Corporate Basics – Part II

• 2.3.2023
• Gary Schall, Daniel Zimmermann

This post is the second in a series looking at what founders should think about when getting ready to launch a company, read part one here. Michelle Sidle was a co-author for this post.

Founders often wonder who actually controls the corporation they create – is it themselves and the rest of their management team, their directors, or their shareholders?

Immediately after incorporation, the founders are often the only directors, officers and shareholders of a corporation, which makes decision making fairly straightforward. However, as corporations mature, founders face the challenge of understanding who has the power to make important decisions and control the corporation.

In this blog post we’ll explore who makes decisions for a corporation, and how these parties balance control and report to one another.

The Players:

• The shareholders of a corporation are the owners. They vote their shares to elect directors and to approve certain important transactions.
• The directors oversee the corporation’s management. They set the overall strategy and direction of the corporation. In doing so, they elect officers.
• The officers, including the Chief Executive Officer, oversee the day-to-day operations of the corporation.

Their Responsibilities:

• Directors have fiduciary duties that require them to act in the best interests of the corporation and its shareholders. These fiduciary duties are:
• Duty of Loyalty: This requires directors to act in the best interests of the corporation. As a practical matter, this involves putting shareholder interests above a director’s own personal interest when making decisions on behalf of the corporation. This includes not engaging in self-dealing or making use of the corporation’s confidential information for personal gain.
• Duty of Care: This requires directors to exercise the same degree of care that a reasonable person would use in the same circumstances. Practically speaking, this requires that directors obtain and review all material information available to them before making a decision.
• Officers also have to be mindful of fiduciary duties while controlling the day-to-day decision making. In doing so, they answer to the directors, who, in turn, have a responsibility to the shareholders.
• Shareholders are not involved in the management of the corporation and rely on the directors to prudently manage the corporation. Shareholders elect the directors who in turn delegate day-to-day management to the officers.

Because of this dynamic, it’s important to understand the pathway to becoming a shareholder.

Becoming a Shareholder:

Initially, the sole incorporator designates the initial board members and the initial board members approve the issuance of shares of the corporation to the founders. Oftentimes, the initial board consists entirely of the founders, or includes a key advisor.

As the corporation grows and fundraises, the investors customarily receive shares of preferred stock in exchange for their capital investment and become shareholders. As part of their investment, they may also require control rights, such as consent rights over important transactions and representation on the board of directors. Because of this, as corporations mature, the founders’ ownership and control dilutes as the corporation raises more capital.