Formation of a Company

Formation of a Company

Introduction and Overview

**Formation of a company** refers to the series of legal and procedural steps required from the conception of a business idea until the company is legally authorised to commence business operations. These steps are undertaken by **promoters**, who are individuals or groups that identify a business opportunity and take initiative to establish a company to exploit it.

**Key reasons for preferring company form:**

Large capital requirements for medium and large-sized organisations

Need to distribute risk among multiple shareholders

Increasing competition and rapidly changing technological environment

Limited liability protection for investors

Three Stages of Company Formation

The formation process is divided into three distinct stages:

**Promotion** (preliminary stage)

**Incorporation** (legal registration)

**Subscription of capital** (raising funds)

Note: Private companies are exempt from some formalities like issuing prospectus and completing minimum subscription requirements, as they cannot raise funds from the public.

Stage 1: Promotion of a Company

Definition of Promotion

**Promotion** is the initial stage involving conception of a business idea and taking necessary initiative to form a company. It begins when someone discovers a potential business opportunity and decides to convert it into a viable company.

Definition and Legal Status of a Promoter

**A promoter** is a person who undertakes to form a company with reference to a given project and sets it in motion by taking necessary steps to accomplish this purpose.

**Legal definition as per Section 69 of Companies Act, 2013:** A person is a promoter if they:

Are named as such in a prospectus or identified in the company's annual return

Have control over company affairs directly or indirectly as shareholder, director, or otherwise

Are such that the Board of Directors is accustomed to act in accordance with their advice, directions, or instructions (provided they are not acting in merely professional capacity)

**Important distinction:** Professionals like chartered accountants, auditors, or legal consultants assisting promoters do not become promoters merely by providing professional services.

Functions of Promoters

#### (i) Identification of Business Opportunity

The first and foremost function is identifying a viable business opportunity. This may involve:

Producing a new product or service

Making an existing product available through a different channel

Any other opportunity with investment potential

The identified opportunity is then analysed for technical and economic feasibility before proceeding further.

**Example:** Avtar, an automobile engineer, develops a new carburettor reducing petrol consumption by 40%. This represents a genuine business opportunity requiring large-scale production.

#### (ii) Feasibility Studies

Not all identified business opportunities can be profitably converted into real projects. Promoters conduct detailed feasibility studies examining:

**Technical Feasibility:** Whether the business idea is technically possible to execute. Issues examined include:

Availability of required raw materials

Access to necessary technology

Existence of technical constraints

**Example:** If Avtar's carburettor requires a specific metal unavailable domestically and cannot be imported due to political relations, the project lacks technical feasibility until alternative sources are arranged.

**Financial Feasibility:** Whether required funds can be arranged within available means. The promoter must:

Estimate total fund requirements for the project

Evaluate if the required capital outlay is achievable through company formation

Abandon the idea if capital requirements exceed manageable limits

**Example:** Developing townships may appear lucrative but may require capital of several crores, making it financially unfeasible for promoters to float a company.

**Economic Feasibility:** Whether the project will be profitable despite being technically viable and financially feasible. This involves:

Market demand analysis

Competitive analysis

Profit projections

Experts like engineers, chartered accountants, and management consultants assist in these studies. Only positive feasibility reports justify proceeding to company formation.

#### (iii) Name Approval

The promoters must:

Select an appropriate name for the company

Submit an application (Form INC-1) to the **Registrar of Companies (ROC)** of the state where the registered office will be located

Provide three names in order of priority (in case the first choice is rejected)

**A name is considered undesirable if:**

It is identical to or too closely resembles an existing company's name

It is misleading (suggesting the company is in a particular business when it is not)

It violates the **Emblem and Names (Prevention of Improper Use) Act, 1950**, which prohibits names resembling:

UNO and its bodies (WHO, UNESCO, etc.)

Government of India, state governments

President of India or state governors

Indian National Flag

Names suggesting patronage of government or local authorities

The ROC approves the name if it is not undesirable; otherwise, an alternative name may be approved.

#### (iv) Fixing Signatories to Memorandum of Association

Promoters must decide which members will sign the **Memorandum of Association (MOA)**. These signatories are typically the first directors of the company.

**Requirements:**

Written consent from each proposed signatory

Confirmation of their willingness to act as directors

Undertaking to purchase qualification shares as per Articles of Association

#### (v) Appointment of Professionals

Promoters appoint specialists to assist in preparing required legal documents:

Chartered accountants (for financial documentation)

Advocates/legal consultants (for legal compliance)

Mercantile bankers (for financial advisory)

Auditors (for financial scrutiny)

These professionals prepare documents for submission to the ROC and prepare the **Return of Allotment** showing shareholders' names and share allocations.

#### (vi) Preparation of Necessary Documents

Promoters prepare critical legal documents required for company registration:

A. Memorandum of Association (MOA)

**Definition (Section 2(56) of Companies Act, 2013):** The Memorandum is the original document framed and altered as per company law defining the company's constitutional relationship with the external world.

**Importance:** MOA is the most critical document as it defines the company's legal scope and objectives. The company cannot legally undertake activities outside its MOA.

**Clauses of Memorandum of Association:**

**(i) Name Clause:**

Contains the company's official name

Must be previously approved by the ROC

Example: "ABC Manufacturing Limited"

**(ii) Registered Office Clause:**

Specifies the state where registered office will be located

Exact address need not be provided at this stage

Must be notified to ROC within 30 days of incorporation

Example: "The registered office shall be situated in the state of Maharashtra"

**(iii) Objects Clause:**

The most important clause defining the company's purpose. It includes:

**Main objects:** Primary business activities for which the company is formed

**Ancillary objects:** Activities incidental or essential for achieving main objects are deemed valid even if not explicitly stated

**Example:** For a manufacturing company, the objects clause specifies manufacturing, trading, and distribution of its products as main objects, while purchasing machinery and leasing premises are ancillary.

**Important principle:** An act is valid if it is either essential or incidental to achieving the main objects, even without explicit mention.

**(iv) Liability Clause:**

Limits members' liability to unpaid amount on shares owned

Protects shareholders from personal claims beyond their share value

**Example:** If a shareholder owns 1,000 shares of ₹10 each and has paid ₹6 per share, liability is limited to ₹4 per share (₹4,000 total), even if company debts exceed this.

**(v) Capital Clause:**

Specifies maximum authorised capital the company can raise through share issuance

Includes authorised share capital amount and its division into shares of fixed face value

**Example:** "The authorised share capital of the company shall be ₹25 lakhs divided into 2.5 lakh shares of ₹10 each."

**Signatories:**

Signatories state their intention to be associated with the company

They undertake to subscribe for shares mentioned against their names

**Minimum signatories:** Seven for public company; two for private company

**Forms:** MOA must be in forms specified in Tables A, B, C, D, or E of Schedule I, depending on company type:

**Table A:** Company limited by shares

**Table B:** Company limited by guarantee without share capital

**Table C:** Company limited by guarantee with share capital

**Table D:** Unlimited company without share capital

**Table E:** Unlimited company with share capital

B. Articles of Association (AOA)

**Definition (Section 2(5) of Companies Act, 2013):** Rules governing the internal management and administration of the company.

**Nature:** Subsidiary to MOA; must not contradict or exceed anything stated in MOA.

**Adoption:** Companies use forms specified in Tables F, G, H, I, or J of Schedule I, but may adopt their own articles if they wish, superseding standard forms.

**Forms for Articles:**

**Table F:** Company limited by shares

**Table G:** Company limited by guarantee with share capital

**Table H:** Company limited by guarantee without share capital

**Table I:** Unlimited company with share capital

**Table J:** Unlimited company without share capital

**Important matters typically covered in AOA:**

Number and value of shares

Issue of preference shares

Allotment, transfer, and transmission of shares

Calls on shares and share certificates

Voting rights and proxies

Directors' appointment and powers

Board meetings and general meetings

Managing director, whole-time director, and manager provisions

Borrowing powers

Dividends and reserves

Audit and accounts

Winding up procedures

**Qualification Shares:** Articles usually require directors to purchase certain shares before the company obtains Certificate of Commencement of Business to ensure directors have stake in the company.

C. Consent of Proposed Directors

A written consent from each proposed director is required confirming:

Agreement to act as director

Undertaking to purchase and pay for qualification shares as per Articles

D. Agreement for Managing/Whole-time Director

If the company proposes to appoint a Managing Director, whole-time Director, or Manager, the employment agreement must be submitted to the ROC for approval before company registration.

E. Statutory Declaration

A formal declaration stating that all legal requirements for registration have been complied with must be submitted. This declaration can be signed by:

An advocate

A chartered accountant

A cost accountant

A company secretary in practice

A proposed director, manager, or secretary named in the articles

F. Receipt of Registration Fee

Registration fees must be paid based on the company's authorised share capital. Fee structure varies with capital amount.

Position and Liabilities of Promoters

Legal Status

**Promoters are neither agents nor trustees of the company** because:

The company has not yet been incorporated when promoters act

No legal principal-agent relationship can exist with an entity not yet in existence

Personal Liability

**For pre-incorporation contracts:** Promoters are **personally liable** for all contracts entered on behalf of the company before its incorporation, unless the company later ratifies these contracts after incorporation.

**Example:** If Avtar signs a machinery purchase contract before company incorporation, he remains personally liable if the company refuses to ratify it after incorporation.

Fiduciary Position

Promoters enjoy a **fiduciary position** (position of trust) with the company. This imposes strict duties:

**Profit disclosure:** Promoters may make a profit from the company but must disclose it. **Secret profits are prohibited.**

**Consequences of non-disclosure:**

Company can rescind (cancel) the contract

Company can recover the purchase price paid to promoters

Company can claim damages for loss suffered due to non-disclosure of material information

Expenses and Compensation

**Promotion expenses:**

Promoters have **no legal entitlement** to claim reimbursement for promotion expenses

However, the company **may voluntarily** reimburse these expenses

**Compensation methods available to promoters:**

Lump sum payment for services

Commission on property purchase price through them

Commission on shares sold through their effort

Allotment of shares or debentures

Option to purchase securities at future date

Stage 2: Incorporation

Application for Incorporation

After completing all promotion formalities, promoters file an **application for incorporation** with the **Registrar of Companies (ROC)** of the state where the registered office will be located.

The application must be accompanied by all required documents as previously discussed.

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Key Exam-Important Points

**5-Marker Distinctions:**

**Promoter vs. Director:**

**Promoter:** Individual who identifies business opportunity and takes steps to form company; role is pre-incorporation

**Director:** Person appointed to manage company after incorporation; has statutory duties; elected by shareholders

**Memorandum vs. Articles:**

**Memorandum:** Defines company's external relationship and objectives; scope of powers

**Articles:** Internal management rules; subordinate to Memorandum; cannot contradict it

**Technical vs. Economic Feasibility:**

**Technical:** Whether the business can be executed using available technology and materials

**Economic:** Whether the business will generate profit despite being technically viable

Definitions to Memorise

**Promotion:** Stage of company formation involving conception and initial steps toward incorporation

**Promoter:** Person undertaking to form company and set it going

**Memorandum of Association:** Most important founding document defining company's objectives and scope

**Articles of Association:** Rules governing internal management of company

**Registered Office:** Official address of company for legal notices and communications

**Authorised Capital:** Maximum share capital a company is permitted to raise

**Qualification Shares:** Shares directors must hold to ensure they have stake in company

**Fiduciary:** Position of trust requiring honest dealing and disclosure