Articles of Incorporation – 6 Mistakes that Will Cost You!

A company’s Articles of Incorporation are also known as its Certificate of Formation, or Articles or Organization.  Its is among the simplest and first documents to file to create a business entity.  Articles of Incorporation can be done without any special expertise.  They can be done quickly for little money.  Simplicity and ease are the reasons huge mistakes are commonly made.

1. Do you intend to expand your business so it becomes large?
2. Do you intend for your business to have such success that it is worth many millions of dollars?

You will need expert legal advice from its inception to accomplish those two goals.  This article explains the five most glaring mistakes made in Articles of Incorporation.

MISTAKES IN ENTITY FORMATION

Mistake #1 – Not Using a Lawyer

This only seems like self-serving advice.  Articles of Incorporation are like a precision dive.  Anyone can jump in a pool, but if you are going to be judged in the future regarding how you get into the pool, do it right.  Businesses vary.  Each has its unique combination of vision, industry, location, employees, and other circumstances.  It is the job of the business lawyer to understand the legal and industry environment, learn your business, and then combine his knowledge and experience to put the first steps of the business on the right path.  This process is not expensive for Articles of Incorporation.  They are permanent public documents.  Your business will be judged by them, and that judgement will matter.

The ”Corporate Kit”

The Articles of Incorporation are part of what is often referred to as the “Corporate Kit,” meaning part of the package to form the business correctly.  Corporate kits usually contain:

• Customize Articles of Incorporation
• Formal Entity Records Book
• Corporate By-Laws
• Corporate Minutes
• Stock Certificates
• Direct Legal, business, credit and tax advice

Investing in a competent industry specific business lawyer is money well spent.

Mistake #2 – Choosing the Wrong Type of Business Entity

There are important differences between LLC, single member LLC, S-Corp, C-Corp, and Non-Profit entities.  What may be a convenient corporate entity type may prevent your business from capitalizing on important advantages later.

Mistakes in corporate formation may not be fixable without significant time and money cost.  There are advantages, disadvantages, and options depending upon your industry, business activities, unique profit opportunities, unique risks, and future business plans. Choosing the wrong entity type can cause issues with:

• Control over owner decision making
• Tax liability
• Raising capital investments
• Limited legal liability
• Business location – Expanding into new markets
• Business scope – Expanding into new areas of profit
• Anonymity – Privacy or Owners

Your unique opportunities and risks need to be compared with the advantages disadvantages, opportunities and limitations of the various entity types.  Choosing the wrong entity type early can cause great time, money, and opportunity costs later.

Mistake #3 – Choosing the Wrong Registered Agent

Registered Agent as a Job

It is great that your nephew, or spouse’s sibling needs a job.  However, the Registered Agent of your business is the wrong opportunity to offer.  The job of the registered agent is to receive filings, tax notices, court notices, official documents.  Choosing the wrong person may lead to problems, like:

• Privacy breaches. (No attorney client privilege. May voluntarily disclose.)
• Defaults in lawsuits (Failing to recognize and pass along important documents)
• Bad standing with governments and businesses (having a flawed personal reputation or criminal record)

A registered agent needs to consistently, dutifully perform the task without errors.  What your business does not find out about can hurt it.

Registered Agent Reputation and Record

The registered agent is the public face of the business.  The agent is occasionally the only actual person identified in the Articles of Incorporation.  You should expect your business to be investigated at some point.  This investigation may be for a potential sale, merger, or acquisition. This investigation may be an important customer evaluating your business for a great opportunity.  This investigation may be a government employee considering business culpability.  What will an investigation into your registered agent find?   You want a look into your registered agent to improve, not detract from your reputation.

How to Choose the Right Registered Agent

Many professional entities and law firms offer the services of registered agent for a reasonable cost.  The non-law firm entities are popular because of their consistent performance and low cost.  Law firm entities are popular because they provide the added benefits of advanced legal scrutiny and attorney client privilege, and their cost is not particularly higher than the non-law firm entities.  Either way, the choice of a Registered Agent should be intentional and informed.

Failure to have protective agreements

• Custom Articles of Incorporation
• Custom Operating agreements
• Indemnification agreements. Shield directors and officers from personal liability and costs for actions taken on behalf of the corporation.
• Non-disclosure agreements
• Non-compete Agreements
• Proprietary Information and Invention Assignment Agreements
• Shareholder’s Restrictive Agreement. Outlines their obligations and restrictions to each other.
• Shareholder divorce protection clauses. Right of first refusal.

Mistake #4 –Think More About the Corporation Name

Forgettable Brand Identity

Brand identity is a critical business asset.  Some business owners choose a business name that sounds serious, but is not the actual name of the business they intend to put to the public.  If you want people who are looking for your business to be able to find you, use a name they will notice.  A bland, forgettable corporate lingo name may not be appropriate for your marketing plan.

Privacy Loss

Other business owners highly value their privacy and want their business information to remain as anonymous as possible.  Yet, they put their public name on all filings, like the Articles of Incorporation.  They are simply making it easy for their competitors, and others who wish to track them.

Trademark Protection Loss

A corporate name can typically be created and used in any jurisdiction that does not yet have an identical filing.  Thus, what if you wish to do business as “Crypto Blockchain Wallet Company” and build your reputation around that name, but use a different name on your Articles of Incorporation or Certificate of Formation?  A competitor or “knock off” business can then file under your “Crypto Blockchain Wallet Company” name.  What claim do you have when your competitor advertises to your customers under its official name?  You may wish to safeguard your business name through your Articles of Incorporation.

Mistake #5 – Electing Member Managed versus Manager Managed Control

Some jurisdictions require businesses to disclose the type of owner decision-making control the entity will use.  These Certificate of Formation disclosure broadly break down the options between:

• Member Managed, and
• Manager Managed.

The term “member” is synonymous with “owner” in the LLC context.  The members are the persons who own the equity (stock or units) of the business entity.  In a member managed entity, each member has decision making authority over company decisions.  That owner authority cannot be taken away by employees or executives.  Many startup founders like this degree of control and elect “Member Managed” in their Articles of Incorporation, Certificate of Formation, and Operating Agreements.

Manager managed business entities delegate decision making authority from the owners to executives.  Thus, decision making authority lies not with the owners (members) of the business, but rather with those who have been delegated the authority … the Managers.

A Jack of All Trades Master of None

The largest advantage of any business has been specialization of skills, and coordination of activities.  Company’s crave clarity.  The best most efficient businesses match up people’s talents and experience with their best role in the organization.  What goes for employees should also go with management.  Executive decisions should be made by the person with the best qualities to make those decisions.  However, in a Member Managed corporation, any owner of equity in the company can make decisions, regardless of whether there is a fit between the decision and their experience.

Vitalik Buterin is the primary founder of Ethereum.  He is a computer programmer, cryptologist, and the son of a computer scientist.  Mr. Buterin would be a perfect choice for creative decision making for a blockchain application business.  However, Vitalik would likely be a poor choice to lead a corporate athletic team.

Boss Shopping

Decision making authority is also not divided in member managed companies.  This means that any member can make business decisions.  This can cause several problems.  First, employees will quickly learn who is likely to decide in a particular way given the circumstances.  Employees will be able to direct questions and decisions to the owner (member) they expect is most likely to agree with them.

Too Many Cooks in the Kitchen

Second, one member (owner) may not agree with the decision of another member (owner).  With all members having authority to decide, conflicts are more likely to arise with the overlapping authority granted by member managed organizations.

The Company Storm Crow

Third, some decisions may be put off, or not made, at all in member managed entities.  We all have experienced problems with which we just did not want to deal.  In a member managed organization, since it is every member’s responsibility, it is also no member’s responsibility (in particular).  This means someone can always state (I thought that other person was going to deal with it).  Worse, some members (owners) may always delegate unpopular decisions to a particular member, making them the company “Storm Crow.”  This will lead to resentment, at best.

Merger, Acquisition, & Sale Woes

Many companies expand to the point where venture capital investors wish to give money to the owners for a share of the company equity.  This results in a large payout to owners, which they like.  This results in a large infusion of money into the organization, giving it capital to expand and grow.  This is also good.  However, consider what is given in exchange for the money.  The investors are now part owners of the company.  This means they are “members” and have decision making authority that is unchecked in a member managed company.

Divorce!

Similar new-owner problems can arise should a divorce occur.  The former spouse of an owner may gain a share of the ownership of the company and marital property in a divorce.  This makes your business partner’s ex-spouse your new business partner, and that spouse has decision making authority difficult to limit.

Death!!

An owner may die.  That owner’s heirs may inherit the owner’s business equity interest.  Those heirs, whom you may not know, and who may know nothing about the business, suddenly are managers with authority.

All these issues can be resolved in the Articles of Incorporation, Certificate of Formation, and Operating Agreement by electing Manager Managed control.  Remember, if you want authority, you can still have yourself named a President.

 Mistake #6 – Business Purpose – Poorly Thought Out

Most jurisdictions require a company to provide a written statement of its purpose as part of its Articles of Incorporation.  The purpose statement is notice to the government explaining what business activities the entity is requesting legal approval to conduct.  It is not a business vision.  The “Purpose” is not a mission statement.  It is not meant to attract customers.  The purpose statement is not to inspire employees.

These statements break down to several aspects, which include:

• Why the entity exists
• The Legal purpose of the entity
• What activities the government can expect from the entity

The Generic “Dial It In” Purpose Statement

Most businesses utilize “catch-all” business purposes statements, like “The purpose of this limited liability company is to engage in any lawful activity for which limited liability companies may be formed in this State.”  Catch-all business purposes statements work, but are rather unhelpful in distinguishing a company.

The Too-Specific Purpose Statement

A legal nuance businesses must keep in mind is that its owners, executives, agents, and employees are barred from activities that conflict with the business purpose statement.  People can be held personally responsible for their decisions, actions, or omissions that do not fit within the Purpose statement.

What is more, businesses often evolve.  What may initially be a crypto liquidity mining (yield farming) business may morph into a NFT (ERC 721) blockchain promotion business, as opportunities arise.  The business purpose statement must take into account changing business circumstances to allow room for evolution of business activity.

Other Major Mistakes

There are other Mistakes with Articles of Incorporation.  They are not “fleshed out” in this article as the Top 6, because of their limited application (only problems for some types of businesses.  Other errors may be less frequent.  They may be correctable.  Other errors include:

• Failing to spell out what kinds shares will be issued
• Failing to state what voting rights shareholders will have.
• Stating how shareholders will be paid.
• Multiple modifications to the Articles.
• Failing to provide for many share types of classes, unlimited capital, allow for a range of directors.

Contact us at Whale.Law if you expect your business to achieve a level of success that professional help will increase its value and better achieve its goals.

Author:

Matt Hamilton

Juris Doctor

Trial Lawyer