Welcome to Broken Legalese, a blog that seeks to explain legal concepts of everyday relevance to people untrained in the law in as simple and straightforward a manner as possible. That’s the position of the law, minus unnecessary case names and avoidably complex words like “notwithstanding”, “encumbrance”, and “arbitrability”.
To better understand the functioning of a company, let’s assume I want to start a company to teach legal reasoning for CLAT, and call it StandAlone Educational Services. Because I intend to limit my company’s liability, I necessarily have to put the term ‘Ltd.’ at the end of my company’s name. My company is therefore incorporated as StandAlone Educational Services Ltd., and I am its promoter.
Now, starting a successful coaching institute involves a considerable investment – I’ll need premises, whiteboards, stationary, furniture, several employees, a marketing team, lawyers to get the permits and all, and a bunch of other running expenses. It’s very rare that someone actually has enough money to be able to afford this entire investment on their own, which is why the concept of shares was invested.
Each share is essentially a small fraction of the company. What I would do then is offer shares in my company to other people, by which they could own a fraction of the company. In return, they give me money, which I use to run the company and meet its expenses and (ultimately) turn a profit. I decide to divide my company into 1000 shares of Rs. 10 each. This means that people can purchase as many shares as they want, as long as they’re willing to pay me the price. Let’s now say you decide to buy 50 such shares, in the hopes that it’ll ultimately turn a healthy profit. You pay me Rs. 500, which I use to run the company. You, meanwhile, now own 50 out of 1000, or 0.5% of my company. The shares that you own are called Equity Shares, signifying that you own a part of the company. This could potentially yield high returns for you, if the company does well, but at the same time is a risky investment, because if the company doesn’t do well, you’d lose your money.
Because I’m not the sole owner of the company, the decisions of the company can’t be taken by me alone. Therefore, the shareholders of the company take part in meetings and decide company policy. They also form a Board of Directors who make most of the important decisions as to how the company is to be run and the policies and business strategies that it should adopt.
Let’s say you as an investor want to invest in my company, but you don’t want to have a part to play in the running of the company. You just want to invest money and turn a profit. In that case, you could also invest in what are called Preference Shares of the company - these are a safer investment than equity shares, the trade off being that since they do not have any linked voting rights in the company, they get paid an assured dividend in return for their investment.
Now that I’ve sold enough shares in my company to finance it, I start running my company. As time goes by, my company grows and grows, and becomes much bigger than the tiny little classroom I started out in. Because the company turns a healthy profit every year, the Board of Directors sanctions a certain portion of the profits to be given to the shareholders, since it IS their company after all. These profits that are given to the shareholders are called the ‘Dividend’ of the company.
With every year, my profits grow, as a result of which my dividends also increase steadily. People are now more willing to invest in my company, because they realize they could potentially gain huge profits from my company. As a result, there are a lot of people that want my shares, and only 1000 in the market. Basic economics tells us that as the demand for a particular thing goes up, unless supply also goes up proportionately, the prices will shoot up as well. Therefore, the shares in StandAlone – which once sold for Rs. 10 each – are now selling at Rs. 1000. This money, however, doesn’t reach the company itself. This transaction is merely a sale of the fraction of the company that the seller owned to the buyer in return for money. It’s not unlike how a wholesaler buys a product from the manufacturer at a certain price and sells it at a markup - none of the profits from any subsequent sale of the product make their way back to the manufacturer, but are independent transactions between third parties.
A couple of weeks ago, an acquaintance of mine from a non-law background came to me and told me that she was prepared to offer a very substantial sum of money to help set up a company that she wanted to start, but didn’t know how to. I wish I could tell you that my good conscience and sense of altruism prevailed, and that instead of taking her up on her very generous offer, I told her how to do it herself. I really wish I could.
Instead, what prevailed was my borderline unhealthy desire to watch Netflix and stuff my face with junk food all day. As a result, I did not take her up on her offer. I also did not sit her down and tell her how to do it herself. This article may or may not be considered my atonement.
It’s very, very easy to incorporate your own company. You can do it from the comfort of your own room, in fact! And no, you do NOT in fact need to engage the services of a lawyer/law student acquaintance to get it done either! Confused? Read on.
Step 1: Understanding the terms involved
Just as with the previous posts, it’s critical to understand the terms that are involved in your brief foray into company law before you begin the process of setting up your own company.
- Company: To put it simply, a company is a new legal entity that is created in order to run a business. A company is basically just another mode for you to do business aside from conducting that business in your own name. Among other reasons, it’s important to have a company of your own because of separate legal personality (which we’ll discuss shortly) and to simplify a lot of the filings you’d have to do otherwise. Think of running a business like travelling down a river. Sure, you can swim, but it’s so much easier if you have a boat.
- Separate Legal Personality: To better understand what exactly the term Separate Legal Personality means, let me give you an example. Let’s say you and your friend are walking down the road, when your friend suddenly gets into an argument with a passerby. Things escalate quicker than they should, and what started out as a mere shouting match has suddenly turned into a full on slug fest. You stay out of the fight, but your friend and the other person are at complete loggerheads, throwing punches up, down, left, right, and centre. Things get uglier, and the cops get involved. They can take your friend and the other person to the police station, but can they arrest you as well? Obviously they can’t, for the simple reason that it wasn’t you but someone else that got into the fight; in other words, your friend is a separate legal personality from you. How is this relevant for a company? Much like your friend, a company is a separate legal personality from you, so you as an individual are considered separate from the company - it’s debts, owables, obligations, and others are all its own, and not yours, even if you were the person who was involved in incurring them. This is super important for a company because in case your company doesn’t do well, creditors can’t come after your property to recover a loan they gave the company (there are rare exceptions to this, but that’s outside the scope of this article).
- Memorandum of Association (MoA): A Memorandum of Association is the document that gives the name of the company, the number of shares the company has, its Directors (we’ll be looking at Directors also shortly), and other basic information about the company. For understanding purposes, you can think of the MoA as the birth certificate of the company.
- Articles of Association (AoA): The Articles of Association of a company is the document that gives (among others) information about the functioning of the company, i.e., regulations that govern the operation of the company, definition of its purpose, as well as the procedure for appointment of directors. For understanding purposes, you can think of the AoA as the User Manual of the company.
Apart from these terms, we’ll also be looking at Directors, Promoters, Equity, and Preference Shares in context in the next part.
So just how does a company function?
Starting a company often requires more resources than are available with any single individual, which is why the money can’t always come from one person. The people who pool in money to form a company are called ‘investors’. ‘Promoters’ start the company. There are two main types of companies in terms of shareholding – private companies and public companies. Private companies are the ones where the shareholding is restricted and confined to certain individuals only, whereas public companies are ones where the shareholding is open to the general public. The Walt Disney Company (India) Private Limited is a good example of a private company, whereas Reliance Ltd. is an example of a public company. This is because while Disney shares aren’t tradable by the general public, the shares of Reliance can be held by anyone and actively traded – your friends, your teachers, the security guards in your school – there is literally no bar to who can trade in these shares (there are certain cases where people are barred from trading in the stock market, but we won’t be dealing with these.)
To better understand the functioning of a company, let’s assume I want to start a company to teach legal reasoning for CLAT, and call it StandAlone Educational Services. Because I intend to limit my company’s liability, I necessarily have to put the term ‘Ltd.’ at the end of my company’s name. My company is therefore incorporated as StandAlone Educational Services Ltd., and I am its promoter.
Now, starting a successful coaching institute involves a considerable investment – I’ll need premises, whiteboards, stationary, furniture, several employees, a marketing team, lawyers to get the permits and all, and a bunch of other running expenses. It’s very rare that someone actually has enough money to be able to afford this entire investment on their own, which is why the concept of shares was invested.
Each share is essentially a small fraction of the company. What I would do then is offer shares in my company to other people, by which they could own a fraction of the company. In return, they give me money, which I use to run the company and meet its expenses and (ultimately) turn a profit. I decide to divide my company into 1000 shares of Rs. 10 each. This means that people can purchase as many shares as they want, as long as they’re willing to pay me the price. Let’s now say you decide to buy 50 such shares, in the hopes that it’ll ultimately turn a healthy profit. You pay me Rs. 500, which I use to run the company. You, meanwhile, now own 50 out of 1000, or 0.5% of my company. The shares that you own are called Equity Shares, signifying that you own a part of the company. This could potentially yield high returns for you, if the company does well, but at the same time is a risky investment, because if the company doesn’t do well, you’d lose your money.
Because I’m not the sole owner of the company, the decisions of the company can’t be taken by me alone. Therefore, the shareholders of the company take part in meetings and decide company policy. They also form a Board of Directors who make most of the important decisions as to how the company is to be run and the policies and business strategies that it should adopt.
Let’s say you as an investor want to invest in my company, but you don’t want to have a part to play in the running of the company. You just want to invest money and turn a profit. In that case, you could also invest in what are called Preference Shares of the company - these are a safer investment than equity shares, the trade off being that since they do not have any linked voting rights in the company, they get paid an assured dividend in return for their investment.
Now that I’ve sold enough shares in my company to finance it, I start running my company. As time goes by, my company grows and grows, and becomes much bigger than the tiny little classroom I started out in. Because the company turns a healthy profit every year, the Board of Directors sanctions a certain portion of the profits to be given to the shareholders, since it IS their company after all. These profits that are given to the shareholders are called the ‘Dividend’ of the company.
With every year, my profits grow, as a result of which my dividends also increase steadily. People are now more willing to invest in my company, because they realize they could potentially gain huge profits from my company. As a result, there are a lot of people that want my shares, and only 1000 in the market. Basic economics tells us that as the demand for a particular thing goes up, unless supply also goes up proportionately, the prices will shoot up as well. Therefore, the shares in StandAlone – which once sold for Rs. 10 each – are now selling at Rs. 1000. This money, however, doesn’t reach the company itself. This transaction is merely a sale of the fraction of the company that the seller owned to the buyer in return for money. It’s not unlike how a wholesaler buys a product from the manufacturer at a certain price and sells it at a markup - none of the profits from any subsequent sale of the product make their way back to the manufacturer, but are independent transactions between third parties.
In order to keep this article at a readable length, this will be published in parts. This is part 1 of 3, and I’ll add the subsequent parts as and when time permit. In the meantime, feel free to write to me if you have any questions on the subject! :)
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