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Understanding Corporation Formation

Updated on September 7, 2009

Understanding the Legal and Technical Aspects of Corporations

The laws pertaining to corporations vary from nation to nation and, within the United States, from state to state. Although there is much variation in detail, the main lines of corporate organization and practice are quite similar in most nations. This section delineates the more important aspects of the structure, Organizational relationships, and legal rights and obligations of corporations in the United States.

The three most basic forms of business organization are the proprietorship, the partnership, and the corporation. The single proprietorship is a business owned by one person. The partnership consists of a contractual agreement between two or more persons, which sets forth the amount of capital to be supplied by each partner and defines the general framework of business operation. Typically, the partners, like the proprietors, own and manage the enterprise. These are more "personal" forms of business organization than the corporation. Although they have certain advantages of their own, they lack limited liability for the owners and other corporate advantages. Proprietorships and partnerships are most frequently found in small-scale economic enterprises. Corporate organization, with its impersonal structure, is useful in businesses of all sizes, above the very smallest, though its advantages are most apparent for large-scale enterprises.

Forming a Corporation

To form a corporation, the incorporators first must obtain a charter, which is in effect a contract between a government and a corporation. This charter, which may be modified by the state or federal government, represents a grant of certain powers from the government. It expresses the relationship between the government and the organization. Usually the secretary of state of a state government or a state commissioner of corporations issues the charter under the authority of a general incorporating act.

In the United States the procedure for procuring a charter varies from state to state, although there are a number of requirements common to them all. In each case the incorporators (usually three or more individuals) are required to draw up a petition addressed to the proper official, setting forth the required information about the proposed corporation. Because this petition will become the company charter, it is important that it be carefully worded and it will normally be drawn up by a lawyer. It is customary for the incorporators to seek broad powers for the corporation to provide substantial latitude in its undertakings. Often the only limitation imposed on manufacturing corporations is that they not engage in insurance, banking, or public utilities. In addition to a statement of the objects and power of the corporation, the charter will usually contain the name of the company, the location of its main office, the initial capitalization, the number of shares to be issued, the par value of the shares, the privileges assigned to the various classes of stock, the maximum amount of indebtedness that may be incurred, the officers who are to conduct the business of the corporation and the manner of their selection, the number of the directors and the manner of their election, and the signatures of the individuals requesting the incorporation. The notarized application together with the incorporation fees will go to the proper state official and upon his endorsement the legal life of the corporation begins. Thereafter the corporation must file an annual report with the state in order to facilitate the collection of taxes and the enforcement of legal requirements.

Bylaws

The bylaws are the internal rules of the corporation; they may limit the charter provisions, but they may not extend them. Typically, the bylaws define the internal organization and administration of the company. Essential points they cover include the address of the principal office; the date and place of the annual meeting of stockholders; provisions for meetings of stockholders; the voting powers of the stockholders and the use of the proxy (a power of attorney authorizing some person other than the owner to vote shares of the company stocks); the number of the directors, their powers and the frequency of their meetings; the composition of the management, including the powers and the responsibilities of the officers; and the authority of the management and the procedures to be followed in amending the bylaws or the charter itself. The bylaws of large corporations are generally comprehensive and stated in broad terms to permit flexibility in operation.

Foreign Incorporation

Although it would appear natural for a corporation to seek a charter in the state in which it expects to conduct a major portion of its business, this is not always the case; it is considered a "foreign corporation" everywhere except the state in which it is chartered. Small corporations usually incorporate in the state in which they expect to conduct most of their business, but large companies, particularly those with a nationwide market, find significant advantages in obtaining a charter from certain states rather than others.

Because each individual state is a sovereign authority, it is not surprising that they differ in the incorporation fees and corporate taxes as well as in the powers, privileges, and immunities provided by the incorporation laws. There is a wide diversity among the states in calculating the fees required to incorporate. This is usually related to the number and values of shares to be issued. Moreover, most states impose annual taxes, based usually on the amount of capital stock outstanding or authorized. State incorporation laws are equally diverse in regard to many matters of vital concern to corporations, such as the statutory provisions for the issuance of securities, the payment of dividends, and the qualifications, liabilities, and powers of corporate directors. In the race to attract corporations, states have generally continued to liberalize provisions to encourage incorporation.

The implication of the foregoing discussion has been that a corporation having a charter from one state can do business in another state. Such is the case, but there are some important problems involved. Because each state is sovereign it is obvious that its authority is nonexistent over the activities of the corporation in another state unless the other state in some way acknowledges the authority of the state from which the corporation received its charter. While this whole problem involves complicated legal and constitutional questions (because the federal government is fundamentally involved in interstate commerce), the outcome is that although a state may control the activities of "foreign" corporations doing business within its borders this power is limited by two considerations: (1) it may not interfere with interstate and foreign commerce, and (2) it may not discriminate between "domestic" and "foreign" corporations so that the latter are not accorded equal legal protection and privileges. Typically therefore, a foreign corporation must fulfill a number of the requirements of domestic corporations. The usual procedure is that it must register as a foreign corporation by filing a copy of its articles of association, in addition to which it must designate an officer within the state as a legally empowered agent. Entry fees for foreign corporations vary with each state.

Directors

The direct link between the stockholders and management is the director. In the broadest sense he is a trustee appointed by the stockholders to guide the enterprise in their best interests. The board of directors is the representative of the corporation. When the board makes decisions, undertakes contracts, or conducts any business, it is the corporation that acts.

The power of the board belongs to theĀ board as a whole, not to individual directors. The powers of the board of directors usually are such that directors may determine the policies of the corporation (within the limits of the charter and bylaws), elect the officers, declare dividends, make contracts in the name of the corporation, issue stock, and exercise any other powers granted them by the bylaws or charter. Misuse of his powers, negligence, and at times merely failure to use good judgment may, in special circumstances, expose a director to a suit for recovery of damages if the corporation should sustain losses.

In the selection of directors, varying policies are followed by different corporations, depending upon the type and size of the business enterprise. In some companies the rule is that the board of directors should be composed entirely of management personnel who would be intimately familiar with the operations of the business. In other large companies the directors are individuals of outstanding achievement in industry and business who would be expected to have only limited knowledge of operating details of the corporation. On such boards the only representatives of management may be the president and executive vice president.

In some states the laws require that directors shall be stockholders in the corporations for which they act; in others directors need not have a stock interest. Again the practice varies with the character and policies of the individual enterprise. The remuneration received by the directors also varies according to the policies of the company.

The price at which a stock is quoted on an exchange reflects a variety of factors, including the history of earnings, the prospects for increased earnings, the capital investment represented by each share, the stability and demonstrated ability of the management, and the prospects for a continuing and expanding business.

Raising of Capital

There are a variety of ways by which a corporation may raise capital to finance a new undertaking or to expand an old one. In a new corporation formed to exploit a mineral deposit where there is a substantial amount of risk involved, the typical method would be to sell stock to the public. If the total amount to be raised is in excess of $300,000, a regulation of the Securities and Exchange Commission requires that the venture be publicly described as speculation.

A large well-established corporation with a consistent earning record would be able to raise funds needed for expansion or for productive purposes by a variety of methods. It could borrow on short or long term loans from a bank or insurance company; it could sell bonds to institutional investors or the public; or it could sell common or preferred stock. The corporation would be guided in its decision by the cost of borrowing money, the level of business activity and future prospects of the business, the receptivity of the public to recent financing operations, the nature of the corporation's business, and the problem of taxes.

The sale of new corporate securities to the public usually requires the services of an investment banker who will underwrite the issue. If a corporation decides to float bonds, it will issue the bonds and sell them directly to an investment banker at their face value less a fee for the investment banker's services. The investment banking firm or syndicate that undertakes the distribution may be chosen by direct negotiation or by competitive public bidding. The latter method is used almost exclusively by governmental bodies in their bond issues. The success of the sale of the bonds to the public will depend not only on the record of the corporation, but also upon the price at which the bonds are issued.

The pricing of a new issue of corporate securities is an operation demanding a high degree of skill on the part of the underwriter. The ultimate objective is to provide the largest possible amount of money for the use of the issuing corporation, and its accomplishment depends on several factors. The underwriter is guided in the fixing of the price by the current yield on various kinds of debt, with the yield on U. S. government bonds an important basic consideration. A bond paying 5% interest may be sold at par, and thus the yield to the buyer will be 5%. However, if interest rates on loans are generally higher, the investment firm underwriting the issue may price a $1,000 bond at $995, which would give a net yield of slightly more than 5%, depending on the length of term until maturity.

An even more difficult exercise of financial skill is involved in pricing a new issue of common stock. If an underwriter overprices an issue, he may suffer a severe financial loss if the public refuses to buy the stock; if an underwriter under-prices an issue, the corporation will not receive all the money it should realize from the sale of stock. The investing public has a great deal of information available on which to base a judgment on the value of stock and securities.

Corporate Bonds

Because the sale of bonds is a convenient means of raising capital, corporations often issue bonds as well as stock. In contrast to stock, which represents an ownership interest in the company, the bond is a contractual obligation. It represents a promise to pay a fixed sum of money at the date of maturity and to pay a stipulated amount of interest at periodic intervals. Bonds constitute a debt that must be met according to contract as a part of the cost of the business; stock constitutes a residual claim to income after the costs have been met. The bondholder therefore is not usually a part of the corporate organization.

Corporate Dissolution and Reorganization

There are many occasions when the company may be dissolved or the capital structure reorganized. Corporate dissolution usually occurs when either the purpose of the company has been fulfilled or when the company is in financial difficulties and does not appear to have expectations of making a profit. The customary procedure in such cases is for the board of directors to recommend dissolution, which is then voted upon by the stockholders at a meeting. Typically, it requires a three-fourths majority of the voting stock to adopt such a resolution. Thereupon the assets may be sold, and after all liabilities have been paid, the residual is divided among the stockholders in accordance with the priority position of each class of stock.


When they get into financial difficulties, large corporations with substantial investment in fixed assets are more likely to reorganize the capital structure than to dissolve the corporation. The reason is that the fixed assets are usually specialized for some particular purpose and therefore are worth a great deal more if maintained as a unit rather than sold separately. A reorganization typically involves a reduction in the capital stock or in the liabilities of the company. In the former case, where the reorganization affects only the stockholder, the typical procedure is to reduce the par value of its stock or reduce the number of outstanding shares. This is known as a quasi-reorganization. Other forms of reorganization reduce the debt or interest charge of the corporation.

Corporate Taxes

Corporations are subject to a variety of taxes on both a federal and state level. All corporations, except some nonprofit religious, educational, and charitable organizations, pay state and local taxes on real and personal property just as do individuals. Special franchise taxes are levied upon corporations by many states on the theory that special advantages are obtained in operating a business under the corporate form. Taxation imposed by states has been an important consideration in establishing a corporation in one state rather than in another.

The taxing of corporate incomes produces a substantial portion of the revenues of the federal government and a considerable share of taxes for most state governments. The federal internal revenue code does not limit the application of its corporation taxing provisions to chartered business, usually classed as corporations, but includes associations, trusts classed as associations, joint stock companies, insurance companies, and certain types of partnerships. In the United States the taxing of corporation income is based on the concept that a corporation and its stockholders are separate legal persons. Thus one tax may be collected on the operating income of the corporation, and another on the personal income of the stockholders derived from dividends. This so-called "double taxation of corporate dividends" is a subject of controversy. The rate on corporate income taxes increases substantially in wartime because of the extraordinary demands on the government.

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