Incorporation is a logical step for many small businesses.
(article continues below)
But before you and your partners incorporate, you should consider spelling out the terms of the partnership in a pre-incorporation agreement. Here's what you need to know . . .
To the uninitiated, pre-incorporation agreements might seem like a big waste of time. After all, there is no legal requirement for pre-incorporation documents and most of the content finds its way to the final incorporation agreement, anyway. But pre-incorporation agreements serve an important role in clarifying the nature of your corporate partnership and protecting each partner's interests during the transition to a corporate entity. In certain instances, a pre-incorporation agreement can even reveal issues that cause one or more partners to withdraw from the process before incurring the hassle and expense of formal incorporation.
Although details can vary, here are some of the issues your agreement should address:
Name & Purpose of the Corporation
If you and your partners can't agree on the corporation's name and purpose, you have little chance of succeeding as a corporate business. The pre-incorporation agreement explicitly states what the corporation will be called and offers an explanation of its primary activities. Since this information will influence the corporation's future identity, each partner must be in complete agreement.
All partners may not share equally in the ownership of the corporation. In fact, it is fairly common for various partners to own different shares of the corporation based on their investment share and other factors. The pre-incorporation agreement describes each partner's interest and eliminates any surprises later on.
Officers and Directors
The incorporation process requires the identification of directors and officers. These names should be included in the pre-incorporation agreement as well, if for no other reason than it forces you to identify key figures early in the process.
The initial sources of capital are typically described in the pre-incorporation agreement, including the names of investors and the amount of capital they will invest in the corporation. The pre-incorporation agreement may also contain a clause describing each shareholder's responsibility in the event that operating capital fails to meet operating expenses.
Right of First Refusal
Many corporations reserve the right of first refusal on the transfer of corporate shares. This becomes particularly relevant when a corporate partner elects to sell his share of the corporation. If partners' are required to first offer their shares back to the corporation, their ability to pass their ownership share on to an individual of their own choosing will be limited. However, first refusal rights also serve to protect remaining shareholders against unwanted ownership interests.
There are several ways a business can choose to incorporate. For example, if the corporation is planning to be an S-corp for federal and state tax purposes, that information should be specified in the pre-incorporation agreement.