Setting up a limited company is complicated and expensive because more legal formalities must be met. Before limited companies can be established and begin trading, all governments insist that certain legal steps must be taken in order to protect shareholders (investors who invest their money in the business) and creditors (individuals and institutions who lend money to the business).
Legal formalities in setting up an incorporated business
The following two documents must be produced and submitted to the appropriate authorities: A Memorandum of Association and The Articles of Association.
1. A Memorandum of Association states the fundamental details of the company: the name of the business, its address of the headquarters, its contact details, the maximum amount of share capital invested for which the company seeks authorization and the main purpose of existence (the aim and objectives of running this business). Knowing the maximum share capital means that shareholders can determine the relative importance of any one share that they own. Knowing the company’s aims mean that shareholders can avoid investing in unethical market or products that they do not wish to be associated with, e.g. gambling, weapons, etc.
2. The Articles of Association stipulates the internal workings, regulations and procedures of running the company. It includes the rights, roles and responsibilities of the Board of Directors (BOD) and states the shareholders of the business. Procedures as of how to organize and run the Annual General Meeting (AGM), the appointment of directors and their names, and how profits will be distributed are also covered in details.
Once the relevant authorities are satisfied with the above two documents and an application fee has been paid on time, the registrar of companies will issue A Certificate of Incorporation to the new company. This license recognizes the business as a separate legal entity from its owners and allows the incorporated business to start trading as a limited liability company.
A limited company may now begin trading.
The Board of Directors (BOD) and The Annual General Meeting (AGM)
A Board of Directors (BOD) is elected by shareholders to run the company on their behalf as they may not have specialist skills and expertise in managing a business organization, or because they do not want to get involved in the daily running of the company. Shareholders may also be busy with investing in other businesses, rather than in managing them.
The Board of Directors (BOD) is held accountable to the shareholders who are, in fact, the righteous owners of a business. Usually, owning each share gives a shareholder one vote during an Annual General Meeting (AGM). So, the more shares an investor owns, the more voting power this person has.
All companies must hold an Annual General Meeting (AGM) to allow all shareholders (owners) to vote on issues such as: how to run the business and the election of the board of directors, ask questions to the Chief Executive Officer (CEO) about various aspects of the company or approve the previous years’ financial accounts after the directors present the annual report.
Every year Warren Buffet and Charlie Munger invite all the shareholders of Berkshire Hathaway to Omaha, Nebraska in the US for an annual shareholder meeting where they meet with other owners and answer questions about the running of Berkshire Hathaway from other shareholders and business journalists.
Transferring into a public limited company
In addition, to gain a listing on the stock exchange, which greatly increases the marketability of shares of a limited company, the accounts and trading records of the private limited company will be carefully scrutinized by the stock exchange regulatory bodies ahead of the approval for shares to be sold publicly on the stock exchange such as The New York Stock Exchange (NYSE) or Nasdaq.
There are rules and regulations of the stock exchange and the Securities and Exchange Commission that must be obeyed by all public limited companies. One of the reasons for such legislations is to protect investors who buy shares in businesses that they do not manage directly.
When a limited company sells shares for the first time (sells all or part of its business to external investors (shareholders)) on a stock exchange, it is when flotation, or Initial Public Offering (IPO) occurs.
Individual shareholders, who only own a few shares, tend to have very little to say in the running of a large public limited company. It is initial founders of the business and institutional investors like investment banks or asset management firms who have the most to say, as the ‘big boys’ of the investment world hold the majority of the shares – they are the largest shareholders of public limited companies. And yes, it is very common that limited companies own shares in other limited companies.
When public limited companies are unsuccessful in generating earnings, shareholders face potential risks (despite having limited liability). First, the company will not be able to distribute any dividends to the shareholders from Net Profit After Interest and TAX. And, second, the share price is likely to fall as a result (causing potential negative capital growth), as there will be less demand from the market to own shares in a company that is not doing really well in terms of earning money.
In the worst-case scenario, the share price will drop to USD$0 and the shareholders will lose the amount of money that they had paid to own shares in the first place.
