USING PREINCORPORATION AGREEMENTS TO ESTABLISH GROUND RULES FOR GOVERNANCE OF NEW CORPORATIONS

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1 Becoming a Business Counselor Alan S. Gutterman USING PREINCORPORATION AGREEMENTS TO ESTABLISH GROUND RULES FOR GOVERNANCE OF NEW CORPORATIONS Preincorporation agreements include various contracts entered into by incorporators, promoters, subscribers and the principals (e.g., executive officers and directors) regarding the future organization of a corporation. The agreements establish the ground rules for the organization, capitalization, and management of the proposed corporation. Other agreements may also be used in certain instances, either separately or in combination with the general preincorporation agreement. For example, reorganization of an existing business that had been operated in the partnership form into a corporation may require special provisions, particularly if the new corporation has not elected to be treated as a pass-through entity for tax purposes (i.e., a Subchapter S election). Also, those parties who will be working with and for the corporation may wish to enter into employment agreements which will become effective on completion of the formation and organization of the new corporation. In order for the process of preparing the necessary preincorporation agreements to proceed smoothly, the attorney should be sure that the clients are familiar with the steps that will need to be taken in order to form the corporation and the specific issues that they need to consider in order for the agreements to fit their particular circumstances. Much of the information can be exchanged at face-to-face meetings between the attorney and the clients; however, attorneys should also send letters to the clients that describe the procedures for forming new business entities and summarize the form and content of owners' agreements-shareholders' agreement in the case of a corporation. If it is more convenient, the attorney may also use a standardized message that template that includes a list of all the information that the attorney will need from the client in order to form a new corporation. Once the information has been collected, the attorney should circulate drafts of the proposed forms of key documents and, if appropriate, convene a preliminary meeting of the organizers of the new corporation to approve the articles or certification of incorporation which are to be filed and any other relevant matters. Minutes of any such preliminary meeting of the organizers should be prepared and included in the minute book for the new corporation. An agreement to incorporate may be used by the parties to establish the general terms and conditions associated with the formation and initial organization of a new corporation. The content of a preincorporation agreement will vary depending upon the circumstances. Among the matters which are commonly included in such an agreement are the following:

2 Names and addresses of the parties; The proposed name of the corporation and a description of the procedures that will be followed to check the availability of the name and reserve it for future use on behalf of the corporation; A description of the proposed purpose and activities of the corporation; A summary of the place or places where it is anticipated that the corporation will conduct its business, including a statement of the procedures that will be followed in order to qualify the corporation as a foreign corporation; A description of the proposed capitalization of the corporation, including subscriptions by the parties; A list of the incorporators, initial directors and officers of the corporation; A description of the terms of engagement of any persons required to assist in the incorporation process, such as lawyer, accountants or appraisers. Other matters which might be covered in a preincorporation agreement include the following: A description of the terms of any proposed employment relationship between the new corporation and any of its organizers and/or promoters; The general terms of any buy-sell arrangements among the corporation and its future shareholders; If the principals wish to have the corporation treated as a Subchapter S corporation for tax purposes, the agreement may contain various covenants regarding the steps that will be taken to perfect and maintain Subchapter S status; A description of any proposed purchase of assets by the new corporation, which will be relevant whenever the new corporation is going to take over the operations of a going concern; When subscriptions will be sought from persons not otherwise affiliated with the founding group, a description of the procedures that will be followed in making the offering, including the preparation of an offering document, engagement of investment bankers and payment of the fees and expenses associated with complying with any securities law requirements; If an existing business will be incorporated, a description of the assets that will be transferred to the new corporation, the shares that will be issued in exchange for each proprietor's interest and a summary of the tax elections that will be made in connection with the incorporation. Preincorporation agreements which include parties other than the principals may be useful in certain cases. For example, some form of preincorporation agreement is usually appropriate when a bank or other institutional lender is willing to take stock in a new corporation in satisfaction of preexisting claims and agree to make additional advances in the form of loans to finance the new corporation. A preincorporation agreement may also include detailed provisions regarding the terms of securities to be issued to outside investors, such as preferred stock and/or convertible subordinated notes. An interesting variation is an agreement entered into prior to formation of a new corporation that sets out the terms upon which one of the parties to the agreement may become a shareholder of the corporation at some point in the future after certain conditions have been satisfied and/or the party has performed activities detailed in the agreement. One example would be an agreement between a construction company and a real estate management company that provides for the construction company to form a new corporation to acquire property and construct a new building on that property and calls for the management company to assume

3 responsibility for managing the building once it is constructed in exchange for shares of the corporation to be issued in the future. A related form of agreement would be one between a builder and a rental agent that calls for the builder to erect a new building and the rental agent to find tenants for the building with the equity ownership of the rental agent in the corporation being tied to the agent s success in locating acceptable tenants. A unique feature of each of these types of agreement is that they will not only address issuance of shares and governance of the corporation, but will also detail other aspects of the entire project including the duties and responsibilities of each of the parties with respect to construction, leasing and management of the building that will be owned by the corporation. Preincorporation agreements may take different forms. For example, the promoter may prepare a proposal for formation of corporation that can be presented to prospective investors and other business partners. The proposal would combine many of the elements of a preincorporation agreement with a description of the proposed business strategy for the corporation.

4 Agreement to Incorporate as S Corporation Agreement to incorporate made [date], between [name], of [address], [city], County, [name of state], and [name], of [address], [city], County, [name of state] (the "incorporators"). RECITALS A. The parties desire to organize under the [appropriate business corporation act] a corporation to be known as, or such other name as the parties may select, for the purposes set forth in Article of the proposed articles of incorporation, a copy of which is attached to this agreement as Exhibit and incorporated by reference. B. The capitalization of the corporation shall be as set forth in Article of the proposed articles of incorporation. C. The parties contemplate that the shares of the corporation will remain closely held and will not, therefore, be readily marketable. To provide a market for the shares of any party or the estate of any party desiring to sell the same, the parties propose, immediately on entering into this agreement, to execute a stockholders' buy-sell agreement in the form attached to this agreement as Exhibit and incorporated by reference. The parties further propose, immediately on formation of the corporation, to cause the corporation to become a party to such buy-sell agreement. D. The parties desire to ensure full deductibility of any losses they may sustain in the disposition of any shares of the corporation issued pursuant to this agreement, and to this end it is understood that the parties shall cause the corporation to take such action as may be necessary to assure that the authorized shares of the corporation, including the shares issued pursuant to this agreement, shall qualify as "Section 1244 stock" within the meaning of Section 1244 of the United States Internal Revenue Code. E. The parties seek to avoid double taxation of the earnings of the corporation, and to this end it is understood that they shall cause the corporation to elect to be taxed under the provisions of Subchapter S of

5 the United States Internal Revenue Code, and that each of them shall consent in writing to such election. In consideration of the matters described above, and of the mutual benefits and obligations set forth in this agreement, the parties agree as follows: SECTION ONE. SUBSCRIPTION FOR STOCK Each of the undersigned parties subscribes for and agrees to purchase from the corporation at the prices set forth below in this agreement, the number of shares appearing opposite the party's name below: Subscriber Number of Shares Subscribed For Amount Per Share Total Amount of Subscription SECTION TWO. INCORPORATION The parties and each of them shall act as incorporators of the corporation and shall execute and file with the [Secretary of State of (state) or as the case may be] [duplicate or as the case may be] original articles of incorporation in the form attached as Exhibit. SECTION THREE. ADOPTION OF BYLAWS On formation of the corporation, the parties shall use their best efforts to cause it to adopt bylaws in the form attached to this agreement as Exhibit and incorporated by reference. SECTION FOUR. STOCKHOLDERS' AGREEMENT

6 Immediately on execution of this agreement, the parties agree to enter into a stockholders' buy-sell agreement in the form attached as Exhibit. On formation of the corporation, the parties, and each of them, shall exercise their best efforts to cause the corporation to consent in writing to be bound by the terms of the stockholders' buy-sell agreement. SECTION FIVE. SECTION 1244 STOCK PLAN Prior to the payment for or issuance of any of the shares of the corporation pursuant to this agreement, the parties and each of them shall use their best efforts to cause the corporation to adopt a Section 1244 Stock Plan in the form attached as Exhibit. SECTION SIX. SUBCHAPTER S ELECTION; CONSENTS On formation of the corporation, and within the time provided by law, the parties and each of them shall exercise their best efforts to cause the corporation to elect to be taxed for federal income tax purposes as a small business corporation under the provisions of Subchapter S of the United States Internal Revenue Code and to file timely notices of such election with the United States Internal Revenue Service. Such election shall be for the initial taxable year of the corporation, and for all subsequent taxable years. Additionally, each party shall consent in writing to such election and file timely notice of such consent with the United States Internal Revenue Service. SECTION SEVEN. EXEMPTION FROM SECURITIES ACT OF 1933 Each party represents and agrees that the party's subscription for and purchase of shares under this agreement is for investment purposes for the party's own account, and that the party has no present intent to resell or distribute such shares. Each party further represents and agrees that the party is now and shall be at the time of purchase of the shares subscribed for under this agreement a bona fide resident of [name of state]. The undersigned incorporators have executed this agreement at [designate place of

7 execution] the day and year first above written. [Signatures] [Attach exhibits] (10) Conduct meeting, prepare resolutions describing the actions taken by the directors, prepare minutes of the meeting and circulate same to directors for approval, and include a copy of the approved minutes in the minute book. Notes This form is an example of a template for an agreement to form and organize a new corporation that will elect to be treated as an S corporation for federal income tax purposes and issue shares that would qualify for favorable tax treatment under Section 1244 stock of the Internal Revenue Code. In order for this agreement to be complete the parties must also negotiate and draft acceptable forms of bylaws and shareholders agreements, all of which will be appended as exhibits to this agreement along with the initial articles of incorporation of the new corporation. Corporations must be formed under the enabling legislation of a state or the federal government, since corporations may lawfully exist only by consent or grant of the sovereign. Hence, in drafting pre-incorporation agreements and other instruments preliminary to incorporation, the drafter must become familiar with and follow the particular statutes under which the corporation is to be formed. 1 The material in this report appears in Business Counselor s Law and Compliance Practice Manual (2011 Edition) by Alan S. Gutterman and is presented with permission of Thomson Reuters/West. Copyright Thomson Reuters/West. For more information or to order call Alan Gutterman is the Founder/Principal of Gutterman Law & Business ( which publishes the Emerging Companies Blog and the Business Counselor Blog.