There can be a short-term economic incentive for early start-ups to issue restricted stock - rather than stock options - as incentive equity to employees/advisors, in no small part due to an IRS (409A of the code) requirement that a formal (i.e., costly) valuation be conducted prior to issuing stock options (so as to set the exercise (FMV) price of the stock option). The externality is that restricted stock (absent some special story) carries all the voting and dividend rights of regular stock. This can play out myriad ways but, as illustration of the potential for unforeseen consequences, consider the following issue:
Delaware (where most start ups are incorporated) law requires that a corporation hold an annual meeting of the shareholders to elect directors.FN1 (Industry standard bylaws track this requirement). While the law allows shareholders to act by written consent in lieu of an actual (sending out notices, arranging a time and place, etc.) annual meeting, such paper consent is sufficient only IF it's unanimous (i.e., ALL the company's stockholders sign the consent (as opposed to a voting majority of the stockholders)).FN2 There is only one exception to this: where all the directorships are vacant (because the director resigned or died, etc.)
Note the implication: a start-up that proceeds by paper consent in lieu of an actual meeting must find each shareholder, communicate the consent process and retrieve a signature. In the event that myriad restricted stockholders (employees/advisors) are spread over a diverse geographical area (e.g., engineers based overseas), this presents no small logistical annoyance, exacerbated by the reality that the outcome of the director elections is almost always a foregone conclusion (i.e., the advisors/employees own a materially insignificant percentage of the voting stock), and, more importantly from a fairness perspective, is almost never a contested issue (generally start-ups do not alter the Board until a financing event).
Such inefficiencies may and probably do motivate many start-ups to ignore the unanimity requirement. But the case law is crystal clear that this is a statutory violation.FN3 In 1996, presiding over Hoschett v. TSI International Software (in which a minority shareholder sued a privately-held Delaware corporation for electing directors through a non-unanimous shareholder written consent in lieu of a meeting), the Delaware Court of Chancery reached this conclusion: "an argument predicated on alleged efficiency and practicality [is] unpersuasive ... absent unanimous consent that the mandatory language of Section 211(b) places on TSI [there is a] legal obligation to convene a meeting of shareholders to elect directors pursuant to the constitutional documents of the firm".FN4
In light of Hoschett, private companies seeking a consent in lieu of an annual meeting have three basic options: 1) solicit signatures from each and every stockholder, 2) ignore the law (by not holding a meeting or not electing directors at the meeting), or 3) precede the consent with the removal or resignation of the sitting directors (as noted Section 211 allows for non-unanimous actions where directorships are vacant at the time of the action). The first is a hassle, the second is illegal, and the third is technically compliant but such a contrivance it's unclear how it would stand up in court.
It is hardly sound legal counsel to advocate the nonobservance of the law but it's also difficult to argue against a line of action that is almost surely supported/acceptable by and fair to all affected parties and the prevailing norm. And that's all the New Media Lawyer is going to say about that.
FN1. Section 211 of the Delaware General Corporation Law says in pertinent part, "an annual meeting of stockholders shall be held for the election of directors."
FN2. Ibid to FN1, saying, "Stockholders may, unless the certificate of incorporation otherwise provides, act by written consent to elect directors; provided, however, that, if such consent is less than unanimous, such action by written consent may be in lieu of holding an annual meeting only if all of the directorships to which directors could be elected at an annual meeting held at the effective time of such action are vacant and are filled by such action."
FN3. Interestingly, although the tradition of an annual shareholders meeting for the election of directors goes way, way back, there's little case law on the issue. The 1996 Delaware Chancery Court opinion in Hoschett may be the only U.S. authority directly on point.
FN4. Note that the scope of the Court's holding explicitly covered a shareholder action that re-elected current directors: "[T]he mandatory requirement that an annual meeting of shareholders be held is not satisfied by shareholder action pursuant to Section 228 purporting to elect a new board or to re-elect an old one."
Delaware (where most start ups are incorporated) law requires that a corporation hold an annual meeting of the shareholders to elect directors.FN1 (Industry standard bylaws track this requirement). While the law allows shareholders to act by written consent in lieu of an actual (sending out notices, arranging a time and place, etc.) annual meeting, such paper consent is sufficient only IF it's unanimous (i.e., ALL the company's stockholders sign the consent (as opposed to a voting majority of the stockholders)).FN2 There is only one exception to this: where all the directorships are vacant (because the director resigned or died, etc.)
Note the implication: a start-up that proceeds by paper consent in lieu of an actual meeting must find each shareholder, communicate the consent process and retrieve a signature. In the event that myriad restricted stockholders (employees/advisors) are spread over a diverse geographical area (e.g., engineers based overseas), this presents no small logistical annoyance, exacerbated by the reality that the outcome of the director elections is almost always a foregone conclusion (i.e., the advisors/employees own a materially insignificant percentage of the voting stock), and, more importantly from a fairness perspective, is almost never a contested issue (generally start-ups do not alter the Board until a financing event).
Such inefficiencies may and probably do motivate many start-ups to ignore the unanimity requirement. But the case law is crystal clear that this is a statutory violation.FN3 In 1996, presiding over Hoschett v. TSI International Software (in which a minority shareholder sued a privately-held Delaware corporation for electing directors through a non-unanimous shareholder written consent in lieu of a meeting), the Delaware Court of Chancery reached this conclusion: "an argument predicated on alleged efficiency and practicality [is] unpersuasive ... absent unanimous consent that the mandatory language of Section 211(b) places on TSI [there is a] legal obligation to convene a meeting of shareholders to elect directors pursuant to the constitutional documents of the firm".FN4
In light of Hoschett, private companies seeking a consent in lieu of an annual meeting have three basic options: 1) solicit signatures from each and every stockholder, 2) ignore the law (by not holding a meeting or not electing directors at the meeting), or 3) precede the consent with the removal or resignation of the sitting directors (as noted Section 211 allows for non-unanimous actions where directorships are vacant at the time of the action). The first is a hassle, the second is illegal, and the third is technically compliant but such a contrivance it's unclear how it would stand up in court.
It is hardly sound legal counsel to advocate the nonobservance of the law but it's also difficult to argue against a line of action that is almost surely supported/acceptable by and fair to all affected parties and the prevailing norm. And that's all the New Media Lawyer is going to say about that.
FN1. Section 211 of the Delaware General Corporation Law says in pertinent part, "an annual meeting of stockholders shall be held for the election of directors."
FN2. Ibid to FN1, saying, "Stockholders may, unless the certificate of incorporation otherwise provides, act by written consent to elect directors; provided, however, that, if such consent is less than unanimous, such action by written consent may be in lieu of holding an annual meeting only if all of the directorships to which directors could be elected at an annual meeting held at the effective time of such action are vacant and are filled by such action."
FN3. Interestingly, although the tradition of an annual shareholders meeting for the election of directors goes way, way back, there's little case law on the issue. The 1996 Delaware Chancery Court opinion in Hoschett may be the only U.S. authority directly on point.
FN4. Note that the scope of the Court's holding explicitly covered a shareholder action that re-elected current directors: "[T]he mandatory requirement that an annual meeting of shareholders be held is not satisfied by shareholder action pursuant to Section 228 purporting to elect a new board or to re-elect an old one."
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