The first installment of our Due Diligence Series addressed a fundamental issue in crowdfunding due diligence: making sure that the offered shares have been properly issued. This installment concerns an equally basic and essential issue: making sure that the company whose shares you are buying has been properly incorporated.
There are many corporate forms a company can use, such as the “C” corporation, the “S” corporation, and the limited liability company (“LLC”). Each form has its own advantages and disadvantages in terms of taxes, liability, and flexibility. Although the investigation of a prudent investor in the management of their own affairs (i.e. due diligence) would certainly consider these factors, this discussion is only concerned with whether incorporation, of any type, has been achieved at all.
Why is incorporation so important?
Incorporation requires neither assets nor profits, it doesn’t even require a business plan; but it’s not just a mere administrative detail. Properly incorporated, a company becomes a separate legal entity from its founders. It can own property, it has rights, and it can even be charged with a crime. Incorporation means that essential business assets can be transferred from the founders to the company, so that it is the company alone that can benefit from their use (this is especially relevant for intellectual property rights). Non-compete agreements can be signed with the company on one end and key employees on the other. Incorporating documents outline a company’s basic governing rules allowing insight into how disputes will be resolved (although slightly different rules apply to an LLC). For these reasons and more, incorporating a business shows discipline and care, and that is why it is such an important part of an investor’s due diligence.
Possibly even more importantly, if a company hasn’t been properly incorporated, any securities that it issues to investors are probably worthless.
How do you check that a company has been properly incorporated, and if so, that it is still in good standing.
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- To be incorporated and recognized as a separate legal entity, a company must file a certificate of incorporation (or articles of incorporation) with the Secretary of State where it wants to be organized. The certificate is a matter of public record and is readily available to any who look for it. Check the National Association of Secretaries of State’s website for a list of most secretaries of state. You will need to know where the company has been organized, which is not always the same as the state where it does business.
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- Check that the company is in good standing by formally requesting a “certificate of good standing” from the relevant secretary of state. This will cost money. Bear in mind that the information that some states provide about a company’s status on their websites is not necessarily up to date, and just shows the company’s status when the state last updated its records, which could be some time ago. You want an updated certificate, not a database entry.
It is important to note that a state government may impose further requirements for incorporation, such as permits or licenses, and a company may receive a certificate of good standing and still have other problems. For example, a company could be in bankruptcy, be the subject of a lawsuit, or have any number of other problems and still receive a certificate of good standing because it has filed all its paperwork and paid its fees.
CrowdCheck’s investigation only begins with incorporation and extends far beyond what is discussed here. A prudent investor can do it all alone, or she can look to CrowdCheck for help. More to come as our Due Diligence Series continues.