Now that I am founding a company, what are the minimal documents I need to establish a corporation? My answer on that question is, my typical response, it depends. Now let us start why appropriate paperwork for that company is required. Whether the company is undergoing due diligence by an investment bank for an IPO or for a Series A funding by a VC fund, two service provider groups always execute the due diligence – a law firm and an accounting firm. The law firm will look and confirm whether a company has been registered, whether the corporate records have been maintained, and whether any ancillary, executory documents are in order and legally enforceable. And so does the accounting firm.
Let us go to square one – creating the corporation. There are two groups – C Corporation or the LLC. I am focusing only on the C corp. Also, for the basis of this blog, we will assume that the management team and operation are in California. We can establish the company in California. Automatically you follow up with filing for a federal tax id number, EIN, and the California equivalent in order to pay salaries and file for income taxes. What you pay then are fees only to the state of California.
But many companies incorporate in Delaware – as noted in an earlier blog. Now your filing expenses go up. Since we assumed California operations, we first register with Delaware, then California, but we must also pay for an agent to represent the company in the State of Delaware in addition to the filing fee. These are separate fees. Why? Since the company has no physical presence, the State of Delaware requires that the company appoint an agent in case of a lawsuit being filed in the state. We don’t stop there. Now, the company operates in California and is a “foreign” corporation. The company must register with California as a foreign entity and obtain its registration number with the state of California. So every year, the company must pay franchise tax fees for two states, not one had it only incorporated in the State of California. As CLO, I had to handle over 30 companies registered in over 30 states on an annual basis. The yearend administration can be challenging.
Next, we being to prepare the corporate book. Besides the Articles of Incorporation or similar document, we begin to put together the Bylaws, first meetings for Shareholders and Directors that begin to set up management teams, bank account, and adoption and distribution of shares. With the book, you need to have a seal and share certificates. We insert the approval by the state. Depending on the law firm, it can cost about $2,000 besides the filing fees. I have seen the incorporation pricing for less.
For many companies, we can stop there. However, many startups are looking for formal advisors and begin to set up stock incentive programs. Some look to hire senior managers and lock them up with an employment agreement that has restrictive stock. For these considerations, we now have to add various other corporate documents: a formal Incentive Stock Option program (“ISO”) with formal director meetings. Advisory agreements should set up some metrics so that the company can get a real benefit from the advisor on an annual basis. Then reward that advisor with stock incentives. By formally adding such agreement and internal board approval charter, now you have something to show investors that the advisor not only adds a name but a monthly valid contribution to the company.
I also discuss in a previous blog on ISO and how it creates an incentive for employees. These are complex but important documents with long term tax implications. I normally add these documents for companies attempting to achieve fast growth. But to add these documents legally, one begins to add several thousand dollars to the cost of establishing the company – anywhere from $3k to $5k more – but they are costs that will happen on a Series A financing since VC funds expect an ISO as part of the company infrastructure. In other words, sooner or later someone has to bite that bullet.
Another document I have drafted or seen for early startups is the Shareholder Agreement. Generally, the purpose of this document is to protect the founding shareholders in the event “sh*t hits the fan” among the founding shareholders. Whether a founding partner leaves or that founding partner divorces a spouse or similar departing conditions, the company has the first option to buy back those shares at FMV. Frankly, if that event occurs, I sincerely believe that company might not survive anyway. And I have yet to see the company voluntarily buy back those shares. Generally, I don’t insist that document unless there are multiple founders and possibility of that event is more likely on account of the larger number of founders. I have seen complex versions of these agreements with obfuscating legal verbiage — however, they all tend to achieve the same objective, to provide the company or the other founding shareholders an opportunity to buy back the shares.
As a summary, I wanted to describe what are the due diligence documents that outside counsel will look for. Not having those documents will raise a red flag to the investor that something is wrong. And since I have established international entities, the level of details and complexity can explode. Even the simple documents require details. Yet, remember what I have stated earlier – investors look for reasons to say “no”. And you don’t want to be “pennies wise but pounds foolish” by attempting to cut corners and not getting the appropriate formation documentation.