The corporate structure selected by entrepreneurs is generally based upon three considerations: control, liability and taxes. There are several corporate structures to choose from: sole proprietorship, general and limited partnerships and incorporation.
To raise equity capital the structure necessary should be a separate legal entity in the form of a corporation. This has several advantages over other structures which are owner (sole proprietorship) versus investor (shareholder) oriented. As an entity, a corporation can act as an individual in terms of selling and buying assets, borrowing money, suing or be sued, taking advantage of certain government-sponsored programs, and if need be, go bankrupt (heaven forbid). The main advantage, however, is that a corporation can facilitate the transfer of shares from one person or entity to another.
To set up a corporation, an entrepreneur must first consult a lawyer and accountant because there is a myriad of paperwork to be filled out. Included in this myriad are articles of incorporation, bylaws, and stock certificates. In addition, a name availability search needs to be conducted to ensure the company’s selected name is not already in use. A good lawyer or accountant will also counsel on the number of shares to be issued along with other capital structure, tax and business issues.
Angel investors and Venture Capitalists will not enter into discussions with an entrepreneur if the foregoing structure is not in place. These investors are interested in participating in the exchange of capital for equity, so if corporate structure cannot make this happen, it is a non-starter, and an entrepreneur is advised to go back to his drawing board.
The Importance of Corporate Governance Practices
In 2002 the Sarbanes-Oxley Act came into being in the United States and had an effect in Canada as well. The bill was enacted in reaction to a number of major corporate and accounting scandals including such companies as Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom. These scandals had a dramatic effect on the value of the companies, and share prices plummeted almost overnight to all-time lows, costing shareholders billions of dollars.
The Act brought about sweeping changes to how companies report, control, and manage their financial activities. Although it focused primarily on publicly traded companies there was a spill-over effect in how privately held companies with investors were managed. Corporate governance, thus, is important for any size company using “other peoples’ money” to fuel the development of their companies.
Organizing your company to adhere to good corporate governance practices is something that should be in the best interests of all stakeholders: management, board members, and shareholders. Transparency is important. Having a solid accounting system in place, human resource and accounting policies developed, audited financial statements regularly prepared, regular communications with shareholders, and good Board operating procedures allow a company to build a corporate structure based on the right level of discipline and accountability.
A qualified CFO can ensure that the proper framework is developed and executed; however, for a start-up company a CFO may not be on the team yet. In these instances it would be wise to rely on a good accountant and lawyer to prepare the foundation until a CFO is hired. In addition, a focus on this framework will make it easier to accept capital from more sophisticated investors because you can demonstrate your “house is in order,” particularly during due diligence.