In December 2013, the Delaware Chancery Court rendered a decision highlighting the importance of properly documenting the issuance of stock. Read on to learn what this means and why it is important.
What is stock?
Stock (or "shares") constitute the equity stake of the owners of a company. In a privately held company, stock is represented by a stock certificate. The stock certificate itself is a preprinted form that a third party prints as part of the company's corporate kit (which is provided upon formation of the entity). The act of authorizing the issuance of the stock certificate and completing the stock certificate are the required steps for documenting the issuance of stock. This procedure is identical regardless of the size of the company.
As we previously discussed in a previous blog post, a corporation is formed by filing a Certificate of Incorporation. That document states how many shares of stock the corporation is entitled to issue, commonly referred to as "authorized" stock.
How does a corporation issue stock?
Generally speaking, stock is authorized to be issued by the board of directors of the corporation. Such authorization must be evidenced by a written instrument (a written consent of the board of directors). The power to issue stock is conferred to the board of directors in the corporation's bylaws. The stock certificate itself then must be completed. A company does this by inserting the name of the stockholder, the number of shares owned, and obtaining the President's and Secretary's signature.
The corporation must also maintain a "ledger". This is similar to an excel spreadsheet; it states the names, addresses and number of shares owned by the stockholders.
Why should you care?
If you fail to follow the correct procedures when issuing stock and that issuance is challenged by another stockholder (for example (i) if a stockholder believes he or she owns a larger percentage of the corporation than indicated in the ledger or (ii) if a stockholder wants to challenge a decision made by the board of directors), a court could void the purported issuance. This results in the shares issued pursuant to that transaction to be null and void.
Here is a hypothetical, let's assume two stockholders (Stockholder A and Stockholder B) each own 50 shares in a company. The board of directors then issues an additional 50 shares to Stockholder A, but fails to document the issuance in writing. Stockholder A and B subsequently get into a heated argument over a corporate decision. Stockholder B goes to court, challenges the issuance and wins. While it was intended that Stockholder A owned 100 shares and Stockholder B owned 50 shares, the actual result is that Stockholder A owns 50 shares and Stockholder B owns 50 shares.
Moisan Legal P.C. is a boutique law firm focusing on representing entrepreneurs and businesses in a variety of legal issues. Matthew J. Moisan can be reached at 646.741.5222.