preemptive right to purchase ten of those newly offered 100 shares, allowing him to retain his 10% of the corporation overall.

Something else to consider is creating a set of express limitations on the freedom of the actions of the board of directors. Normally a board for a small company might consist of just four or five directors while there may be over 100 shareholders. Board’s are fiduciaries and tasked with maintaining the financial accountability of the company, but as almost everyone has witnessed, this is not always the case. You can assist in preventing potentially devastating shareholder lawsuits by controlling the directors’ freedom of action in writing.

To this end, it may be a preferred option, too, on a very basic level, place the corporation’s business plan into the shareholders’ agreement. Sometimes setting out the business plan in this document can help to ensure that all of the shareholders have the same vision. Even if it is a very general statement, this sometimes assists in creating a degree of transparency from the outset.

Remember, when developing a corporation, you need to keep all of these factors in mind from the start, and you will likely need an attorney experienced in startups to guide you in assuring that all the corporate documents are drafted in order to adequately protect you and all the shareholders.  

To learn more, contact me here.

Aaron Pierce
(212) 882-1752
299 Broadway, Suite 1405
New York, NY 10007

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