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Incorporating in Delaware: Traps for the Unwary

By October 28, 2022No Comments

Delaware laws provide the greatest level of flexibility for the organization and governance of business entities. However parties should assess what choices they make carefully. Here is a brief summary of various traps for the unwary depending on whether the choice is incorporation or Limited Liability Company. At Dunnington, Bartholow & Miller LLP we are ready to assist our clients with sound and reliable legal advice on these options and their impact.

Choosing Incorporation

  • Beware the power of the Board of Directors. Directors wield significant power over a corporation’s affairs. Their decisions can impact the investments made by company owners significantly. Owners should be careful that the certificate of incorporation does not allow directors to entrench themselves in their positions. Owners may want to consider a classified or staggered board and provide for this in the certificate of incorporation.
  • Protect your rights. Numerous important rights and prerogatives are granted to company owners, directors, and officers only by operation of the certificate of incorporation. One example is preemptive equity rights allowing owners to preserve their stakes in the company. Another is the exculpation of directors and officers for damages caused to the company by their negligence. Equally important may be the owners’ right to repossess resources invested in the corporation at a specific time.
  • Careful drafting is always critical. Various rules regulating the governance of the corporation may be included either in the certificate of incorporation or in the bylaws. Owners should be aware that amending the certificate of incorporation requires much more effort than amending the bylaws. Therefore, in the event changes are needed, careful drafting of both documents is a critical necessity to avoid unwelcome delays or consequences.

 Choosing a Limited Liability Company

  • Beware the terms of the operating agreement. The governance document for an LLC is the operating agreement. An operating agreement can exculpate managers for any damage caused to the company by those managers. It can even relieve managers from the duty of loyalty and the duty to act in the company’s best interest. Therefore owners should strike from the operating agreement any provisions altering managers’ duties. They should also be sure the operating agreement sets forth clear procedures allowing them to remove the company managers easily and timely.
  • Being a manager does make a difference. Unless the operating agreement provides otherwise, all of the owners of the company may also be deemed managers of the company. This means the owners may assume significant additional responsibilities. For example, company managers owe a duty of loyalty and a duty to act in the company’s best interest. Managers can be held responsible for the damages stemming from any breach of those duties. Owners who are also deemed managers could find themselves exposed to additional significant liability.
  • Create an exit strategy. Statutory protections prohibiting unfairness can be waived by owners when executing the operating agreement. Owners should review the operating agreement carefully and strike any provisions which may lock them into the company and deprive them of any rights to manage the company. Owners will also want to be sure the operating agreement grants them the right to leave the company at a certain time or upon the occurrence of certain circumstances.

At Dunnington, Bartholow & Miller LLP we are a full-service firm providing both expertise and experience helping organizations, their founders and owners evaluate their options and draft appropriate organizational documents wisely under Delaware law.

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