Business Associations Outline

Introduction

Business Forms

Sole Proprietorship

A sole proprietorship is a business owned by a single person who has not submitted paperwork to establish a different legal form. In other words, when a single owner opens a business, the default is a proprietorship.

A consequence of a sole proprietorship is that it is very simple to run. The owner has sole discretion about management and is not restricted by any governing rules. Additionally, taxes are quite simple. The owner simply adds the income to his/her personal taxes, likely by attaching a Schedule C to Form 1040.

The main downside of a proprietorship is that the owner is directly liable for any and all business expenses. For instance, if Joe is an electrician and purchases tools to use in the business, those tools are owned by Joe. If the business is sued, Joe might not only lose his tools, but his other personal assets, such as a car or house, may also be at risk.

Because the business and the owner are essentially the same, the legal name of the business will be the name of the owner. For example, “John H. Doe.” However, many of these businesses want to give the business a name. As such, they establish a DBA (doing business as). This simply means that they wish their business to be called something other than their legal name. However, any documents signed by the business still need to include the legal name of the business, the owner’s name.

Partnership

Also known as a “general partnership,” this form of business is created when two or more owners establish a for-profit business with no other legal form. In other words, it is the multi-owner form of a proprietorship. However, because there is a partnership, there are additional rules governing the partnership. Each state has adopted a set of partnership statutes. Many have adopted either the Uniform Partnership Act (UPA) or the Revised Uniform Partnership Act (RUPA). Although many states have adopted these standards, they are free to adjust them however they please.

Governance and Management

The main governing document of the partnership is the Partnership Agreement. This is a contract (usually written but can be oral) between the partners where they can decide who gets what and who contributes what. It also sets up the managing structure of the company. There are four main ways a partnership may establish the management:

1. The partners select a managing partner who makes all business decisions (external decisions would still be made by the partner body).
2. There is a committee of partners who can make the decisions.
3. Each partner has an equal say in how the business is run.
4. Each partner has a vote that is equal to the percentage they contribute to the partnership.

By default, the RUPA says that each pattern has an equal say. This default rule may be revised through the partnership agreement.

A major risk of a partnership is that the personal assets of each partner can be reached to satisfy a debt. In other words, just like a proprietorship, there is no liability protection for any individual partner.

As far as taxes go, the partnership is generally taxed under Subchapter K (although the partners can opt for Subchapter C or S in the partnership agreement). Usually, this means that there is no requirement to pay federal income tax. Instead, each partner evaluates their share and their losses and attaches a Schedule E to Form 1040 within their personal taxes. The partnership is still required to file a Form 1065, but this is simply to provide the IRS with information about the business growth.

Limited Liability Partnership

The legal document to establish a Limited Liability Partnership (LLP) is a statement of qualification with the Secretary of State office. LLPs are essentially identical to partnerships with one key difference, LLPs provide more protection to partners. The partnership agreement, management structure, and taxation methods are the same for both partnerships and LLPs. Additionally, governing law is essentially the same. The main difference of governing law is that states added a provision to allow LLPs to exist.

As mentioned, the main difference between an LLP and a partnership is the liability of the partners. In a partnership, the partners liability is unlimited. In a LLP, the partners are afforded full liability protection (except in Louisiana and South Carolina where they are afforded partial protection). This simply means that the assets of partners are protected from the misconduct of other partners or judgment against the business.

Limited Partnership

Think of a limited partnership (LP) as a combination of a general partnership and a LLP. There are two different types of partners in a LP: General partners and limited partners. General partners have all the management power, but they are also personally liable for business decisions. Limited partners have no management power (or vote) but they do have liability protection.

The LP is created by filing a certificate of limited partnership with the Secretary of State. Each LP is then governed by that state’s limited patnership statutes, which often mimic the Uniform Limited Partnership Act.

However, this form may be manipulated easily. A general partner could be an entity. Thus, those who would be general partners, maintain control, but none of the liability. This is a practice usually utilized by Hedge Funds.

Corporations

Structure

A corporation is created by filing articles of incorporation with the Secretary of State. The owners of a corporation are called “shareholders.” These shareholders elect a “board of directors” who then have managing authority of the business.

To establish this structure, the corporation must file a charter and bylaws. The charter outlines the company name, type of stock (preferred or common), rights of stock, and the office of a registered agent within the state of incorporation. The bylaws function similar to a partnership agreement. That is, it outlines outlines rules, meeting requirements for votes, qualifications, appointment of officers, etc.

A shareholder has limited liability. In all states, this is a full limitation. Thus, if a corporation fails, the shareholder will lose what they had personally invested into the company, but will not lose their personal assets.

Governance

Each state has passed laws governing corporations. Most states utilize the Model Business Corporation Act (MBCA). However, there are a few states that do not utilize the MBCA, that are very important to corporations. For instance, Delaware is non-MBCA, but more than half of all publicly traded companies are incorporated in Delaware. Thus, it is important to always check the statutes within the state of incorporation.

Taxation

Often, you may hear of two different types of corporations C-Corps and S-Corps. This is simply referring to which Subchapter of the IRC the corporation elects to file taxes. A C-Corp files its taxes as a separate entity. This means that it is subject to federal income tax, then taxed again when it distributes money to the shareholders. An S-Corp utilizes a similar method to an LP, where it does not file federal income taxes, and then passes the profits to the shareholders to file directly on their individual tax returns.

Limited Liability Company

Also known as LLCs, Limited Liability Corporations are created by submitted articles of organization. Owners of LLCs are called members and there are two main types of management systems: member management or manager management. Member-management functions in the same was as a general partnership, where each member has a vote. Manager management operates in the same way as a corporation, where the members elect a board of managers who have the authority to make business decisions. The governing document (where this system is established) is called the operating agreement.

If the LLC has more than one member member, the IRC treats the LLC as a general partnership. That is, they are taxed under Subchapter K. If the LLC has only one member, it is taxed the same as a proprietorship. Thus, a single-member LLC owner simply has to note the income on their individual tax returns.

Other Business Forms

Although the above is the most common types of business forms (crazy to think that there were once only 3), there are several other types of business forms. They are:

1. Professional Entities: professional limited liability partnerships, professional limited liability company, and professional corporations. These must be licensed professionals to have this entity form associated (law, medicine, etc.)
2. Close Corporation: small corporations, but few take this route.
3. Nonprofit corporations
4. Benefit corporation: corporations where they not only consider the welfare of the shareholders, but also the welfare of the public.
5. Benefit limited liability company
6. Low-profit limited liability company: the goal is not to gain a profit, but to pursue a social benefit.
7. Business trust: managed by trustees
8. Joint venture: when multiple entities combine resources to explore a separate business opportunity or venture.

Key Principles

Internal Affairs Doctrine

This doctrine simply states that the law governing the entity will be that where the entity is incorporated. So, if the parties live in Iowa, but are incorporated in Delaware, then Delaware corporate law will govern.

Please note that this only applies for the internal affairs of the corporation. This does not apply when determining which law to use for contract, torts, or other malpractice.

Default v. Mandatory Rules

Most of the rules within the RUPA and MBCA are default. That is, they are the binding rules unless if the entity’s governing documents alter the rules. There are only a few rules that cannot be altered. For example, the only mandatory rules in the RUPA are found in § 103(b).

This also plays a role into how majority share owners and minority share owners feel about the rules. For instance, default rules generally favor majority share owners (default rules basically give majority owners most if not all the decision making power). Thus, those who strive to alter the rules are typically minority share owners.

Private v. Public Companies

The main difference between a public and private company is that public companies have their shares traded as stock on a public exchange market. This benefits the companies because it means that the stock assets can become much more liquid. Although the majority of public companies are large, there are a few large private companies.

A large consequence of a public company is that there are a lot of owners (each stock holder ultimately is an owner of a small piece of the company). Typically, private companies have few owners that own a larger share of the company.

Agency Law

Agency law can simply be summarized as laws governing the relationships of parties. The only question becomes, how is a proper relationship formed?

An agent is somebody who does something for another person (a principal) with that person’s authority. A common example of an agency relationship is an employer and an employee. The employer (principal) asks the employee (agent) to engage in certain activities. The employee is then bound to follow those instructions on behalf of the employer.

Creating an Agency Relationship

There are three elements that must be satisfied to establish an agency relationship:

1. Assent by the principal that the agent will act for him/her (e.g. an employer providing a new hire with their list of responsibilities).
2. Acceptance by the agent of that undertaking (e.g. an employee agreeing to do those responsibilities).
3. An understanding between the two that the principal remains in control of the undertaking.

The order of these elements do not matter so much, just as long as they are present. We see an example of this principle in the case below:

Johnson v. Priceline.com, Inc.

An agency relationship is created when three elements are satisfied:

1. Assent by the principal that the agent will act for him/her (e.g. an employer providing a new hire with their list of responsibilities).
2. Acceptance by the agent of that undertaking (e.g. an employee agreeing to do those responsibilities).
3. An understanding between the two that the principal remains in control of the undertaking.

An interesting thing to know about agency law is that only the agent owes a fiduciary duty to the principal. In other words, the agent is required to tell the principal about their dealings and the principal has no requirement to reciprocate. Everything in this case depended on the existence of an agency relationship. If there is no agency relationship, then there is no fiduciary duty. If there is no requirement to disclose.

When is the Principal Bound to a Contract?

If an agent makes a contract in behalf of the principal, the principal may be bound to fulfill those contractual obligations. For the principal to be bound, there must be actual or apparent authority.

Authority

Actual authority is simply a manifestation by that principal to the agent that they have authority to act for them. This can be express or implied. Express actual authority is a direct communication from the principal to the agent authorizing actions. Implied actual authority is where the agent is may be acting under the impression of authority based on the principal’s actions (e.g. buying a product for the principal, notifying the principal, and the principal consents to the purchase).

Apparent authority arises when a third-party has reason to believe that the agent is acting in behalf of the principal. Notice here that it is the communication between the principal and third-party that matters in this situation, not the communication between the agent and principal. A simple way of summarizing apparent authority is through two elements:

1. The third-party reasonably believes the agent or other actor has the authority to act, and
2. That belief is traceable to the principal’s manifestations.

H.H. Taylor, C.A. v. Ramsay-Gerding Construction Co.

“Apparent authority requires that the principal engage in some conduct that the principal ‘should realize’ is likely to cause a third person to believe that the agent has authority to act on the principal’s behalf.”

The analysis always begins with whether there was actual authority. If there is actual authority, then there is no need to explore further, the principal is bound. However, if there is no actual authority, the next step is to determine if there was any apparent authority.

Here apparent authority can be found simply because the third-party perceives that the agent has the authority. This perception came because of the job title, work responsibilities, communication, etc.

Estoppel

Even if there is no authority (there is no manifestation), a principal may still be bound to fulfill the contract. There are three requirements for estoppel to be found:

1. Justifiable belief that the individual is an agent,
2. Reliance on that belief by the third-party to their detriment,
3. The reliance comes because of the principal’s actions.

Inherent Agency Power

This is really a legal fiction. Ultimately, the idea is that agencies have the requirement to be fair to the general public. Regardless of authority, estoppel, the principal may still be bound to the contract. This was covered in the 2nd Restatement of Agency, but has not been included in the 3rd Restatement of Agency.

Ratification

If the agent acts in behalf of the principal without any authority (actual or apparent), the principal can later approve the agent’s actions. In this instance, the agent’s actions are ratified and the principal is bound to the agreement.

Entity-Specific Rules

Partnerships

Under RUPA § 301(a), unless a third-party has notice, it is assumed that a partner has apparent authority. In other words, the partnership automatically acts as the manifestation of authority. This is true as long as it is within the ordinary course of events of the business. If the actions are outside the ordinary course of events, then the regular common law rules apply.

Elting v. Elting

First, all managing partners are agents for the partnership, who has authority to act in behalf of the partnership unless the partnership agreement states otherwise. Second, ratification requires the actual knowledge (not constructive) of the partners.

First, the court agrees that Kerwin had no authority to enter into the contract. The partnership agreement clearly states that an agent required a partnership majority to alter business dealings. Because there was a lack of discussion and approval between the managing partners, Kerwin lacked that authority.

Second, the actions taken by Kerwin were not ratified by the other managing partners. Although the signing of the accounts sheet at the 2009 meeting could serve as constructive notice, the other managing partners had no actual knowledge of Kerwin’s actions. Because actual knowledge is the requirement before ratification can occur, there was no ratification provided.

Corporations

Unlike partnerships, corporation owners are not automatically endued with authority. As such, owners are not automatically agents of the company. Instead, the decision making process is governed by a board of directors (which must act collectively) in determining which individuals have authority to make decisions for the corporation. Usually, this means appointing a CEO, who has authority to bind the corporation and also has the authority to appoint other agents with authority to act in certain capacities.

LLCs

LLCs are tricky when it comes to authority. Some jurisdictions follow the partnership standard where LLC members are automatically agents with authority to bind. Other jurisdictions follow corporations, where LLC members are not automatically agents.

In re Nothlake Development L.L.C.

Under Mississippi law, a member of an LLC is an agent with authority to bind the LLC in the ordinary course of business events (unless the operating agreement alters that authority). As such, any unauthorized and unratified actions are void.

First, Earwood clearly had no actual authority. Although a member as an agent, he only has the capacity to act within the normal business dealings of Kinwood. This is certainly a situation where he was not acting in normal business dealings. As such, there is no actual authority.

Second, there is no apparent authority. Earwood, as the sole owner of Northlake, had knowledge that he did not have the authority to transfer the property of Kinwood to Northlake. As such, there is no apparent authority.

Because Earwood had no authority, and the actions were not later ratified by Kinwood, the transaction is void and the property interests returns to Kinwood.

Ensuring an Agent has Authority

There are three main methods to ensure that an agent has authority. First a Secretary’s Certificate (a document by a designated secretary certifying that certain individuals have authority). Second, opinion letters (letters exchanged by attorneys to confirm who has authority). Third, a statement of authority (a certification that is filed with the government).

Principal Liability for Agent Torts

Quite simply, if an agent engages in a tort while within the scope of work of a business, the business may be liable for the agent’s conduct. This doctrine is called “respondeat superior” which directly translates to “let the master answer.” However, this only applies if the tortfeasor is an agent of the principal and engaged in the tort while in the scope of employment.

The Principal-Agent Problem and Agent Duties

The principal-agent problem is that both the principal and the agent have interests and sometimes that agent does not act in the interest of the principal but instead acts in their self-interests. In this situation, principals are required to make expenditures to limit costs associated with agent self-interest.

In an effort to reduce to reduce this self-interest, the law imposes a fiduciary duty of loyalty on the agent. These often protect the principal from the agent engaging in competition against the principal, take from the principal, etc. However, these requirements often come as a safety net, rather than the primary mode of recovery.

Foodcomm International v. Barry

Agents owe a fiduciary duty of loyalty to:

1. Not exploit their positions within the corporation
2. Hinder the ability to conduct business.

A breach occurs when agents:

1. Fail to inform the company that they are forming a rival company
2. Solicit the business of a single customer before leaving
3. Use company equipment to assist them in the breach
4. Or solicit other employees to join them.

Additional Notes

When we consider a duty of loyalty, the first consideration is whether there are conflict of interest transactions. This occurs when an employee may be doing the same work for competitors.

Considerations to Choice of Form

Liability Exposure

There is a distinction between inside and outside liability exposure:

• Inside: owner exposure on business obligations.
•  Outside: business exposure on owner obligations.

Inside Liability Exposure

Inside liability exposure refers to the potential liability owners of a business may personally have. Essentially, this is why businesses often form as Corporations, LLCs, or LLPs, so there is an existing liability shield. Most often, those who want internal liability protection choose Corporations or LLCs because they provide even more protection than LLPs.

However, even this protection can be shattered. There are two ways this occurs. First, by direct liability. If an owner engages in a tort (even while going about normal business activities), that owner will still be personally liable to the victim and will not be shielded. Second, by a process called veil piercing. This is when the courts determine that the shield should not apply in that specific instance. The only problem is, the factors applied when determining whether the veil pierce are inconsistent.

GreenHunter Energy, Inc. v. Western Ecosystems Technology, Inc.

The liability shield can be pierced if:

1. The LLC is not really separate from the owners due to misuse of the LLC and
2. The facts would lead to injustice, unfairness, or inequality.

To determine if these elements are met the court will consider:

1. Fraud (usually required to pierce, and can be a sole reason for the piercing)
2. Inadequate capitalization
3. The degree of intermingled finances

Although there is nothing wrong with a holding company (a company owning a subsidiary company), the subsidiary should have all of their own features. That is, own employees, own accounts, own finances, etc.

Ultimately, there are two takeaways if: 1) separateness ceases to exist and 2) it results in unfairness, then there are grounds for piercing.

Outside Liability Exposure

This refers to the owners assets within the company to be protected from outside creditors. For instance, if an owner gets into a lawsuit and has a controlling interest in the company, LLCs would protect the owners interest from being seized if there is a judgment.

There is an exception to this rule. That is, the party could obtain a foreclosure against the owner. Even in this case though, often times the company assets are still protected. There is another exception to this rule. A creditor could go to the courts and request that the LLC is dissolved. At this point, the creditor could then liquidate assets to satisfy any judgment.

In re Albright

291 B.R. 538 (Bank. C. Dolo. 2003).

Facts

Albright was in bankruptcy court and a creditor was trying to reach the assets of his business. He was the sole-member of an LLC

Analysis

Because Albright was a sole member of a LLC, there is no need to protect the assets of other owners. As such, the business assets can be reached to justify the debt of the sole member.

Reverse Veil Piercing

C.F. Trust, Inc. v. First Flight Limited Partnership

The court adopts the theory of reverse veil piercing. Ultimately, reverse veil piercing works the same way as a traditional veil piercing. The difference between the two are whose assets are going to be reached.

Reaching corporate assets.

Tax Treatment

Businesses have the end goal of minimizing federal income tax and minimizing federal employment tax.

Federal Income Tax

There are four main types of tax systems that govern how business’s are taxed. They are Sub-K, Sub-C, Sub-S, and disregarded. For every type of business, there is a default rule applied (for instance, a Limited partnership is atomically taxed under Sub-K). However, nearly every type of business has the opportunity to opt for another tax system, if eligible. The “if eligible” is important, especially for Sub-S taxation. Many of the requirements to become a Sub-S business is fragile, and breaking one of the eligibility requirements automatically defaults to Sub-C. Below will discuss the differences between these tax systems.

Sub-K and Sub-S

Under Sub-K and Sub-S, the business can pass through it’s income to the owners. What this means is that the business will calculate it’s profits and losses. Any income the business makes will be divided amongst the owners based on the percentage of their ownership (this is true, even if the business retains that income to further the growth of the business). The owners then add that percentage to their income statement while filing their taxes and pay a percentage depending on the business income.

Sub-C

Sub-C businesses are treated as a separate entity, which means that they are required to pay federal income tax for all of their income. Assuming the business also distributes some of that income to the owners (usually through a dividend), the owners must report their reception on their individual tax statements. Thus, Sub-C corporations are double taxed (although the income is usually taxed at a lower rate).

Disregarded Entity

Single-Member LLCs are the only incorporated businesses that are treated as a single entity (much like a sole proprietorship). Unless they opt for Sub-S or C taxation (can’t opt for Sub-K), they report the business gains and losses on their individual tax returns.

Choosing Between Sub-K and Sub-C

Tax Allocation

Owners can determine who shares most of the burden of the tax. However, this is quite complex and subject to ensuring that the allocation has a substantial economic effect. For instance, if one owner is in a higher tax income and the other is in a lower tax income, and the business anticipates losing money in that year, the owners can allocate the losses more to the owner in the higher tax bracket. This means that the tax deductions are going to be higher and decreases the burden on the individual tax returns.

Federal Employment Tax

An owner that is categorized under a Sub-S has to pay FICA (Social Security and Medicare) for itself and employees. However, owners categorized under Sub-K are subject to self-employment tax “SE tax” which is means that the owner is subject to paying all (not just half) of the tax (in Sub-S, the business only pays half).

However, this presents an issue for those who abuse the system. You see, under this system, a business could provide a small salary, but provide large compensatory benefits. This means that the individual has a lot lower reported taxable income. If suspicious, the IRS will audit this amount to determine if the salary is unreasonably low.

Watson v. Commissioner

Was Watson’s salary reasonable compensation?

The court considers:

1. The qualifications of the individual
2. How much the individual works
3. The gross earnings of the employer
4. The salary compared to others in a similar capacity
5. Comparing the salary alongside other compensatory benefits paid to the individual.

Considering the factors above, the salary paid to Watson was unreasonable compensation. He went to school, worked full time, made a lot of money for the employer, was paid considerably less than others in his capacity, and his salary was disproportionately low compared to his other compensatory benefits.

Takeaway: Become a Sub-K corporation if you want to allocate percentage of ownership (as long as there is a substantial economic effect). Or, become a Sub-S business if you want to reduce employment taxes, but be careful of under compensation of a salary.

Attractiveness to Investors

There are two main types of investors: Venture capitalists and Angel investors. Venture capitalists typically are an entity that invests in several companies hoping that a few will make a private. Angel investors are typically individuals who like the idea and the parties behind it. Both Venture capitalists and angel investors are likely to prefer a C-Corp because of tax limitations of an S-Corp and the additional security of having a liability shield.

Other Considerations

• Paperwork
• Expenses
• Lifeline of the business
• Waiving fiduciary duties
• Form restrictions (by law)
• Management default rules
• Buyout rights
• Newness of legal forms (lack of case law)
• Conversion – ease of converting from one form to another

Unincorporated Entities

Partnerships and Limited Liability Partnerships

Partnerships

Formation

Holmes v. Lerner

The parties expressly agreed to associate as co-owners with the intent to Cary on a business for profit. As such, they have formed a partnership. Likewise, there was a definite partnership agreement (“we will do everything . . . together.”)

Management

The default rule of management is that every partner has an equal vote when making decisions for the partnership. As long as the decision is about the ordinary course of business, the decision requires a bare majority. If the decision is about something outside of the ordinary course of business, the decision must be unanimous.

The key is to determine what is the ordinary course of business. Because this determines how many votes the decision requires (if using the default rules).

Partnership Agreement

Most partnerships are formed with a written partnership agreement. This agreement typically addresses management (voting power), allocation of profits and losses, admission and withdrawal of partners, etc. The partnership agreement can also alter the default rules (although there is no alteration of mandatory rules See RUPA § 103(b)).

If there are parts in a written agreement that are contrary to the mandatory rules, then the contract is void (if there is no severability clause). Thus, we see that every written partnership agreement should include a severability clause and a merger clause.

Fiduciary Duties and Obligation of Good Faith and Fair Dealing

There are at least two fiduciary duties partners owe each other: 1) duty of loyalty, 2) duty of care. Although these duties can be defined, they cannot be removed from the partnership. By default, RUPA defines these duties as

Duty of Loyalty:

“Duty to account to the partnership and hold as trustee for it any property, profit, or benefit . . . derived from a use by the partner of partnership property.” RUPA 404(b)

Duty of Care:

“Refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law.” RUPA 404(c)

Additionally, the duty of loyalty also prevent partners from engaging in self-dealing (acting in personal interest rather than partnership interest) or competing against the partnership.

Other obligations that cannot be removed in the partnership agreement is the obligation of good faith and fair dealing.

Meinhard v. Salmon

Salmon has a duty of loyalty to the partnership that brings along a desire to disclose. Due to the failure to disclose Meinhard may have missed out on opportunities that would have otherwise been fully available to him. Consequently, there was a breach of loyalty and Salmon can be found liable.

RUPA § 103(b) – You can’t eliminate the duty of loyalty or care, but you can limit it to a certain point. See comments 103(b)(3) and (b)(4).

Additionally, partners have the obligation of good faith and fair dealing. The terms of good faith and fair dealing are not defined in RUPA, but instead left to the courts to determine how they should be interpreted and applied. The obligation is integral in the other duties (not separate) and likewise cannot be eliminated.

Liability Exposure

Every partner in a partnership is subject to personal liability for the actions taken by the partnership (partnership assets go first then partner assets). A partner not in the wrong could then still indemnify against the partner who caused the loss.

Transferring Partnership Interests

The default rule under RUPA § 503 is that a partner is not allowed to transfer its management interest, but can transfer its economic interests. The reason for this is because of the “choose your own partner” principle. That is, partners have the right to choose their partners and thus one partner cannot freely give up the partnership to another without unanimous consent of other partners. This principle can be modified by the partnership agreement.

Allocation of Profits and Losses

According to RUPA § 401(b), the default rule is that partnerships equally divide profits and losses. The unique thing about a partnership though is that the partners can agree who bears most of those profits and losses (especially if one partner contributes more than others).

There is a difference between distribution and allocation of profits. Allocation of profits discusses how much each partner is required to report on their taxes. Distribution discusses how much each partner is actually paid. Most partnership agreements ensure that the distribution amount is sufficient to cover the taxes based on the allocation calculation.

Dissociation

A partner may no longer become part of the partnership either 1) express notification of the will to withdraw, 2) expelled by the partnership agreement, 3) becoming bankrupt, or 4) through death. The dissociated partner must then be bought out and immediately cash the check. See RUPA §§ 601 and 701.

Dissolution

A partnership may dissolve in one of several ways. For instance, if one partner expressly shares a will to withdraw, the partnership will dissolve. The partnership may also dissolve if the partnership has an expiration date, completes its scope of work, or is ordered by a court to dissolve. Although most of these methods for dissolution may be addressed in the partnership agreement, a court order to dissolve cannot be altered.

Once an event has triggered the dissolution, the partners begin the winding-up phase (wrapping up the work). In this phase, the partnership continues until all the work necessary to complete the dissolution has been achieved. This includes the balancing of capital accounts (Contributions + Profits – Distributions = Capital Accounts).

See RUPA §§ 801 and 807

Limited Liability Partnerships

Formation

A LLP is essentially the same as a partnership but with liability protection. Rather than having no filing, a LLP submits a “statement of qualification,” which requires the name of the partnership, street address, and a statement of the desired LLP status. See RUPA § 1001.

Liability Exposure

The benefit of the LLP is found in RUPA § 306(c). That is, a partner within a partnership is not personally liable for the contract, torts, or other issues made by the partnership.

Limited Partnerships and Limited Liability Limited Partnerships

Limited Partnerships

Limited Partnerships are becoming less and less significant, considering the rise of LLPs and LLCs. However, there are still some large businesses (and often family partnerships) that are formed as an LP.

Formation

A LP is formed by filing a “certificate of limited partnership” with the Secretary of State that includes certain details about the business (business name, address, names of general partners).

Governing Law

The law that governs the LP are the statutes passed within the state the LP is formed in. Most states have adopted some version of the Uniform Limited Partnership Act (ULPA), which is the LP version of RUPA. Just like RUPA, the ULPA usually consists of default rules which can be adjusted by the partnership agreement.

Management

The general partners have the management rights to make decisions for the business. The limited partners have ownership rights, but make no influence on business decisions. The exception to this rule is if the general partners wish to dispose of partnership property (by amending the partnership agreement) the partners need to have a approval of the limited partners.

The friction here is that general partners want discretion and limited partners want to limit that discretion. The question is how do the limited partners limit that discretion when they have no controlling vote.

Liability

The general rule is that the general partners are liable while the limited partners have a liability shield. However, limited partners may become liable if they participate in the decision making process for the partnership. General partners also get around the liability problem by assigning an entity, usually a LLC, as the general partner. Thus, both the general and limited partners have a liability shield (the general partners through the LLC). Most of the time, a limited partnership is not a selected business format because the liability can be expensive.

Duties and Obligations

The duties and obligations of the limited partnership are similar to the general or limited liability partnerships. That is, there is both the duty of loyalty and care. Additionally, there is the obligation of good faith.

The general parties owe these duties and obligations to the limited partners (the limited partners by default do not have these duties). The way to remember this is to determine if anyone has the ability to make a decision alone, then those entities have a fiduciary duty. Thus, in a LP, the general partner has a fiduciary duty to the partnership and the limited partners.

In the ULPA, this duty can only be limited, but not eliminated. However, in Delaware, then these duties can be eliminated. However, you cannot eliminate the obligation of good faith and fair dealing. The challenge here is determining the fine line between duties and obligations (when do you cross into obligation territory instead of just a duty).

Transferring Interest

The default rule is that limited partners cannot transfer their interest except for their rights to collect dividends. This is often amended in a partnership agreement though because the amendment does not adversely affect the general partners.

Profit and Loss Allocation

There is no requirement to allocate profits. However, most partnership agreements have a provision that allocate dividends to help the partners pay taxes. See § 503.

Buyout Rights

Unlike the default RUPA rule, a dissociation of a partner does not trigger buyout rights. § 602(a).

Limited Liability Limited Partnership

The main distinction between a LP and LLLP is that the LLLP provides a liability shield for all the partners, general and limited.

Limited Liability Companies

Formation

The limited liability company (LLC) is formed by filing a “certificate of formation” with the Secretary of State. Each state is somewhat unique in what information must be included on this certificate, but generally, the name of the company, address, and the name and address of the registered agent is required.

Governing Law

Once again, each LLC is governed by the law where the company was formed. However, most states have adopted the Revised Uniform Limited Liability Company Act (RULLCA). Delaware has not adopted the RULLCA but has the Delaware Limited Liability Company Act (DLLCA). Most LLCs (80%) are formed in Delaware and are thus governed by the DLLCA.

Operating Agreement

The operating agreement is similar to a partnership agreement for partnerships. That is, the operating agreement tailors the state’s statute to fit the needs of the LLC. There are still some parts of the statute that can’t be worked around in the contract, so attorneys should remain familiar with the default and mandatory rules of the statute.

Management

A LLC can be either member-managed (like a decentralized partnership) or manager-managed (like a centralized corporation). The default rule under the DLLCA is that LLCs are member-managed. However, this can be altered in the operating agreement to be manager-managed. Under RULLCA, there are new default rules that form if the LLC elects to be manager-managed.

Fiduciary Duties

LLCs may have the duties of loyalty and care imposed upon all members/managers/the LLC. RULLCA § 409 has fiduciary duties on members and managers (depending on the format). Delaware does not have any provisions, leaving that up to the operating agreement and the courts.

William Penn Partnership v. Saliba

12 A.3d 749 (Del. 2011).

For the sale to be valid without breaching a fiduciary duty, the sale needed to engage in fair dealing and fair price. Fair price does not equal fair dealing. Fair price is determined by a proper evaluation of the company. To establish fair dealing, courts consider the structure, timing, disclosures, and approvals of the sale.

The operating agreement did not disavow any duties and so the fiduciary duty of loyalty and care apply. To meet this standard, the parties had to show that the transaction had fair dealing and fair price. Although there was a fair price, there were several misrepresentations made by the Lingos in their self-interest that caused a breach of duty. These included:

1. Imposing an articifical deadline for the sale
2. Failing to inform Saliba of the sale terms
3. Failing to inform Saliba that they had committed selling the property to a third-party (owned by the Lingos)
4. Holding a vote that did not include Saliba.
5. Representing that the vote was unanimous when it was not.
6. etc.

The case notes that the operating agreement did not expressly disavow fiduciary duties. According to DLLCA, the LLC can expressly say that members do not owe a fiduciary duty of loyalty or care. Under RULLCA, an operating agreement can modify, but not eliminate these duties.

Feeley v. NHAOCG, LLC

In Delaware, there are default fiduciary duties unless the operating agreement expressly eliminates, restricts, or displaces those duties. The Operating agreement present does not discount those duties and so they could be found in this case. The motion to dismiss is thus denied.

Obligation of Good Faith and Fair Dealing

Even in Delaware, the operating agreement cannot eliminate good faith and fair dealings. § 18-1101(c). Likewise, the provision remains in full force within the RULLCA. § 409(d).

Liability Shield

The liability shield rules can be found in RULLCA § 304(a) and DLLCA § 18-303(a).

Estate of Countryman v. Farmers Co-op. Ass’n

A liability shield will protect individuals and entities from the liability of others. However, if the individual or even entity engaged in tortious conduct, they can be found liable for that conduct.

Transfer of LLC Interests

The default rule under the DLLCA (18-702(a)) allows a member to transfer economic rights but not the management rights. Same applies for RULLCA § 501.

Achaian, Inc. v. Leemon Family LLC

By default, one does not transfer member rights unless the operating agreement says so. Here, the operating agreements stated that the entire rights could be transferred. As such, the next issue to resolve would be whether the company should be dissolved (a deadlock = dissolution).

Allocating Profits, Losses and Distributions

DLLCA §§ 18-503 and 504.

RULLCA § 404(a) – distributions are made equally among members.

Withdrawal

DLLCA § 18-603 – Default rule is that a member cannot withdraw before dissolution or winding up. But this rule can be altered in the operating agreement.

RULLCA § 601(a) – Members can withdraw at any time.

Touch of Italy Salumeria & Pasticceria, LLC v. Bascio

There was no breach of contract because the provision specifically allowed the withdrawal of members. Thus there was no breach. Additionally, there was no breach of the obligation of good faith because there was no noncompete clause included (so there was nothing to violate). Finally, there is no evidence of a breach of fiduciary duties because the plaintiffs failed to bring any support to the claim that the “planning” actually occurred. In other words, Bascio was formed after the party left Touch of Italy.

Dissolution

DCLLA § 18-801 – The LLC is dissolved at the time specified in the operating agreement once a trigger (also specified occurs). Dissolution can also occur with a two-thirds vote of the ownership interests.

Haley v. Talcott

Here, we have two LLC members with 50% ownership each and at complete odds. Because of the situation, it makes sense that the LLC should be dissolved to overcome the impasse. This is true, even with the exit mechanism contained in the operating agreement. The exit mechanism is impractical because neither party is willing to buy, but also because both parties are guarantors of the mortgage. Should one be bought out, then the business fail, they would still be liable for the mortgage despite having no control over the property. As such, the LLC should be dissolved, auctioned, and the market value distributed to the owners.

Series LLCs

A series LLC is where an LLC can categorize their assets into series. The idea is that if an accident arises within one series, then the amount recovered would be taken from that same series, leaving the other assets untouched. This is primarily used in Delaware and a few other states. Mostly investment companies utilize this form and there are uncertainties on whether the form will be accepted in federal aspects, such as federal bankruptcy law.

Corporations

The Incorporation Process

Pre-Incorporation Activities

Because the corporation entity is often formed after the idea has started being put into action, there are activities that may occur before incorporation. A person engaging in these activities is called the promoter. So who is liable for any contracts signed by the promoter? The individual promoter or the corporation?

The general rule is that the promoter will be personally liable for the contract. However, there could potentially be an exception to this rule if the other party knew the corporation was not yet formed and contracted specifically with the future corporation.

Additionally, a corporation can later become liable if they “acquiescence” to the contract. In other words, the corporation ratifies the action. Typically a promoter will add a “novation” clause into the contract saying that once the corporation is formed, the corporation will automatically substitute as the party in the contract (instead of the promoter).

Jurisdiction of Incorporation

So, where should the corporation incorporate? Typically, there are two options, the state where the corporation is going to be headquartered or Delaware. If the corporation is only going to do business in one state, it would be better to be incorporated in that state. However, if the corporation seeks Venture Capitalists or wishes to go public in the future, it might be worth spending the extra money to incorporate in Delaware.

Incorporating in Delaware is more expensive because you essentially have to pay doing business in multiple states (getting a registered agent and office in Delaware and the home state). However, VCs like Delaware because of the laws governing the corporation, the respect, and knowledge of the the court system.

Mechanics

First, file articles of incorporation – often called the charter. Required information is outlined in DGCL § 102 or MBCA § 2.02(a). The articles contain:

• Note that the name of the corporation needs to be distinguishable from other business entities within the state (and also the USPTO office).
• Authorized shares = the maximum number of shares the corporation is authorized to issue. Typically set to the highest amount possible while paying the least amount of fees (more shares = more fees).
• Shares outstanding = the number of shares held by a corporation’s shareholders.
• Par value = the minimum amount of consideration that must be received to issue a share. Thus, if the par value is set at $10 and sells 100 shares, the corporation must receive $1,000. Today, this value is hardly relevant because it can be set as a nominal amount or not set at all.
• Purpose – which can be narrowed but is usually broad. Broad = avoiding invalidation of decisions that go beyond a narrow scope.

The articles of incorporation need to also list the address and the incorporator (usually the attorney doing the filing). The articles also only meet the required elements and everything else is put into the bylaws because bylaws are cheaper and easier to amend.

After the articles of incorporation are completed, the directors need to be elected to finish completing the organization of the corporation. This includes, adopting bylaws, appointing officers, and approval of issuing stock.

If the corporation wishes to do business in states other than where they are incorporated, they need to become a “foreign corporation by qualifying to do business in that state. Typically this involving filling out a form, filing a fee, and maintaining a registered agent. This has to occur if the corporation is “transacting business,” an imprecise term.

Harold Lang Jewelers, Inc. v. Johnson

A party is transacting business if they are “engaging in, carrying on or exercising some of the functions for which the corporation was created.” Here, the jewelers were in the business of selling and consigning Jewelry and did so frequently and consistently within NC. As such, Lang was transacting business in NC and should have obtained the requisite certificate. Because he failed to do so, the case is dismissed.

Defective Incorporation

What happens if the corporation is running but (for whatever reason) fails to actually become incorporated? Under partnership law, individuals would be personally liable. However, courts have often sided that the corporation is either de facto incorporation or a corporation by estoppel.

Pharmaceutical Sales and Consulting Corp. v. J.W.S. Delavau Co.

De facto corporation requires (1) a law that allows the doctrine, (2) a bona fide attempt to become incorporated, (3) use of corporate powers.

PSCC cannot be a de facto corporation because the bona fide attempt to become incorporated occurred too late (Aug. comes after July).

A party that engages with the defective incorporation and acts as if the company is a corporation may be estopped. This is especially true if the party is tying to get out of liability as a defendant. Here, the defendant is trying to escape liability, and it makes sense that (for purposes of this contract) PSCC should be afforded corporate by estoppel status.

Ethical Issues

First, is multiple founders come to the same lawyer for the incorporation process, there is the potential of a conflict of interest. Consequently, lawyers will often provide informed consent and obtain a conflicts waiver from each founder.

Second, because founders are low on money, they often offer stock in exchange of legal services. Not advisable, but acceptable as long as the terms are “fair and reasonable” to the client.

Third, if the incorporation occurs in another state where the lawyer is not licensed, the lawyer may help with getting everything set up (temporary), but nothing else.

Finance

Debt

Overview and Risk

Debt is simply a loan, typically comprised of the principal (initial loan amount), interest rates, and installments (how much of the loan needs to be paid back in each payment). Loans are typically made by creating a promissory note and may also be secured by collateral (in this case, probably the corporation).

The interest rate of debt is likely going to be dependent on the riskiness of the investment. The more risk, the higher the interest rate, and vice versa. So, creditors need a reliable way of evaluating risk, usually by checking a credit score. Businesses also have a “credit score” by obtaining a PAYDEX Score. The three major credit agencies for businesses is S&P, Moody’s, and Fitch, each rating the business as AAA, AA, A, BBB, BBB-, BBB+, BB, B, CCC, CC, C, or D. AAA being the best and D being the worst (typically in default).

Loan Agreements

The more money involved, the higher the likelihood that the creditor will require a loan agreement. These loan agreements include:

• Representations and Warranties – Statements of fact by the contracting parties. False information being a reason of breach.
• Covenants – Promises either to do something (affirmative) or not do something without consent of the lender (negative).

Leins

Either in the form of a mortgage for real property or a security interest in personal property, liens are used to secure the transaction by associating it with collateral that can be collected in the case of a default.

Guaranties

Most lenders ask shareholders to waive their liability status by personally guaranteeing that the loan will be paid back. If the corporation fails, the guarantor will be liable for the obligation.

Types of Debt

• Term loan – payments made periodically for a term
• Line of credit – pulling from a set amount (not given all at once, but could be if requested). The debtor can payback then reborrow at later times.
• Equipment loan – Loan specifically designed so the corporation can purchase product producing equipment. Loan equals 50% – 80% of equipment value.
• Equipment lease – Lender purchases the required equipment then leases it to the business.
• Inventory loan – Loan secured by inventory. Loan equals 50% of inventory value.
• Mortgage loan – loan for real estate
• Subordinated debt – junior creditor. See priority issues with secured transactions for more details.
• Accounts receivable loan – secured by the businesses accounts receivable.
• Syndicated loan – One loan funded by a group of lenders.
• Corporate bond financing
• Debenture financing – Selling unsecured bonds, called debentures.
• Junk bond financing – Selling bonds with a grade of BB+ or lower.
• Commercial paper – Short-term debt used to fund “current transactions.”
• Trade debt – See PMSIs in secured transactions.

Typically, the role of the lawyers is to create term sheets (what the business wants out of the loan), draft agreements, review them, make revisions, and then recirculate the changes for approval. Once all the changes are made, the business can close on the deal and the loan may be issued.

Equity

Equity = Business ownership. For corporations, this is denoted as “shares” of stock, either common or preferred.

Common Stock

DGCL § 212(a); MMBCA § 7.21(a).

Common stock has two benefits for owners: (1) full voting rights and (2) a residual claim on net assets after dissolution. As for voting rights, by default, one share equals one vote of common shareholders. As such, many charters will authorize multiple classes of common stock, with different voting power depending on the class. So, if Party A has 10 shares of Class A with one vote each, and Party B has 10 shares of Class B with 10 votes each, Party B will have more say in the business because they have more votes (despite having the same number of shares).

Preferred Stock

Preferred stock means that the owners have a preference over common stock owners in either dividends and/or asset distributions upon dissolution. Corporations typically have several “Series” or rounds of preferred stock.

Dividend Preference

A per share amount of the dividend the holders will receive before common stock holders. These can be cumulative or non-cumulative from year to year. If the charger is silent, the default rule is that the dividends are cumulative.

Additionally, this preference can also “participate” in receiving the dividends of common stock (must opt into it in the charter).

Liquidation Preference

A per share amount of the liquidated assets the holders will receive before common stock holders. Again, this preference can be participating or non-participating. Cumulative does not apply because liquidation is a one-time event.

Conversion

Conversion refers to when a preferred stock can be converted to a common stock and how much value the converted stock has. Holders of preferred stock are not likely to convert unless if the corporation is being bought out and common is worth more or if the common stock can be sold but not the preferred stock (the holder wishing to sell their shares). Automatic conversion could also occur if the business receives an initial pubic offering (IPO) of a certain price (the purpose is to simplify the capital structure of the corporation).

Anti-Dilution

Dilution is when the percentage interests of existing shareholders and their power decrease. Typically, this is going to occur when a new investor joins in and pays less than the book value of the share. As such, Anti-Dilution clauses are put in place to adjust the weight of the shares given changes in the number of shares outstanding.

Protective Provisions

These are clauses that prevent the corporation from harming preferred stock holders without their approval.

Voting Rights

The default voting rights of preferred shares is one share equals one vote. Many clauses will alter this to say that the preferred holders would have the same number of votes as they would if their shares were converted to common stock.

Electing Directors

Preferred stock holders typically have the right to elect a certain number of directors.

Redemption

Preferred stock holders may require the corporation to buy the stock back (essentially, preferred stock is debt).

Necessity for Careful Drafting

Lack of careful drafting (typically done by the investor’s lawyers) of any of the provisions listed above will lead to holes that the corporation may exploit.

Benchmark Capital Partners IV, L.P. v. Vague

There was nothing in the protective provisions guarding against changes made by a merger. As such, there was no need to request the approval of Series A and B for the creation of Series D. In other words, the lack of one word “mergers” allowed Benchmark to suffer significant losses to voting power and ownership rights.

Public Company Preferred Stock

Public companies can sell preferred stock too, except they typically lack the provisions above.

Corporate Law Requirements

Preferred stock terms are established in the corporation charter (articles of incorporation), which means each new series would subject the charter to amendment with shareholder approval. However, this can be done by creating a provision at the charter’s drafting called a “blank check preferred” which allows the corporation to create new series without approval. See DGCL § 151(a); MBCA § 6.02(a).

Warrants and Options

Warrants and options are not equity, but instead the right to purchase equity at a specified price on or before a specified date.

Warrants are often offered in addition to debt financing. In other words, lenders will likely lessen the interest rate in exchange for the right to exercise a warrant.

Options on the other hand are often offered to employees as an incentive plan (work here and we’ll give you an option to purchase stock). Typically, an option will “vest” when the employee has worked there for a certain period of time (you can’t exercise the option until it has vested, meaning no access to the money until then).

Corporate Law Requirements

Issuing warrants and options requires board approval. DGCL § 157; MBCA § 6.24.

Internally Generated Funds

Businesses can also fund themselves by making sales and applying the proceeds to business expenses. Additionally, businesses could sell some of their assets to finance the business.

Capital Structure

Capital structure references the balance between financing through both debt and equity. Below are some ways this structure varies depending on the type of funding provided.

Ownership Dilution

Ownership dilution only occurs through equity changes. Changes to the debt will not affect ownership.

Leverage

Leverage can only be utilized in debt scenarios. It is the principal that when you make an investment with debt funds, you retain any gains or losses of that investment. Thus, if you increase your leverage by accepting more debt (and thus your risk), you are much more likely to make more money in a quick turn-around time (assuming everything goes right).

Repayment Obligations

Debt needs to be repaid, even if the business is struggling.

Priority

In the event of bankruptcy, debt will beat out equity.

Taxation

Debt interest is deductible while dividends from equity dispersement is not.

Bottom Line

Businesses prefer debt over equity. If the business relies primarily on equity first, it is generally because they have to.

Federal Securities Regulation

Any security sale is regulated and either needs to be registered or exempt. Because stock is a security, the federal securities regulations need to be satisfied for each transaction.

Registering an Offering

The company must file a registration statement that involves several pieces of documentation describing the financial position of the business. Then, the filing is reviewed, comments made, and revisions provided until the registration is “effective.” At that point, the sale could occur. The whole purpose of the registration is to ensure that investors are well informed before making an investment decision.

Exempt Offerings

Section 4(a)(2)/Rule 506

Public offerings must be registered but private offerings do not. Rule 506 serves as a safe harbor to determine whether the requirements of 4(a)(2) are satisfied.

SEC v. Ralston Purina Co.

A public offering does not require that the offering be made to everyone. The offering can be made to few or to many and still be considered public. What turns the offering to private depends on the knowledge of the individual who is made the offer. If the individual would have access to the same kinds of documentation required by the registration, then the filing can be considered private. However, if the individual does not have that access, even if they are an employee, then the offering is considered public.

Rule 504

This rule allows a business to make an offering to as many individuals as it wants, as long as the offering does not exceed $5 million in a 12-month period. No information requirements are necessary. However, these are still subject to state security laws.

Crowdfunding

The process of gathering small amounts of money from large numbers of people. Typically, selling securities through crowdfunding is not a viable option.

Private Placement Memorandum

Basically, this is a letter to the investor providing them with the information that would otherwise be required in an investment.

Definition of Security

Securities include: notes, stock, bonds, debentures, evidence of indebtedness, transferable shares, investment contracts, voting-trust certificates, put, call, straddle, option, warrant, etc.

The biggest question with this definition is how an investment contract is defined.

Securities and Exchange Commission v. W.J. Howey Co.

An investment contract means “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”

In other words, invest in my business to return a profit, and that is an investment contract.

Governance

Shareholders elect the Board of Directors who in turn appoint officers to manage the day to day activities. The governing documents of the corporation include (1) corporate statutes, (2) the charter “articles of incorporation, and (3) the bylaws. The priority of governance also falls in that order. For example, if the bylaws are inconsistent with the charter, the charter will win.

Shareholders

Shareholders can only vote on the following unless authorized by the board:

1. Electing/removing directors
2. Amending the charter
3. Shareholder initiated amendments to the bylaws
4. Dissolution
5. Mergers
6. Sale of all corporate assets.

Meetings

Voting occurs through meetings. Annual meetings are required via MBCA § 7.01(a); DGCL § 211(b). Other special meetings may occur to vote on things that can’t wait. See MBCA § 7.02; DGCL § 211(d). For a vote to be valid (1) notice between 10-60 days must be provided and (2) a quorum of votes (minimum number of votes represented) must be present. The default rule for a quorum is a majority of the votes. MBCA § 7.25(a); DGCL § 216. The MBCA allows the quorum requirement only to increase. However, the DGCL allows the quorum requirement to be lower (down to one-third) or higher.

Proxies

A shareholder can appoint another to vote in their place if they cannot attend the meeting in person. All the shareholder has to do is grant express authority to the proxy person and create a proxy form which the proxy will then use to vote. MBCA § 7.22; DGCL § 212.

Written Consents

Rather than holding a meeting, the corporation can obtain the shareholder’s written consent if enough of the shareholders sign off on the decision. According to the MBCA § 7.04(b), this needs to be unanimous but can be reduced (as long as it does not go below the minimum number of votes to actually approve the decision). The default under DGCL § 228(a) is the minimum number of votes standard.

Voting Requirements

The minimum number of votes required for a decision to pass. MBCA § 7.25(c) says that as long as there are more votes for than against the proposal, it will pass, unless the charter says it needs more. DGCL § 216 requires the majority of votes present to pass, which can be altered by the charter or bylaws.

However, the standard for electing directors is plurality (the candidate with the most votes win). The purpose is to avoid failed elections.

Class Voting

Different classes and series of shareholders may vote in different bodies. This depends on what the charter says about voting and what matter is up for vote. The MBCA called this a voting group where one or more classes are entitled to vote and be counted together. MBCA § 1.40(26).

Directors

The directors manage the company by appointing officers and providing oversight. MBCA § 8.01; DGCL § 141.

Number and Qualifications

The number of board members is typically established by the bylaws and can be as low as one director. There is no default qualifications for a director, but the charter or bylaws can add them.

Board Action

Board action occurs in regular or special meetings. The MBCA default rule is a 2 day notice period for special meetings, but that can be reduced. DGCL has no requirement. Likewise, a quorum must be present (the default is a majority but can be lowered to one-third within the bylaws). See MBCA §§ 8.20(b), 8.24(a); DGCL §141(b), (i).

Likewise, majority vote is required or written consents could be obtained for a provision to pass.

Elections

Shareholders elect the director via straight voting (one share equals one vote). Those with more shares are going to get more say in who becomes a director. However, the charter could opt into cumulative voting (all your votes could be combined for one person instead of several). MBCA § 7.28(b) and (c); DGCL § 214.

Terms

The term of a director is generally one year, but a provision in the charter (MBCA) or bylaws stagger the election years. The purpose of which is to avoid turnover all at once, makes sure that the corporation continues to run smoothly, minimizes the impact of cumulative voting, and acts as an anti-takeover device.

Removal

By default, shareholders can remove directors at anytime with or without cause. The charter could add a “for cause” requirement. MBCA § 8.08(a). Only shareholders can remove directors. The required vote under MBCA § 8.08(b) is more votes for removal than against. Under DGCL § 144(k), the number of votes required is the same that was required to elect him.

Vacancies

Either directors or shareholders can fill vacancies (typically done by directors because they can call a meeting sooner).

Committees

A committee is built up by two or more directors who act for all the directors in the actions they take. The only real limitation is that they cannot engage in activities that requires the votes of shareholders (such as amending the charter).

Officers

Only one officer is required to be appointed, that is a secretary (to take board minutes). However, most corporations appoint other offices such as the CEO, President, CFO, etc.

Bylaws

The bylaws denote the rules of the corporation such as how meetings are to be conducted, the procedure for voting, etc. The complicated thing about the bylaws is that some things are not allowed to be included in them, but instead need to be altered in the charter. So, when reading the bylaws:

1. Read the bylaw
2. Check that the provision can be included in the bylaws by statute.
3. If the statute does not allow the provision to be in the bylaws, check to see if the provision is in the charter.

The default rule in the MBCA § 10.20 is that the bylaws can be amended by either the board or the shareholders. The charter can limit this power in respect to the board but not the shareholders. In the DGCL, the shareholders have the sole ability to amend the bylaws, but the power could be conferred to the board.

Litigation Related Bylaws

Forum Selection

The internal affairs doctrine states that the governing law is the state of incorporation. However, bylaws may contain forum selection clauses other than the state of incorporation. Although these have been deemed valid, there is controversy as to whether they would be enforced.

Fee-Shifting

Many boards attempt to shift the legal fees to unsuccessful plaintiffs. Once again, the statutes are unclear about whether these are valid.

Amending the Charter

1. Send notice to the board of a meeting.
2. Obtain approval from the board – either in person or by written consent with the requisite votes.
3. Send notice to the shareholders of a meeting.
4. Obtain approval from the shareholders – either in person, proxy, or by written consent with the requisite votes.
5. Record the decision.
6. Send in the articles of amendment to the Secretary of State with the filing fee.
7. The amendment becomes effective.

Fiduciary Duties

Director Duties

The directors are subject to the fiduciary duties of loyalty and care. The bulk of this discussion will focus on the Delaware law, supplemented by the MBCA at the end.

Standards of Conduct v. Standards of Review

Standard of conduct (what directors are supposed to do – duties of loyalty and care) verses the standard of review (defines when directors are liable for their conduct). Standards of review include the business judgment rule and entire fairness, which may be excuses to poor conduct.

Business Judgment Rule

A presumption that the directors acted in good faith and were informed in making decisions for the company. To overcome the business judgment rule, the plaintiff must show “the decision was so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.” In other words, to prove waste, the plaintiff must show that the majority of directors either (1) were interested, (2) lacked independence, (3) were not adequately informed, or (4) acted in bad faith.

Entire Fairness

Two parts: Fair dealing (timing, structure, negotiations, etc.) and fair price. This is a more difficult standard for the corporation to defend, but can be done.

Analysis

1. Majority of directors made a poor decision affecting a plaintiff.
2. Plaintiff must overcome the business judgment rule by showing waste.
3. Plaintiff must then overcome the principal of entire fairness.
4. If successful, the plaintiff will have shown that there was a breach of the duty of care.

Duty of Care

When evaluating whether there was a breach of the standard of care, the courts will examine the corporations “decision making process” rather than the decision itself or the result. In other words, was the board adequately informed before they made their decision? To answer this question, the courts will look at what material the corporation had before them and whether there was gross negligence in neglecting that preparation. Gross negligence is defined as “reckless indifference to or a deliberate disregard of the boy of the stockholders’ or actions which are ‘without the bounds of reason.'”

Exculpation Provisions

Exculpation provisions say that directors are not directly liable for monetary damages for a breach of the duty of care. That is, if a plaintiff is suing for monetary damages, and the charter contains an exculpation provision, the court’s will not consider whether the directors were grossly negligent in being inadequately informed.

These provisions, however, do not protect the corporation from equitable relief. That is, the decision may be stopped by the court if the decision has not yet been implemented (e.g., closing on a merger).

Duty of Loyalty

Addresses the principal-agent problem; directors are required to act in the best interest of the corporation, not self-interest. Liability can be found in any of the following contexts.

Conflicting Interest Transactions

A transaction between a director and the corporation. However, these transactions are not voidable if (1) majority of disinterested directors approve, (2) majority of disinterested shareholders approve, or (3) the transaction is fair to the corporation. DGCL § 144. However, there may still be liability as a breach of the duty of loyalty. The analysis goes as follows.

1. Director has to show it was fair. If so, no breach of loyalty. If not fair, has to pay for the damages (make it fair).
2. The director can avoid showing fairness if it was approved in advance by a fully informed majority of either disinterested and independent directors or shareholders. At that point, the business judgement rule would apply.

Interested = the director receives a material economic benefit that makes it improbable that they will fulfill their duties without bias.

Independence = The decision was made without the influence or control of any interested parties.

Fully informed = Not only informed about the transaction, but of the nature of the conflict and any potential independence issues.

Failure to Act in Good Faith

Good faith is defined as “an intentional dereliction of duty, a conscious disregard for one’s responsibilities, and deliberate inaction in the face of a duty to act.”

Later, this definition was clarified to be applied as a subcategory of the duty of loyalty.

As part of the duty to act in good faith, directors are obligated to ensure that there is adequate oversight over the corporations affairs and failure to do so was a breach of good faith. These types of claims are difficult to bring and even more difficult to be successful.

Usurping Corporate Opportunities

When the director takes an opportunity that should have belonged to the corporation. The director cannot take the opportunity for themself if (1) the corporation can financially exploit the opportunity, (2) the opportunity is within the corporation’s line of business, (3) the corporation has an interest (or expected interest) in the opportunity, (4) by taking the opportunity, the director will by in conflict with the interests of the corporation.

If the opportunity does belong to the corporation, then the director needs to present the opportunity to the board as a safe harbor. Thus, if the corporation renounces that interest, the director is free to take the opportunity. DGCL § 122.

Best Interest Definition

In summary, the best interest of the company is to engage in activities directly designed to make a profit or save expenses for the entity.

Duty of Disclosure

This duty arises both under the duty of loyalty and care. It obligates directors to provide accurate and complete information related to transactions upon which they anticipate making a decision.

Litigation

When the corporation is internally harmed, usually the harm is caused by the directors. However, since the directors often have the discretion to sue, they refrain from doing so. Thus, most lawsuits arising out of a breach of duty are derivative suits (actions brought by shareholders in behalf of the corporation when the directors refuse to do so).

Demand Requirement

For a derivative suit to be successful, the shareholder-plaintiff must first make a demand of the board of directors to pursue the claim or prove that such a demand is futile. A demand is futile if the majority of the board (1) received a material benefit, (2) faced a substantial likelihood of liability if the claim was brought, or (3) lacked independence from a board member subject to (1) or (2).

If the claim is futile, then the board is likely to appoint a special litigation committee with disinterested and independent board members. Their task is to investigate the claim and see if it is in the best interest of the corporation to pursue, settle, or dismiss the claim (most of the time, dismissal occurs). If the SLC determines that the case should be dismissed, the business judgment rule does not apply. In that case, the court will first evaluate the independence and disinterestedness in acting in good faith of the committee board members and second utilize its own business judgment to determine whether the case should continue.

Direct v. Derivative

To avoid the analysis above, the shareholder could claim that they were directly harmed from the decision (thus bringing a direct suit rather than a derivative one). In a direct claim, the shareholder would receive the benefits of any successful lawsuit, not the corporation.

MBCA Approach

Standards of Conduct

MBCA § 8.30: (a) act in good faith in the best interest of the corporation (loyalty) and (b) provide adequate oversight using a reasonableness standard (care).

§ 8.31: standard of liability (Delaware version is review): essentially the same as the business judgment rule. Overcoming the business judgment rule then moves to see whether there was harm done which was caused the director’s conduct.

Conflicting Interest Transactions

MBCA §§ 8.60-8.63: These essentially codified the process utilized by Delaware case law.

Usurping a Corporate Opportunity

MBCA § 8.70: Safe harbor rules.

Shareholder Derivative Suites

MBCA § 7.42: Same as Delaware except no demand requirement. In 7.42, the demand element is required (no futility exception), must be written and then the suit can be filed 90 days after the letter was sent.

Duties of Officers

Same duties as directors. These rules are established by case law in Delaware, MBCA § 8.42, and agency law. The main difference is that under the MBCA, only directors and not officers can have an exculpation provision (DGCL § 102(b)(7) allows certain officers to enjoy the provision).

Duties of Controlling Shareholders

Controlling shareholders owe a duty to the corporation and the other shareholders. A shareholder becomes controlling when they (1) own more than 50% of the voting power or (2) exercise control over the business affairs of the corporation, even if they have less than 50% of the voting power. Exercising control can be proved by the party’s position, decision making ability, filings, etc. This status can change from decision to decision, depending on the shareholder’s involvement.

Indemnification, Advancement, and Insurance

Even if the director loses, the company is likely to indemnify the director (mostly because all the directors will want to be indemnified if they ever face a similar situation). A corporation is required to indemnify if the director or officer is sued and wins. However, the corporation may voluntarily indemnify if they lose. During the litigation process, the corporation is also allowed to advance litigation expenses

The corporation can also purchase Director and Officer Insurance (D&O). Side A protects directors and officers when there is no indemnification available. Side B reimburses a corporation for the expenses made fulfilling indemnification obligations.

Return on Investment

Distributions

Distributions are when the corporation gives money or property to its shareholders and typically takes one of two forms: Dividends or Repurchases. Dividends are when the corporation gives you a certain amount, based on how many shares you have. Approval of the dividends needs to come from the board. Repurchases are when the corporation purchases shares you own. If the corporation repurchases shares from everyone equally, you may have less shares but no less ownership interest. This can change though depending on whether the corporation purchases shares from only a few, instead of everyone. In that instance, you may not receive money, but you increase your ownership interest. Typically, the shareholder cannot be forced to sell their shares (unless there is a call back), but approval of a repurchase needs to come from the board.

Statutory Restrictions

Statutes can restrict corporations from paying out dividends if the purpose of which is to make less money available to its creditors. As such, there are several rules utilized to ensure that the company’s assets do not drop beyond a minimal threshold.

MBCA § 6.40(c): Can’t distribute if you can’t pay debts after distribution (solvency test). Can’t distribute if the distribution causes the liabilities + the liquidation preference of preferred stock is greater than the corporation assets (balance sheet test).

DGCL § 170(a): Can distribute out of it’s surplus or net profits (legal capital and nimble dividend tests). Same applies to repurchases under § 160.

Director Liability

If a director engages in an unlawful distribution under 6.40(c), then they can be personally liable for any distribution made in excess of that rule. However, a director can relieve themselves of liability if they show that the decision was made in good faith by having a full information regarding the distribution. This often means going to an investment bank to purchase a letter that determines whether the corporation is insolvent. If the letter says that the corporation is fine (but it wasn’t) then the letter can be used to show that the directors acted with full knowledge and thus avoid liability.

Sales

Make money by selling more than you purchased the stock for.

State Statutory Rules

States allow stock to be freely traded to anyone at any time. However, a corporation may limit the transferability rights (subject to reasonableness and conspicuous notice). Typically, a corporation will limit the transferability so the offer must first be made to either the corporation, another shareholder, or both before making an offer to a third party.

Federal Securities Law Compliance

Once again, sales of a security such as stock either need to be registered or be exempt. One exemption arises from § 4(a)(1) where you can resell stock as long as you are not an underwriter, issuer, or dealer. If you are one of those, then you must comply with Rule 411. As such, many investors ask corporations to ensure registration so that they do not need to worry about whether the security is registered before making a sale (registration rights).

Secondary Trading Markets

Outstanding shares of public companies can be sold to investors either through exchanges or Over-the-Counter (OTCs).

Exchanges

There are two classic exchanges, the NYSE and the NASDAQ.

The NYSE was originally done in person on a trading floor (which still exists), but now is primarily done over the computers. Essentially, corporations pay big money to be listed on the NYSE, a premium service to sell public corporate stock.

The NASDAQ once was an OTC but became an exchange in 2006. It is comprised of three markets, each with requirements on the initial listing and continued listing. Each market also varies the cost for these listings, proportional to the size of the shares outstanding.

Over-the-Counter

Once again, OTCs used to be conducted by brokers but are now primarily conducted online. The standard OTCs are the OTC Bulletin Board and OTC Markets.

The OTC Bulletin Board uses quotes by a quasi-governtmental agency to sell stock. The only types of stock that can be traded here must periodically be report their security requirements (banks, insurance, etc.).

OTCQX, OTCQB, and Pink Markets all create OTC Market Group, which again has no listing requirements but can only be comprised of corporations with periodic reporting requirements.

Choosing a Secondary Market

Corporations want their stock to be on as active a market as possible (more activity equals more trading). Consequently, most corporations will elect to be listed on the NYSE or the NASDAQ.

Stock Splits

There are two types of stock splits, forward and reverse. A stock split occurs when a corporation wishes to either increase or decrease the stock price on the market (too high and smaller investors can’t afford).

A forward stock split can occur either through providing a dividend (you receive more shares valued at the proportional decrease in price) or through a charter amendment (allowing for more shares authorized to become available).

On the other hand, a reverse stock split combines the shares and thus increases the price (fewer shares equals a higher price). This process must be done through a charter amendment making fewer authorized shares available.

Minority Shareholder Protections

Negotiated Protections

Minority shareholders have only a few rights bestowed upon them by default contract law. But, the minority shareholders have the money to invest. As leverage, they will use the money to negotiate for protections that are otherwise unavailable.

Cumulative Voting and other Board Provisions

DGCL § 214 allows for cumulative voting. We have already discussed cumulative voting, the procedure where you can combine all of your shares to vote on one board member instead of spreading them out evenly for each (straight voting). Cumulative voting often gives a minority shareholder power to elect at lease one director. However, this power can be limited by staggering the election by making fewer directors available to elect.

Instead, a simpler way to achieve the same result with more protection is if shareholders enter into a voting agreement as authorized by DGCL § 218(c) and MBCA § 7.31. A voting agreement is where the majority shareholder agrees to utilize some of their votes to elect a director of the minority shareholder’s choosing. This protects against staggered elections and simplifies calculations.

Preemptive Rights

May be authorized by MBCA § 6.30(b); DGCL § 102(b)(3) through a charter provision but the default rule is that there are no preemptive rights. Preemptive rights are where the minority shareholder is offered an opportunity to purchase shares that are expected to be issued, proportionate to the percentage interest they already own. The purpose? Prevent ownership dilution.

These rights can also be contractually provided, a route commonly followed because it selects who can get the rights and involves less formalities.

Veto Rights

Veto rights are either explicit or implicit. Explicit veto rights are provisions that prevent a majority shareholder from taking actions without the approval of the minority shareholder. Implicit veto rights come from increasing the required number of shares outstanding to constitute a quorum. By not having a quorum, a majority shareholder cannot vote. Implicit veto rights also require preemptions or veto rights over additional issuances of shares so as to prevent the dilution of a minority interest sufficient to obtain the requisite quorum.

Employment Rights

An investor could contractual agree to become an employee for the corporation before investing.

Buyout Obligations

A corporation is unlikely to agree to broad buyout obligations, but without any, a minority shareholder would be stuck (unable to transfer shares or sell them in a public market). As such, these provisions may allow a minority shareholder to sell their shares to the corporation if certain events occur (such as death of the shareholder).

Dividend Policy

Determine when and how much of a dividend should be issued.

Documenting Protections

Documentation can occur in one of three ways: the charter, the bylaws, or through a separate shareholder agreement. Corporations enjoy opting for a shareholder agreement because they are easy to create and amend compared to the charter and bylaws. Additionally, they tend to be more private. These agreements are nice, but should fall in accordance with MBCA § 7.32(b)(1) or DGCL § 350.

Immutable Statutory Protections

Inspection Rights

Shareholders are free to inspect the corporations books and records for a proper purpose. See MBCA § 16.02; DGCL § 229. Shareholders are also entitled to receive annual copies of financial statements under the MBCA.

Judicial Dissolution for Oppression

MCBA § 14.30(a)(2) allows the court to dissolve the corporation if directors or those with control are engaged in illegal, oppressive, or fraudulent activities. Oppression occurs when the majority is engaging in activities that when a reasonable person sees those activities limits the minority holder’s ability to participate in the business. MCBA § 14.34 allows shareholders to purchase the shares of a shareholder wishing judicial dissolution. Nothing like this exists in the DGCL.

Judicial Dissolution for Deadlock

MCBA § 14.30(a)(2) also allows for judicial dissolution for deadlock. Deadlock occurs when there are an equal number of directors who differ in a decision that is necessary for the continued function of the corporation. Additionally, it requires that the corporation has failed to remove or replace directors for at least two annual meeting requirements. To avoid judicial dissolution, the bylaws may contain a “shotgun” provision, designed to remove one of the parties at odds and compensate them well for that removal.

The DGCL also allows for dissolution in accordance with § 273 where there are only two directors who are split 50/50. According to 226, a custodian could be appointed to handle the corporations assets and other business affairs.

Heightened Fiduciary Duties

If the corporation is a close corporation, they may also be subject to higher fiduciary standards such as “utmost” goof faith and loyalty.

Buy-Sell Agreements

When shareholders are part of a closely held corporation, buy-sell agreements are common. They restrict the ability to transfer shares and specify how many shares can be transferred following death or disability. These agreements are often drafted at the beginning of the business and as such are fair to both buyers and sellers (because the parties don’t know which one they may end up being).

Blanket Prohibition on Transfers

“Can’t transfer shares unless allowed under the agreement.”

Right of First Refusal or First Offer

A right of first refusal requires a shareholder who found a third party to sell to offer the shares to the corporation or other shareholders first. If they decide not to, then the shareholder can sell to the third party.

A first offer is where the selling shareholder sets the terms of the sale first, offers it to the corporation or shareholders, then (if denied) can make an offer to a third party for no better terms.

Obligations to Sell and Buy

If a shareholder hits a triggering event, it obligates the shareholder to sell and obligates the corporation or other shareholders to buy. The price of this sale is outlined in the agreement which could either be appraised, stipulated, or based on a formula.

Public Company Regulation

Disclosure Requirements

Almost every publicly traded company is required to disclose information to the Securities Exchange Commission (SEC). These disclosures come in the form of Annual, Quarterly, and Current Reports.

Annual Reports

Also known as Form 10-K or 10-K reports. This report includes a description of the business, risks, financial statements for the year, management analysis, and information about the compensation of executives. Depending on the status of the company, the latest these annual reports are due is 90 days after the end of the year.

Quarterly Reports

Reports need to file annual quarterly reports for quarters 1, 2, and 3. Also known as 10-Q.

Current Reports

After a triggering event listed in Form 8-K, the company is required to file a current report. Some triggering events include: bankruptcy, appointing new officers, changing the bylaws, etc.

Section 10(b) and Rule 10 b-5

According to these Rules, the company is subject to liability for providing inaccurate reports (including public statements). Violation of the rule could result in private action if the following elements are satisfied.

Materiality

A fact is material if it has a substantial likelihood that a reasonable investor would use the information to make an investment decision.

Scienter

Scienter is “a mental state embracing intent to deceive, manipulate, or defraud.” Recklessness in the report can meet this definition. The pleading standard must also be done with particularity (have to describe in detail why scienter exists).

Connection with the Purchase or Sale of a Security

The statements were designed to influence the investing public.

Reliance

The plaintiff needs to show that the misstatements or omissions were in part a reason why the plaintiff made the investing decision. This reliance is presumed under the “fraud-on-the-market” theory.

Economic Loss

Plaintiff must actually show that they suffered an economic loss due to the fraud. “Shares were 25, but are now 20 after correcting the information.”

Loss Causation

The plaintiff must show that the harm/loss was caused by the misrepresentation.

Proxy Voting Regulations

The vast majority of shareholders in private companies vote by proxy (in person attendance is just not that feasible).

Proxy Statement and Card

To prevent a corporation from soliciting proxies by fraud, corporations are required to provide all the information necessary for the shareholder to make an informed decision regarding the proxy. This information is included in the proxy statement and includes: information relating to the decisions to be made, biographies, and the like. The proxy card is the voting mechanism utilized in determining how many votes go where. Additionally, corporations typically need to provide the shareholders with the financial status of the corporation and will distribute a 10-K for the shareholders to review before the decision is made.

Shareholder Proposals

Because shareholders rarely meet in person, proposals often need to be submitted at least 4 months in advance. According to the SEC, shareholders must meet certain financial obligations within the corporation to submit a proposal. Once the proposal is submitted, the corporation can then filter out which proposals will be presented based on whether the proposal is not the responsibility of the shareholders or an improper request of the shareholders. This filtering is then approved or denied by the SEC before being presented for a vote.

Public Company Director Elections

Director elections are not meaningful, despite it being one of the few things shareholders actually have a right to vote on. This is because most shareholders vote by proxy and can only vote for those listed on the proxy card… provided by the management (board) of the corporation. As such, whoever the board picks will win. This is because even if the shareholders disapprove and “withdraw authority” or “reject” the nominee, their vote does not count against (no minus votes). Therefore, as long as there is one vote in favor of the nominee, the nominee will be selected.

The only way for disgruntled shareholders to compete is by creating their own proxy cards and solicit those proxies in competition to the board’s proposal. This is usually an expensive and time consuming process and thus rarely occurs.

Other ways to increase shareholder say is by implementing majority voting (instead of plurality), or to have proxy access bylaws (saying that shareholders have a right to submit contested names up for the proxy vote).

Takeaway: The board’s nominees will usually always be elected.

Corporate Governance Listing Standards

For a corporation to be listed in the NYSE or the NASDAQ, they have to meet certain governance requirements in addition to the financial requirements. These requirements include:

1. Majority of directors must be independent
2. Hold executive sessions comprised of non-management and independent directors
3. Have a corporate governance committee comprised entirely of independent directors (purpose is to nominate directors)
4. Have a compensation committee comprised entirely of independent directors.
5. Constitute an audit committee comprised entirely of independent directors.
6. Maintain and disclose corporate governance guidelines.
7. Maintain a code of business conduct and ethics.

Insider Trading

Parties cannot either buy or sell securities on the basis of material, nonpublic information about the security. In other words, you can’t buy or sell if you have “inside knowledge” not privy to any other party.

Classical Theory

If a party has a relationship with the corporation and as a result of that relationship is able to obtain confidential information that is material in making an investment decision, then trading on that security is prohibited. This relationship can arise from being an actual or constructive (temporary) insider.

Misappropriation Theory

Even if a party is not an insider, if that party has a duty or trust or confidence related to material facts (like a third-party law firm, or spouse of a director), then the party cannot use the information to their advantage in trades.

Rule 14e-3

If a party obtains nonpublic information as a result of facilitating a tender (pending) offer to buyout shareholders, then the party is not allowed to trade based on that information. A breach here does not have to come as the result of a breach of a fiduciary duty, but the rule does require the the transaction involves a “tender offer.”

Tipper/Tippee Liability

A tipper is somebody who discloses nonpublic information (a “tip”). A tippee is the individual who uses that information to make a trade. Under all the theories above, both the tipper and the tippee could be liable for insider trading (depending on the facts).

Introduction to Financial Statements

Financial Statements are often required by GAAP principles and include: the income statement, balance sheet, and cash flow statement.

Income Statement

The income statement measures how much the business has either earned or lost in a simple formula: Revenue – Expenses = Net Income or Loss. The typical line items on an income sheet include:

• Revenue: Amount made from generated sales
• COGS: Direct costs associated with selling the goods
• Gross profit: Revenue – COGS
• Fees
• Depreciation: Loss in value of assets over time.
• Operating Income: Gross profit – operating expenses
• Interest expense: debt interest
• Net income: Revenue – Expenses

Balance Sheet

Lists assets, liability, and equity at any given time. The purpose of a balance sheet is to balance. That is, the assets should equal the combination of liability and equity. Who goes in should also be reflected in what goes out. If there is no balance, then the balance sheet has an error.

Cash Flow Statement

Describes a business’s cash inflows and outflows over a given period of time.