Organizational Structures & Management Mindsets

You can sell an ownership interest in the following three basic types of organizational structures: a partnership, an LLC (limited liability company), or a corporation. In a partnership (general or limited), you can sell general or limited partnership interests. In an LLC, you can sell membership interests and other securities, such as; notes, bonds, or hybrid securities like: royalty financing contracts; convertible preferred membership interests; or convertible notes/bonds. However, if you want to add hybrid securities to your firm’s capitalization structure, in order to specifically permit the type and amount of securities to be authorized, you may need to amend both your Operating Agreement—internally and or the Articles of Organization with the state.  In a corporation, you can sell common stock and other securities, such as; notes, bonds, or hybrid securities like: royalty financing contracts; convertible preferred stock; or convertible notes/bonds. However, if you want to add hybrid securities to your firm’s capitalization structure, in order to specifically permit the type and amount of securities to be authorized, you may need to amend your By-laws—internally and or the Articles of Incorporation with the state.

 

Corporations

 

With corporations, there are two basic types of corporate tax structures. S Corp.s have an “S election” tax status (No corp. tax— single taxation pass-through to shareholders). C Corp.s have a “C election” or a full-corporate tax status. If you choose a corporation to use as the legal entity to build your company, to avoid unnecessary double taxation (corp. tax and tax on distributions to shareholders) of a C corporation, we suggest filing as an S election corporate tax structure at the beginning of a company’s existence. Attempting to change a C corporation into an S corporation at any stage, is a daunting task and it may not work for any one of the various reasons to follow.

 

Corp. Limitations

 

Number of Shareholders. S corporations cannot have more than 100 shareholders. Make sure there are no more than one hundred shareholders. Otherwise, your Company will not qualify for the non-taxable status of an S corporation. C corporations cannot have more than 2,000 shareholders and remain privately held. The C corporation becomes an SEC reporting company when the shareholder number is over 2,000 whether it’s publicly traded or not.

 

Types of Shares. Technically, an S corporation can only issue one class of stock—disregarding differences in voting rights, to maintain it “S” election tax status. Hence, for all practical purposes, in order to maintain the single taxation status, an S corporation is only allowed two classes of stock—Class A voting common stock and Class B non-voting common stock. If your Company issues any other type of equity security or a security convertible into equity, it will lose its non-taxable S corporation status. Thus, most S corporations will choose Class A voting or Class B non-voting common stock, notes, bonds, or royalty-financing contracts. If you wish to maintain your Company’s “S” election tax status, do not sell preferred stock or convertible securities— including warrants, rights, options, convertible notes, and subordinated debentures—as they constitute a third class of stock or equity.

 

Types of Shareholders. Only individuals and qualified S trusts can own Class A and B common-stock shares in an S corporation. You can sell royalty-financing contracts, notes, or bonds of an S corporation to any entity, though because it’s not equity. If any other entity, such as an LLC or other corporation (e.g., S or C corporations), purchases common stock (class A or B) in your S corporation then the corporation will automatically become a C corporation. In addition, S corporations’ securities cannot be held in qualified retirement accounts such as IRAs, SEPs, Keogh plans, etc.

 

Process.

 

If you have not already done so, or if you have not yet incorporated a company yourself in the past, you may want to hire an attorney to incorporate your business. If your Company is a start-up, we suggest you complete the following:

 

  • Have your attorney file your Company’s articles of incorporation with the state you have chosen to incorporate in.
  • When the state sends back a “filed date” copy of your articles of incorporation, get a copy of Form SS-4 from your accountant.
  • In the early stages of a corporation, you must file Form SS-4—Application for Employer Identification Number—with the IRS, per those instructions.
  • After you receive your employer identification number from the IRS, it is wise to file Form 2553—Election by a Small Business Corporation—for S corporation tax status with the IRS (there are time limits on these various procedures, so be aware that this process is time sensitive).

 

You will also need to register for a state tax number with your state’s Department of Treasury. Most states adopt the IRS’s tax ID number assigned to your Company. There is no federal corporate income tax on S corporations.

 

If you elect to conduct a preferred-stock offering, you will need to form a C corporation. If you plan on growing your Company very quickly and are planning to conduct an initial public offering (IPO) soon, it is best to form a C corporation (LLCs cannot currently trade in the public markets). To establish a C corporation, simply do not file a Form 2553 with the IRS. An S corporation will automatically become a C corporation once a security is issued that constitutes a third class of stock (or equity) or when you exceed the “one-hundred-shareholder limit,” according to the IRC 26 US Code Rule 1361. Incidentally, the one-hundred-shareholder limit may change from time to time, so be sure to check the current rules with your accountant or attorney.

 

Although attorneys and CPAs generally suggest setting up an LLC for most new small businesses (and we agree), that may change if you plan to grow your Company quickly if you choose to go public (through either an IPO or a reverse merger into a public shell) within five years. There is value in setting up your organization as an LLC, partnership, or S corporation due to the distribution of losses, which “pass through” to the individual investors. You will need to discuss this strategy with your accountant. However, when producing pro forma financial projections we suggest one budget for paying federal and state tax, not to be paid directly to those government bodies, but as distributions to shareholders because the LLC or S Corp. will create a “pass through” tax obligation when it produces a profit. It’s wise to account for the tax distribution to shareholders, not only so that cash flow figures are correctly reflected, as if one is paying them directly to the government, but to keep shareholders happy.

 

Limited Liability Companies (LLCs)

 

It used to be easier to attract capital by selling shares in a corporation than by selling membership interests in an LLC or partnership interests in a limited partnership, because the term “membership interest” may remind most investors of the term “limited partnership interests” that  imploded in the late 1980s. The large stock-brokerage firms in the mid-1980s to the late 1990s sold vast amounts of limited-partnership interests. Some of those limited partnerships were grossly mismanaged—in some cases, fraud was committed. Bankruptcies were declared, and investors lost fortunes. As a result, the term “membership interests” was closely associated with the term “limited-partnership interests,” which was associated with that situation. One way to circumvent that old issue is to amend your LLC’s Operating Agreement to substitute the term “membership interests” to “Units.” (See LLC Operating Agreement Templates in the Corporate Engineering Conservatory™ for examples.) And then define the number of Units authorized, like authorized shares in a corporation. This one change should allow you to avoid the need for any explanation or confusion of actual equity ownership and voting control. As you’ll soon discover, the LLC as an entity has evolved since the mid-1990s and is now one the very best entities for a start-up or early stage company to be organized as, legally.

 

For your information, most LLCs differ in form from a corporation because they are technically partnerships, managed either by managers or by members (limited partnerships are managed by the general partner, and general partnerships are managed by the general manager). In addition, an LLC differs because of its limited ability—as determined by the state—what type of securities it can issue. In general, if the LLC is managed by managers, the majority of members must vote for the manager(s) according to the LLC’s Operating Agreement. Operating Agreements can allow each member to have one vote per member, or many votes based on their capital contribution to the LLC. If a member has one vote, irrespective of that member’s capital contribution, it will differ substantially from the organizational structure of a corporation. Corporations must allow one vote per share of its Class A, voting, common stock; therefore, those investors who contribute the most amount of capital technically have more voting control over the corporation. It is extremely difficult to raise capital for LLCs that do not allow voting control to be established by the majority of those who contributed the capital. Thus, we strongly suggest that if you have yet to establish an LLC, ensure the LLC’s Operating Agreement allows for a majority of ownership interest to control the Company. And as just mentioned substitute the term “membership interests” to “units” and define the number of Units authorized, like authorized shares in a corporation. For instance, 1,000,000 membership units authorized—as opposed to percentage units.

 

However, only do this with a Regulation D offering. If your LLC or Partnership will be filing for a Regulation A or A+ offering at the federal level, registering for a SCOR at the state level, or registering for a CA 1001 or 25102(n) at the state level for California companies only, use the term “membership interest” or “partnership interest”—regulators may not understand what you are trying to convey with the term that is foreign to the entity.

 

If you already have an LLC that allows each member to have one vote per member—irrespective of that member’s capital contribution to the LLC—we suggest you amend the LLC’s Operating Agreement to reflect that the ownership control is constituted by a majority of ownership percentage interest in the Company. In addition, some LLCs are managed by its members, which are like Class A, voting, common-stock shareholders in a corporation. If you will have many members—e.g., more than five or seven…after the sale of securities—consider amending the LLC’s Operating Agreement to allow the Company to be managed by managers as opposed to the members, because you do not want “too many cooks in the kitchen.”

 

Corporations are controlled by Officers elected by its Board of Directors who are, in turn, elected by a majority vote of its Class A, voting, common-stock shareholders. That is why LLCs should be set up—through the Operating Agreement—to be controlled by capital-contribution-percentage-based managers elected by members.

 

The following terminology is still important for you to understand:

 

  • Corporations have “Articles of Incorporation.”
  • Limited Liability Companies have “Articles of Organization.”

 

  • Corporations have “By-laws.”
  • Limited Liability Companies have an “Operating Agreement.”

 

  • Corporations have “Officers & Directors.”
  • Limited Liability Companies have “Managers, Managing Directors and or Managing Members”

 

  • Corporations have “Shareholders (who own shares of stock).”
  • Limited Liability Companies have “Members (who own Ownership Interests).”

 

  • Corporations have unlimited life spans.
  • Limited Liability Companies, like Partnerships, may have a pre-determined life span according to the Articles of Organization as mandated by the state of organization and or Operating Agreement.

 

  • Limited Liability Companies have Admissions Agreements, like Partnerships, which have Partnership Agreements.

 

  • Corporations, Limited Liability Companies and Partnerships have “Subscription Agreements” for the purchase of securities. We have built the Admissions Agreements directly into the Subscription Agreements in our templates for your use.

 

 

Please remember, the threshold for automatically becoming an SEC-reporting company (with all its mandatory burdens of compliance—i.e., annual & quarterly audited financial statements, pre-filings for insider buys and sales, compliance with Sarbanes-Oxley, etc.) is limited to 2,000 investors, not counting investors acquired during a crowdfunding effort under Section 4(a)(6)—“Regulation Crowdfunding,” whether your Company is publicly traded or not. Therefore, you may have up to 2,000 investors (plus the number acquired under Section 4(a)(6) Regulation Crowdfunding) in any type of organizational structure without the need to become an SEC-reporting company. SEC-reporting companies have an additional blanket of compliance and regulatory responsibility, which includes the need to produce and report through the quarterly, audited financial statements. This is not a bad thing rather another expensive, ongoing process. Thus, if you have more than 2,000 investors, just understand what it entails and be prepared to deal with it.

 

 

Fiduciary Duty

 

There are various districts of authority when it comes to definitions of fiduciary duty of officers and directors of corporations. Suffice it to say that if one exercises stringent corporate governance and protocols with the review and approval of legal counsel, one can avoid breaches of fiduciary duty. Why is maintenance of fiduciary duty a concern? Breaching corporate fiduciary duty to shareholders by officers and directors can pierce the limited liability protection afforded by the corporation or the LLC, as an entity of personal protection, thereby making the assets of each officer and or director subject to attachment, joint and several, in the event of a lawsuit, bankruptcy or court ordered liquidation to satisfy damages. That’s right… your personal assets can be taken from you to satisfy a lawsuit or bankruptcy.

“In discussing corporate fiduciary duties, it is very helpful to refer to the corporate law of Delaware. More than half of publicly traded companies are incorporated in Delaware.  Nonetheless, corporations incorporated in other states may be bound by different rules and obligations.  Consult Table of Statutes for statutes in specific jurisdictions.

Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests.  A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but to refrain from doing anything that would [cause] work injury to the corporation, or to deprive it of profit or advantage which [said corporate officer or director’s] skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its power.”

Directors of corporations, in fulfilling their managerial responsibilities, are charged with certain fiduciary duties.  The primary duties are the duty of care and the duty of loyalty.

A.     Duty of Care: This duty requires that directors inform themselves “prior to making a business decision, of all material information reasonably available to them.”  Whether the directors were informed of all material information depends on the quality of the information, the advice available, and whether the directors had “sufficient opportunity to acquire knowledge concerning the problem before action.”  Moreover, a director may not simply accept the information presented.  Rather, the director must assess the information with a “critical eye,” so as to protect the interests of the corporations and its stockholders.

B.     Duty of Loyalty: As the Delaware Supreme Court explained in Guth v. Loft, 5 A.2d 503, 510 (Del. 1939): “Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. . . . A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but to refrain from doing anything that would [cause] work injury to the corporation, or to deprive it of profit or advantage which [said corporate officer or director’s] skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its power.”

Additionally, courts have imposed the following duties:

  • Duty of Good Faith: Requiring the director to advance interests of the corporation, not violate the law, and fulfill his or her duties.  For a thorough discussion of this duty, see In re The Walt Disney Co. Derivative Litig., 906 A.2d 27 (Del. 2006).
  • Duty of Confidentiality: Required directors to keep corporate information confidential and not disclose it for their own benefit.  Consult Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939) for more information.
  • Duty of Prudence: Requires a trustee to administer a trust with a degree of care, skill, and caution that a prudent trustee would exercise.  Consult Amgen Inc. v. Harris, 136 S. Ct. 758 (2016) for more information.
  • Duty of Disclosure: This duty requires directors to act with “complete candor.”  In certain circumstances, this requires the directors to disclose to the stockholdersall of the facts and circumstancesrelevant to the directors’ decision.

These duties do not mean, however, that the court will always impose its own review over directors’ decisions.  Under the “ business judgment rule” the court presumes “that in making a business decision the directors of a corporation acted in an informed basis,
in good faith and in the honest belief that the actions taken was in the bests interests of the company.
”  Under this rule, courts will generally refrain from questioning the directors’ judgment so long as their judgment can be attributed to some rational corporate purpose.

For a very thorough discussion of corporate officers’ fiduciary duties, consult ‘William M. Lafferty, Lisa A. Schmidt, & Donald J. Wolfe, Jr., A Brief Introduction to the Fiduciary Duties of Directors Under Delaware Law, 116 Penn. St. L. Rev. 837 (2012).'[1]

Do Not Serve Two or More Masters.

The single biggest mistake an entrepreneur can make in this area is creating and managing more than one (1) corporation, joint venture or LLC. Many times we see entrepreneurs attempting to set up and run different entities for perceived liability protection. These strategies actually damage, if not completely negate, their ability to protect against personal liabilities arising out of running a business. If you serve two or more entities, it’s almost impossible not to breach your fiduciary duty to shareholders of either entity. We suggest, you build only one entity (corp. or LLC) and set up either operating divisions or wholly owned and controlled or partially owned but fully controlled subsidiaries—if necessary to avoid a breach of fiduciary duty.

We know this may seem confusing, but laws where written by attorneys for attorneys to maintain a monopoly on the knowledge and process—but that is changing in a very big way with “smart contracts.”

[1] https://www.law.cornell.edu/wex/fiduciary_duty#Corporations and Fiduciary Duty