Many people have only a murky understanding of how a business becomes a corporation and what being a corporation means. Here, you quickly walk through the process and review the characteristics of a corporation to provide a broader context for understanding corporate governance and financial statement disclosures.
Incorporation — the process of turning a regular old business into a corporation — is governed by state statute. If a company wants to set up shop as a corporation, it must play by the rules of the state in which it operates.
In most states, the incorporation process kicks off when the company files a corporate charter or articles of incorporation with the Secretary of State. This document contains all pertinent facts about the new corporation, including its name, address, and information about the type and number of stock shares it’s authorized to issue.
The corporation must name a registered agent: the person the Secretary of State contacts with questions about the corporation. After the charter is accepted by the Secretary of State, parties interested in purchasing shares of stock in the business hold a meeting. These new shareholders then elect a board of directors, and the corporation is off and running!
This is a very simplified version of the incorporation process, which can vary by state. An initial public offering (IPO) — when a company offers shares of common stock to the public for the first time — is much more complicated than the previous paragraph may lead you to believe.
Every corporation has four characteristics:
Limited liability: This term means that investors in a corporation normally can’t be pursued for corporate debt. If a vendor, a lender, or some other entity to which it owes money sues the corporation, the individual investors are generally off the hook.
However, you may encounter exceptions to this general rule, which hinge on the corporation managing itself according to state statute. Also, the federal government and state departments of revenue can go after shareholders or corporate officers for certain types of unpaid taxes.
One example is the trust fund portion of the payroll taxes, which includes the employee portion of federal withholding tax, Federal Insurance Contributions Act (FICA) tax, and Medicare.
Easy transferability of shares: This characteristic means that if a person has the money, he can purchase shares of stock in a corporation — with the expectation of selling the shares in the future if he needs the money. However, for closely held corporations (those with few shareholders), this characteristic doesn’t quite ring true. If you’re the majority shareholder in a private corporation, you don’t have to sell shares to just anyone.
Easy transferability of shares applies more to the purchase and sale of shares of publicly traded stock. Publicly traded stocks trade on exchanges, which are set up to connect buyers and sellers.
For example, if you want to buy shares of AT&T stock, you don’t have to get permission from good ole’ Ma Bell. You just call up your friendly neighborhood stockbroker — or go online. In either case, you make the trade through an exchange.
Centralized management: The management of a corporation shouldn’t be divided among many different groups. For the corporation to function at full efficiency, shareholders give up the right to chime in on every decision it makes. The shareholders elect the board of directors, who oversee the corporate operations and choose officers to handle the day-to-day business operations.
Continuity: Until the corporation is formally dissolved, it’s assumed to have unlimited life, continuing out into perpetuity. The members of the board of directors can change, corporate officers can change, or there can be a different mix of shareholders, but the corporation just rolls on and on.