The Shadow CEO is an ongoing series with tips for entrepreneurs from serial founder and high-tech industry veteran Dennis Cagan, who has served on sixty-seven for-profit corporate boards, including ten publicly traded companies.

Many first, second, and even third-time founders get themselves into bad situations that could be avoided if they knew more about how corporate governance and equity distribution worked in early-stage companies.

Whether you hope to eventually sell your start-up to a larger firm or navigate through an IPO, if you plan on taking in investors—friends and family, angels, venture capital, or strategic corporate investors—you need to understand how to protect yourself and your management team.

The segments in this ongoing series can not only save you time and energy, but they could result in making—or saving—you millions of dollars.

What are foundational documents?

Whether a company is initially incorporated by an attorney or the entrepreneur online, the foundational documents have critical, long-term importance. Often, poorly conceived examples must be amended—sometimes more than once, to accommodate some unforeseen situation. If this only requires a resolution, that may not be a big problem. But if the document requires filing with the SEC, IRS, or State Secretary, or the company has enough shareholders that a shareholder vote is required, it can often become complicated.

Certificate of Incorporation

The initial document filed to incorporate is a Certificate of Incorporation, or Certificate of Formation, or sometimes called Articles of Incorporation (“COI”). Different states, and even different attorneys, use different terms. There also may be differences between a Corporation (sometimes called a C corporation) and an LLC (limited liability corporation). This document is filed with the Secretary of State of the state in which a company is formed. This need not be the state in which the company is actually located. There can be many factors in selecting the best state. These include convenience, cost, taxes, regulatory burden, case law, and more.

Usually, entrepreneurs do not know why they choose a particular corporate structure. While taxes and fees can often drive the choice, in my experience it should boil down to the longer-term objectives of the company. If the goal is to create a large enterprise, to do business nationally, and to raise outside capital—particularly from individuals living outside your state or institutional investors, then typically the States of Delaware or Nevada are the leading choices. Taxes and fees are reasonable, but the solid body of established and universally understood corporate case law tends to make everyone more comfortable. Many people will advise simply incorporating in the state where the business is located. This is fine if the long-term aspirations of the company do not extend outside of that state, and a company can always be reincorporated in another state later.

At minimum, a COI requires the name of the company, the address of a registered company office in the state (almost always outsourced for a small fee if the company is not located in the state of incorporation), the purpose of the company, the name, and address of the person incorporating the company, and the number of shares initially authorized, and the par (or starting/current) value of the shares. Documents containing only this minimum information almost always require amending and restating (additional filing) down the road.

Additional items, that can and often should be included, are a reference to the board (perhaps naming the initial directors) and its authority, reference to the company bylaws (putting most required company authorizations in the bylaws is good practice), indemnification of directors and officers, certain voting requirements, and depending on certain longer-term objectives, reference to multiple classes of stock. If the company intends to raise meaningful capital down the road, I will often suggest an authorization of both common and preferred shares, and a ‘blank check provision’ which allows the future creation of multiple classes of stock and their unique terms by to board of directors.

Bylaws

The second important document is the company bylaws. The bylaws are the core governance processes and guidelines of a corporation. They determine how the corporation runs on a day-to-day basis.

Here is a simple way to remember the differences between the bylaws and the certificate: If you think of a corporation as a picture with a frame, the frame represents the certificate of incorporation and the picture represents the bylaws. So the certificate of incorporation sets the framework for the corporation, while the bylaws are the actual picture of what happens and how it happens.

Bylaws are private documents that are not filed with any government agency, while the certificate of incorporation is a public one that must be filed with the state agency where the corporation becomes incorporated (e.g., with the state’s secretary of state). As such, certificates of incorporation cost a small fee to file or re-file (amend) with the state, while the bylaws may be amended by the board and/or shareholders at any time with no regulatory fees (assuming you do not pay a lawyer to create them for you).

While most incorporators use off-the-shelf boilerplate COIs and bylaws, this is not the best practice. The more inclusive they are of protections and controls, the better. Years later, when facing a crisis or opportunity—like being taken over by an outside majority investor or selling the company—it is often too late to make key changes to the foundational document that allow you to proactively deal with the situation. The COI and bylaws both provide a wide variety of details on the parameters for operating the company. However, they should allow for a great deal of latitude in many of the specifics. For example, the bylaws might set the size of the board as up to seven without setting the specific initial number or electing them; or it might set out definitions of several executive positions that are not initially occupied; or it will define the specifics of board meetings and shareholder meetings, but not actually set any.

Organizational consent

The third key incorporation document is the Organizational Written Consent (“Organizational Consent”). This instrument is the beginning of a line of documents that will be produced over the life of the company. It details specific actions that the board wishes to take on day one, as the company begins operations.

These directions can include the election of board members, the appointment of officers, instructions to establish an office or a bank account, and much more. This overall collection of all these subsequent items includes the minutes from meetings of the board, shareholders meetings, board committee meetings, etc. They serve as a record of the decisions, rulings, and directions of the board pertaining to the ongoing operation of the firm, and the working instructions to the company management.

Written Consents are internal documents that are also often used by directors in a corporation, or members or managers in a limited liability company (LLC), to grant consent to a decision or action, in writing. If these actions take place in an actual meeting of the board of directors, they are usually termed resolutions. An official written consent is typically used when no actual meeting takes the place in order to record a final decision, in lieu of meeting minutes including resolutions.

While it is important to record various discussions, it is not required that this be noted in a great deal of detail in the minutes. However, a key aspect of governance is the accumulating collection of resolutions. These are specific and mandatory decisions and instructions to management. Again, resolutions made and voted on in a meeting would be recorded in the minutes. Resolutions made without a specific meeting would be written consents.

Note: The information provided in this article does not, and is not intended to, constitute legal or tax advice; instead, all information, content, and materials available below are for general informational purposes only.  Information in this article may not constitute the most up-to-date legal, tax, or other information. Readers should contact their attorney or CPA to obtain advice with respect to any particular matter. The views expressed here are those of the author writing in his individual capacity only.

MORE SHADOW CEO

PART 1: Early-Stage Insights for Entrepreneurs

PART 2: Deciding to Distribute Startup Equity? Here’s a Founder’s Guide

PART 3: Using Equity as an Incentive and the Role of the Board

PART 4: What Entrepreneurs Need to Know About the Foundational Documents of a Corporation

PART 5: Equity Distribution Techniques

PART 6: Equity Beyond Stock Options

PART 7: Stock Classes and Raising Capital

PART 8: Determining Startup Value

PART 9: Explaining Common Metrics

PART 10: Calculating Share Price

PART 11: Protecting Founders and Special Voting Preferences

PART 12: Additional Equity Grants

About the author:

Dennis Cagan, a noted high-tech entrepreneur, executive, and board director, has founded or co-founded more than a dozen companies and served as CEO of both public and private companies. The venture capitalist, private investor, author, and consultant, is a long-time board member of some 67 corporate fiduciary boards. In his Shadow CEO® role, he steps in side-by-side with a CEO to help them navigate circumstances and situations on a day-to-day basis.

A version of this column was previously published in Cagan’s “A Primer on Early-Stage Company Equity.”

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