1. C H A P T E R
Organization and Financial
42
Structure of Corporations
Our business is company
creation.
Ann Winblad, venture
capitalist, quoted in Fortune
magazine (Sellen and
Daniels, Oct. 1999)
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2. Learning Objectives
• Appreciate the risk of liability for
corporate promoters
• Understand the process for
incorporating a business
• Know the appropriate sources for
financing a business
• Explain share-transfer restrictions
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3. Overview
• Each state has enacted laws detailing
how a corporation may be created
• A promoter of a corporation incorporates
the business, organizes initial management
team, and raises initial capital
• A promoter may be the person who
originated the idea for the firm or may be
a professional hired to undertake
incorporation activities
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4. Preincorporation Contracts
• A promoter will be liable for contracts made
during the preincorporation period unless the
corporation adopts the contracts made by
the promoter (adoption) and the third party
agrees to substitute the corporation for the
promoter (novation)
– Like agency ratification, may be express or
implied
– Contracts adopted typically: employment
and real property lease or purchase
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5. SmithStearn Yachts, Inc. v. Gyrographic
• Facts:
– SmithStearn Yachts, Inc., (Smithstearn) a
Delaware corporation providing luxury
yachting services in Connecticut, agreed to
a contract with Gyrographic
Communications, Inc., a California company,
for marketing and promotional services to
SmithStearn
– SmithStearn sued Gyrographic, which argued
that it had made a contract with SmithStearn
Yachts, LLC, not a corporation
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6. SmithStearn Yachts, Inc. v.
Gyrographic Comm., Inc.
• Legal Analysis & Holding:
– A corporation generally is not bound by
contracts entered into on its behalf prior to
its existence, but it can acquire rights and
subject itself to duties for preincorporation
matters
– SmithStearn Yachts, Inc. was formed after
execution of the agreement, but received
benefit of the services pursuant to the
agreement and thus ratified the contract
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7. SmithStearn Yachts, Inc. v.
Gyrographic Comm., Inc.
• Legal Analysis & Holding:
– Gyrographic developedg letterheads,
business cards, and other marketing material
for SmithStearn Yachts, Inc., and SmithStearn
Yachts, Inc. made payments to Gyrographic
– SmithStearn Yachts, Inc. is a proper party
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8. Share Subscriptions
• Preincorporation share subscriptions are
contracts in which a prospective
shareholder offers to buy a specific
number of shares in a new corporation
at a stated price
• Under the
Model Business Corporation Act
(MBCA), a prospective shareholder
may not revoke a preincorporation
subscription for a six-month period
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9. Promoter Duties
• A promoter is not an agent of the
proposed corporation or investors since
they did not appoint the promoter, but
a promoter owes a fiduciary duty to
the corporation and to its prospective
investors
– No self-dealing, duty of loyalty, etc.
• A corporation may compensate a
promoter with shares
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10. Incorporation
• A U.S. business may incorporate in any state
• Fees, taxes, and laws vary from state to state
– See, e.g., Texas corporations section:
• www.sos.state.tx.us/corp/index.shtml
Stock Certificate
of a Texas
Corporation
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11. Steps in Incorporation
1. Prepare articles of incorporation
2. Sign and authenticate articles by one or
more incorporators
3. File articles with secretary of state, pay fees
4. Receive copy of articles of incorporation
stamped “Filed” by secretary of state,
along with fee receipt
5. Hold organizational meeting for purpose of
adopting bylaws, electing officers, and
transacting other business
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12. Incorporation Details
• The articles of incorporation (or charter)
is the basic document stating the rights
and responsibilities of a corporation, its
management, and its shareholders
– Must add extension to name indicating
corporate form: Inc., Corp., Co., Ltd.
– Must include other specifics, such as number of
shares authorized, initial registered office and
agent’s name, name and address of each
incorporator
– See Fig. 1
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13. Incorporation Details
• Other provisions (not inconsistent with
law) may be added to articles of
incorporation or included within
corporate bylaws
– See Fig. 2
• To retain corporate status, a corporation
must file an annual report with secretary
of state of the state of incorporation
and pay an annual franchise fee or tax
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14. Defective Incorporation
• Sometimes, an attempt to incorporate
fails
– One consequence is that the corporate
shield does not exist to protect shareholders,
officers, and directors from personal liability
– Another possibility is that a party to a
contract involving a defective corporation
may claim nonexistence of the corporation
to avoid a contract made in the name of
the corporation
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15. De Jure Corporation
• De jure corporation: exists when
promoters and incorporators substantially
comply with each mandatory (shall, must)
requirement to incorporate the business
• The validity of a de jure (by law)
corporation cannot be attacked except
by the state of incorporation due to
noncompliance with state corporation
laws
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16. De Facto Corporation
• De facto corporation: exists when
promoters fail to comply with all of the
mandatory requirements, yet comply
with most of the mandatory provisions
• Validity of a de facto corporation could
be attacked by a third party, or itself, or
the state of incorporation, but may be
treated by as a corporation under the
judicial doctrine of corporation by
estoppel
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17. The MBCA
• Under the MBCA, filing the articles of
incorporation is conclusive proof that the
corporation exists
• MBCA imposes joint and several liability
for a purported corporation’s contracts
and torts on managers and shareholders
who both (1) participate in operational
decisions of the business and (2) know
the corporation does not exist
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18. Christmas Lumber Co., Inc. v. Valiga
• Facts:
– Contractor (Waddell) and Valiga entered home
construction contract, which fell through
– Contractor had purchased construction
materials from plaintiff (through Graves) and in
1990, plaintiff filed suit against Valiga and
contractor
– 1992: Valiga filed separate suit against Waddell
and Graves, claiming defective incorporation
– Suits consolidated; trial court found Waddell and
Graves liable as partners to Valiga
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19. Christmas Lumber Co., Inc. v. Valiga
• Legal Reasoning & Holding:
– Waddell said he didn’t know incorporation failed
– Evidence: Waddell testified he and Graves were
“partners,” the two entered a joint venture
agreement, and they shared contractor’s fee
– Conclusion: Waddell and Graves were partners
– Judgment for Valiga affirmed
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20. Non-Profit Incorporation
• A non-profit corporation incorporates
in same way as a profit corporation,
but must declare whether it is a:
– public benefit corporation, mutual
benefit corporation, or religious
corporation
• Nonprofit corporation’s articles must
also state whether it will have
members
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21. Financing Corporations
• For-profit corporations are financed by:
– Sale of securities: shares, debentures, bonds,
and long-term notes payable
– Short-term financing (e.g., inventory
financing)
– Bank loans
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22. Equity Securities
• Equity securities, better known as stock or
shares, create an ownership relationship,
thus stockholders or shareholders own a
corporation
• State laws permit corporations to issue
classes of shares with specific rights:
– Common
– Preferred
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23. Common Shareholders
• Claims for dividend payments or asset
distribution on liquidation are subordinate
to creditor or preferred shareholder
claims
• However, common shareholders have
the exclusive right to elect corporate
directors and exclusive claim to
corporate earnings and assets that
exceed the claims of creditors and other
shareholders
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24. Preferred Shareholders
• Preferred shareholders generally receive
liquidation and dividend preferences
over common shareholders
• A corporation may have several classes
of preferred shares with specific rights
related to dividend payments, asset
distribution upon liquidation, voting, stock
redemption, and stock conversion
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25. Share Types
• Authorized shares are shares a
corporation is permitted to issue by its
articles of incorporation
– A corporation may not issue more shares
than authorized
• Issued shares have been sold to
shareholders
• Outstanding shares are currently held
by shareholders
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26. Options, Warrants, & Rights
• A board of directors may issue options for
purchasing the corporation’s shares
– Issued to top-level managers as an incentive
• Warrants are options evidenced by
certificates
• Rights are short-term certificated options
that are usually transferable
– Used to give present security holders an
option to subscribe to more shares
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27. Debt Securities
• Corporations may borrow
money to operate by issuing
debt securities, such as
bonds, debentures, and
notes payable
• Debt securities create a
debtor–creditor relationship
between the corporation
and the security holder
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28. Debt Securities
• Debentures are long-term, unsecured
debt securities with a 10 to 30 years term
– Having an indenture, or a contract stating
the rights of the debenture holder
• Bonds are long-term, secured debt
securities
– Identical to debentures except that bonds
are secured by collateral
• Notes generally have less than a five year
term and may secured or unsecured
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29. Consideration for Shares
• MBCA permits shares to be issued in
return for any tangible or intangible
property or benefit to the corporation,
including cash, promissory notes,
contracts for services to be performed
for the corporation, services
performed for the corporation, and
securities of the corporation or
another corporation
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30. Consideration for Shares
• The board must issue shares for an
adequate dollar amount of
consideration
• Par value is an arbitrary dollar amount
that may be assigned to shares by the
articles of incorporation
– Does not reflect fair market value, but is
the minimum amount of consideration
for which the shares may be issued
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31. Share Subscriptions
• Under the terms of a share subscription,
a prospective shareholder promises to
buy a specific number of shares at a
stated price
– Generally in writing, though not required
• A share certificate may not be issued
to a share subscriber until the share
price has been fully paid
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32. Transfer of Shares
• Share certificates are registered with the
corporation in name of a specific person
• Indorsement of a share certificate on back
by the registered owner and delivery of the
certificate to another person transfers
ownership of the shares
• Under the UCC, a corporation owes a duty
to register transfer of any registered shares,
provided it has proper indorsement
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33. Transferability & Restrictions
• Shares in a publicly held corporation
are freely transferable, but often close
corporations (less than 50 shareholders)
restrict transfer to ensure control
• Four categories of transfer restrictions:
(1) rights of first refusal and option
agreements, (2) buy-and-sell agreements,
(3) consent restraints, and (4) provisions
disqualifying purchasers
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34. Coyle v. Schwartz
• Court enforced a poorly
drafted buy-sell agreement
in which the shareholders
were to agree from time to
time on the price to be paid
for the shares, but failed to
do so
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35. Test Your Knowledge
• True=A, False = B
– A promoter is always liable for contracts
made during the preincorporation period.
– A U.S. business may incorporate in any state.
– A de facto corporation exists when
promoters and incorporators actually
comply with each mandatory requirement
to incorporate
– Warrants are stock options evidenced by
certificates.
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36. Test Your Knowledge
• True=A, False = B
– Preferred shareholders have exclusive
right to elect corporate directors and
the exclusive right to dividend payments.
– For-profit corporations are financed only
by issuing securities in the form of shares.
– The MBCA permits shares to be issued in
return for any tangible or intangible
property or benefit to the corporation.
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37. Test Your Knowledge
• Multiple Choice
– Which of the following is not a debt
security:
a) Stock
b) Bond
c) Debenture
d) Note
e) none of the above
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38. Test Your Knowledge
• Multiple Choice
– The Steel Inc. Board of Directors plans to
issue dividends this year. Which of the
following is false?
a) Preferred shareholders receive their
dividends before common shareholders
b) Creditors receive their dividends before
common shareholders
c) Common shareholders receive their
dividends before either creditors or
preferred shareholders
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39. Thought Question
• Do you believe that
a company’s stock
price reflects a
company’s value or
success in (a) the
marketplace, and
(b) society?
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