In the hi-tech world, building value fast is the name of the game. Therefore, proper formation of the entrepreneur’s company is a must. Entrepreneur needs shareholders who understand their concerns, a board of directors that can support and complement the entrepreneur during the fast growth period and not be a hindrance in making quick, correct decisions. The company needs to be located in the right place at the right time so the entrepreneur and the shareholders can create and maintain the financial worth of their investment.
Founders’ agreement
Most hi-tech start-ups have more than one shareholder at the beginning. Usually the initial shareholders are a few entrepreneurs who come together around a business and technological idea. This start-up group is known as the “Founders” of the company, as distinct from those who become shareholders later - investors, and perhaps employees. Therefore, when founders come together it is best that they sign an agreement between themselves to define their relationship.
Main points to be included in this agreement are:
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who contributes what capital and/or loan at the beginning to the company
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how ownership rights of the technology of one or more of the Founders is to be transferred to the new company
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allocation of the management positions among the Founders
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warranties by founders that no obstacles exist that bar them from the new venture from previous employers or otherwise
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appendices such as transfer of technology agreement benefiting the company
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a copy of the Articles of Association (discussed below), and sometimes employment agreements between the founders and the company
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provisions in the event that one of the founders’ fails to follow through on his or her obligations
Sometimes the founders feel that this can wait until the first real investor shows up. Why bother to form a legal relationship if in the end the idea gets no backing? Wrong! A clause can be added to the agreement stating that the formation of the company, the transfer of the technology, and so on, will not become binding until the first monies from third party investors are put into the company. The reality is that the Founders’ Agreement, Company Formation and the first investment agreement with an angel or venture capital fund are generally signed within a short space of time.
Company registration
All you need to form a company is a single shareholder. You submit an application to the Registrar of Companies with a distinctive company name (it must be approved by the Registrar), together with a copy of the articles of association or by-laws, and a declaration of the first directors of the company. There is an initial registration fee, and then an annual fee. If all the conditions for registration have been met, the Registrar of Companies issues a Certificate of Incorporation giving the company a registration number. The company is legally formed.
Company’s purpose; pre-formation acts
The company can approve action taken by the entrepreneur prior to formation as long as the acts approved do not hurt the rights of a third party. If the company does approve the entrepreneur’s acts, then the obligations resulting from such acts pass to the company and the entrepreneur has no further legal involvement. But if the company rejects the acts of the entrepreneur then, within certain guidelines, the third party can bring an action against the entrepreneur, personally, for the harm suffered through his or her acts.
Therefore, when an entrepreneur is running around, forming the start-up, making tentative arrangements with suppliers, future employees, potential investors, before a company has been formed, he or she should be aware of the risk of remaining personally liable.
Articles of Association or By-Laws
A company is owned by its shareholders. The contract between the shareholders and the company, and the shareholders among themselves, is the Articles of Association, known in the US as By-Laws. A few basic items must appear in the Articles: the name of the company; its purpose; description of the registered capital; and details of the company’s limited liability. After that, the shareholders and board have wide discretion in drafting the Articles. Generally, the Articles deal with shareholders’ rights and obligations and how the company will be managed.
Some of the main provisions are:
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classes of shares
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how share capital is increased
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how the company is managed
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allotment of shares
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pre-emptive rights (ability to maintain existing percentage of holdings)
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ability to transfer shares and restrictions on transfers
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general meetings of shareholders and procedures at such meetings
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board of directors meetings
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power and duties of the board
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issue of declaration and distribution of dividends
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persons authorized to bind the company on various matters
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issue of notice and how the company keeps shareholders informed and how shareholders notify the company
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how auditors are appointed
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liquidation rights of shareholders
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insurance for directors and officers
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special powers to certain classes of shareholders to approve certain decisions by the board and management
Share capital
Usually, the founders provide the initial capital and/or loans and are issued ordinary or common shares, depending on whether the company is formed in Israel or America. Ordinary shares give the shareholder basic rights, such as voting and dividend rights, as defined in the Articles. Preferred Shares, which many investors choose to take in a hi-tech company, carry additional rights such as directorship, liquidation rights, approval of major decisions, anti-dilution rights, right of first refusal on founders’ shares, and other rights which we will discuss in later articles.
At the end of the day, before the Company makes the shareholder’s investment liquid, in an IPO or an M&A, all these preferred shares convert to ordinary shares on the basis of some conversion ratio defined in the Articles and/or contracts. When the company’s share capital is formed, the entrepreneur should be aware of the various classes of shares that will be eventually issued and how this impacts on the Articles and other company documents.
Board of directors
As a company develops, the board expands, and the founders need safeguards so they do not find themselves outside the decision making process of their own company. Therefore, it is important that the founders retain control over the board. Obviously, if the financial investors are at odds with the founders on product and market direction the issue is quite major. This still can be resolved where the founders retain voting control but meet the financial investors halfway by perhaps stepping down from some operational function and finding professionals with more experience in management and marketing.
Forming the company overseas
The trend today is for Israeli entrepreneurs to form their companies in the United States and have a subsidiary, the so-called “Research and Development Company” in Israel. This is to allow the company to become known by the American investment community and to be close to its markets. This requires bringing senior Israeli management to America to live and work, and hiring experienced American executives.
Many companies choose the State of Delaware for company formation, but actually reside in other states. In the US, a company is not registered with the federal government but with a state, and must meet the individual requirements of that state.
Matters such as Stock Option Plans, Employment Taxes, State Income Tax, Federal Corporate Tax, and other accounting and tax require the entrepreneur to consult with legal counsel and certified public accountants who have the knowledge and experience in structuring the proper entities to accomplish such international expansion.
Copyright 2000 by Yitzhak Rosenbaum
Published by Israel's Business Arena November 22, 2000