Critical Formation Errors that Will Destroy Your Business

Almost every client I see has already registered their entity with the Secretary of State prior to meeting with me. While technically the registration process is relatively simple, there are a number of common formation errors most clients make. Some mistakes are made out of sheer ignorance during the filing process and others are the result of failing to finish the process.

As stated in the video: The real reason for registering an entity, the Secretary of State is primarily concerned with whom to serve papers to (registered agent) in the event of a lawsuit. That said, there are three common mistakes that I see people make when filing articles of incorporation or articles of organization with the Secretary of State.

Failure to include any entity identifier in the name (LLC, Corp., Company, Inc., etc.). By including the entity identifier in the name, it communicates to the general public that the personal assets of investors are insulated in the event of a lawsuit.
For limited liability companies: Here you need to make the distinction between the election of member-managed and manager-managed. By electing member-managed, you are saying that every investor/member is involved in the decision-making process. As decision-makers, every member, therefore, can potentially be held personally accountable in the event of a lawsuit. While a member-managed LLC is desirable for investors that want a direct say in the company’s direction, it comes with the potential for additional exposure to personal liability in some cases.
For corporations: Here many businesses fail to include/file important additional attachments. For example, these attachments could include documents that spell out indemnification/limitation of liability for officers to deter litigation or the use of restricted shares of stock that do not allow for transfers of such stock or only allows transfers under certain conditions.

In addition to mistakes made during the actual registration process, there are many mistakes that are the result of failing to complete the process that takes place after filing the articles with the Secretary of State. Here is a list of things many incorporators forget or don’t bother to do after they file articles with the Secretary of State:

Corporations:

Failure to create bylaws which are the internal rules that govern the day-to-day operations of the corporation
Failure to create shareholder/buy-sell agreements that describe how a change of ownership may, and may not, occur and what happens where there is a change in ownership
Failure of the owners to appoint a board of directors
Failure of the board of directors to hold the first meeting to:
- Set the corporation’s fiscal year
- Appoint officers of the corporation
- Adopt the bylaws
- Authorize and issue shares of stock

Limited Liability Companies:

Failure to draft an operating agreement that describes how decisions are made and how profits and losses are allocated, capital contributions made, how/when meetings are held, buy-sell provisions, dispute resolutions, etc.

Both:

Failure to move assets from the founders into the company, primarily intellectual property

So, what happens if you fail to complete the process outlined above? Answer: A lot! Here is a short list of the consequences of failing to complete the process.

If the assets aren’t transferred from the founders to the company, then any founder who owns an important company asset can hold that asset as extra leverage to get what they want. After all, it’s still their property. You can often transfer the assets using a simple bill of sale trading equity in the business for the asset.
If there is no operating agreement, bylaws, shareholder agreement, etc., then everyone is free to argue about it later. This often leads to bad feelings and legal actions that are VERY expensive.
Failure to capitalize the company or follow the proper formalities can lead to “piercing the corporate veil,” which means personal liability for the company’s founders/owners. This means that the entire formation process was overall a waste of time.
If you fail to issue stock now, you’ll have to issue it later when the tax cost could be very high.

Related Post: Seven Common Business Formation Errors

Have you followed the proper formation process and are you free from formation errors?

I would like to acknowledge Terry Doherty of the Doherty Law Firm P.C. for his gracious assistance as a reviewer to make sure that the legal issues conveyed in this post were an accurate representation of U.S. corporate law.