Incorporation Agreement: Everything You Need to Know
An incorporation agreement will help prevent misunderstandings about the roles and responsibilities of the principal parties of an incorporated entity.4 min read
2. Importance of an Incorporation Agreement
3. Reasons for an Incorporation Agreement
4. Reasons to Incorporate
5. Risks of Incorporation
Updated November 16, 2020:
An incorporation agreement is an important document when a company takes steps to incorporate. Also known as a pre-incorporation agreement, it will help prevent misunderstandings about the roles and responsibilities of the principal parties of an incorporated entity.
It sets out such details as the name of the corporation being formed, its purpose, the names of the directors and officers at the time the business is incorporated, share distribution, and even salaries for the directors and officers. With this document, you can confidently enter into agreements and make key decisions prior to the actual formation of your business as a corporation.
The incorporation agreement exists prior to the directors filing formal Articles of Incorporation in the state in which the business plans to be established. The directors, also known as the corporation’s promoters, can be held personally liable for any breach of the agreement should the corporation not actually be formed. Therefore, all parties to the agreement should insist on an acknowledgment within the document that the corporation has yet to be formed. This language will ensure that they avoid any personal liability.
Elements of an Incorporation Agreement
The following terms are found in all incorporation agreements:
- The name of the corporation that meets the state of incorporation’s criteria for uniqueness.
- A statement explaining why the business is being formed. This can be general (“to engage in any lawful activity”) or specific as desired, although too specific a statement of purpose can limit the flexibility of the corporation in the future.
- Business address.
- Names and addresses of the directors of the corporation.
- The amount of capital contribution being made by the initial shareholders of the corporation.
- Identifying who can conduct financial transactions, such as opening bank accounts and signing checks.
- Assigning authority to conduct business, i.e. sign contracts, conduct negotiations, etc.
It is common, due to the important role an incorporation agreement plays in the creation of a business, that the directors enlist the services of an attorney experienced in contract law.
Importance of an Incorporation Agreement
While an incorporation agreement is not required by a state as part of the documents that must be filed to incorporate, it is nonetheless an important step that a corporation’s founders should take. Advantages of the agreement include:
- Explicit descriptions of the roles and responsibilities of the directors and officers of the corporation.
- Scope of liability of each director and officer in the event a claim for damages is filed against the corporation.
- Obligation of the corporation to conduct business according to the statutes of the state in which it is formed.
Reasons for an Incorporation Agreement
Of all the types of business entities (sole proprietorship, partnership, limited liability company and corporation), the corporation is the most complex, due to the legal requirements that must be followed to prevent the company from dissolution.
The incorporation agreement provides guidance to the individuals who will eventually form the corporation throughout the early stages of incorporation. Vital shareholder and confidentiality agreements that will impact the operation of the corporation are created throughout this pre-incorporation period.
It is also when key business decisions must be made. The incorporation can grant, and also limit, the range of authority of each founding member. During this early stage, directors actually have the opportunity to clearly assess the actual viability of the success of the corporation. It is not unusual for the decision to abandon plans to incorporate to be made during this critical period. Although it may difficult to do so, it may actually turn out for the best to confront key issues early before the money is spent on legal and filing fees.
Reasons to Incorporate
As a business owner, you may favor incorporating your businesses for several reasons:
- Incorporation can provide tax advantages for shareholders.
- It is easy to transfer ownership of shares of a corporation.
- A corporation provides advantages for raising capital that other business entities do not.
- The personal assets of the shareholders of a corporation are protected in the event a claim for damages is filed against the business.
Risks of Incorporation
However, there are risks associated with incorporating a business that you should be aware of, especially during the early stages of incorporation:
- Banks and financial institutions may require personal guarantees before providing loans or other forms of financial assistance.
- In the event the corporation commits criminal acts, board members can be held liable.
- If legal formalities are not followed, the corporation can be dissolved and a board member’s personal assets seized.
The important role that a well thought out incorporation agreement can play in the enduring health and success of a corporation cannot be understated. Don’t skip this important step.
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