Corporate Formalities: A Necessary Long Game

A common pitfall of many entrepreneurs and startups is a failure to adhere to even minimal corporate “formalities” or good governance practices that can contribute to their long-term upside (positively or negatively). Corporate formalities entail things like entity formation, taking minutes at meetings, keeping reasonably detailed and up-to-date records, and the like. 

For entrepreneurs, the most important place to start is choosing the appropriate type of business entity and filing the necessary documents to legally form that entity with the appropriate state authority.

Choosing the right entity type is an important first step that should not be glossed over as there are many financial planning and tax considerations with varying consequences in addition to the legal considerations, all of which depend upon the type of entity chosen. For some background guidance on entity formation check out our FAQ for entrepreneurs here. 

There are often public websites maintained by the state of organization that provide information regarding forming and maintaining a business entity. The information available on those websites often includes general guidance on starting a business as well as direction regarding registration and filing requirements, sample forms and a list of fees associated with filing them, and routine reporting and renewal requirements for each possible type of entity (corporation, limited liability company, partnership, etc.).

Depending on the terminology used in the state of formation and the type of entity, a company’s formation and governance documents can include (1) the articles or certificate of incorporation/formation/organization; (2) corporate bylaws; (3) an operating or limited liability company agreement; and (4) a shareholder or stockholder (buy/sell) agreement. Many times in the early stages, founders will bypass formalizing these documents on the grounds that they have ultimate authority over the company as its founder(s); however, good corporate hygiene includes adopting these (although a much shorter, simpler version of the applicable document(s) are needed). Along with maintaining a separate list or register of all equityholders, directors or managers, and officers, including up-to-date contact information for each and a record of the company’s ownership, some other relatively simple, but necessary, good governance practices include:

• obtaining a federal employer identification number from the IRS when a company is formed;
• establishing a separate bank account for an entity as soon as it’s formed and contributing enough capital to ensure that the entity isn’t woefully undercapitalized (for corporate veil piercing purposes, see below);
• setting up and maintaining separate books and records of accounts for a company from the start;
• following any formal requirements in the entity’s governing documents (e.g., holding an annual meeting);
• adopting and executing amendments to such documents as necessary to reflect any changes in its actual governance practices (e.g., switching a limited liability company from member-managed to manager- or board-managed); 
• ensuring managers, directors, and officers (as applicable) sign all contracts, agreements, and other instruments for an entity in their designated capacity on behalf of the entity rather than in their individual capacity or in their capacity as an equityholder;
• keeping minutes of any formal meetings and a record of any votes taken in connection with a significant action at a meeting;
• executing written consents to document and evidence the approval of any significant action where such action is approved without a formal meeting;
• documenting all elections, resignations, removals, and vacancies filled with respect to a company’s management either in meeting minutes or with a written consent in lieu of a formal meeting, as applicable; and
• keeping track of and timely making and paying any annual or other recurring filing, registration, reporting, or fee required to keep a company in good standing in its state of formation and any other state in which the company is registered to do business.

Now, why should you care about all these seemingly administrative procedures? For the long game: (1) maintaining the effectiveness of the liability shield provided to equityholders/officers/directors in a legal entity; (2) priming the company for a capital raise; and (3) making the company more attractive to prospective buyers.

In the event of litigation against a company, absent fraud or other willful misconduct, the source of the aggrieved party’s potential recovery is generally limited to the company’s assets; the personal assets of an entity’s equityholders are shielded from the risks of litigation against the entity; provided, that, among other things, the entity has generally maintained the corporate formalities necessary to distinguish it as a legal entity separate from its equityholders. If an entity has failed to observe the corporate formalities, then it’s possible that a third party could successfully argue that the entity is merely an extension of the equityholders (or board or officers) and seek recovery against the equityholders personally by “piercing the corporate veil”.

Serious investors in a capital raising campaign are not only going to want to dig into an entity’s financial records, they’re also going to want to see its governance and other documentation, including a comprehensive capitalization and transfer history, and evidence that the entity’s books and records accurately, and in reasonable detail, reflect the transactions, assets, liabilities, and results of its operations. Following the corporate governance practices outlined above from inception ensures that you will be able to respond quickly and effectively to an investor’s requests for information, thereby expediting the due diligence process and potentially shortening the overall amount of time between engaging with a potential investor and receiving a decision on funding. It also decreases the likelihood of an investor declining to provide funding for a non-financially motivated reason.

Like capital investors, prospective buyers conduct a thorough review of all aspects of a company; however, a prospective buyer places an even greater emphasis on capitalization and corporate governance practices. In an equity sale, a prospective buyer is ultimately going to inherit a company’s entire corporate history, including any potential liabilities or shortcomings (perceived or actual). If a prospective buyer deems the risk associated with a potential equity sale to be too great, they may simply walk away from a deal altogether or they may either (a) instead propose an asset sale or (b) reduce the sale price to account for the potential risks identified. Maintaining good corporate governance practices from inception increases transparency and provides a more clearly defined risk profile for the entity in the due diligence process, thereby making it more attractive to a prospective buyer.

In summation, forming a legal entity for a business and implementing good corporate governance practices from the start helps mitigate liability and maximize marketability.