NCERT Notes for Class 11 business studies Chapter 7 FORMATION OF A COMPANY

Class 11 business studies Chapter 7 FORMATION OF A COMPANY

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NCERT Notes for Class 11 business studies Chapter 7 FORMATION OF A COMPANY

Class 11 business studies Chapter 7 FORMATION OF A COMPANY

• Joint Stock Company is an artificial person.
• It is a legal entity.
• The company is formed, brought up and even wound up after following legal formalities.
• Formation of a company is a very time consuming, lengthy and complex process.
• It involves a lot of formalities and legal procedures. It consists of four stages:

1. Promotion
2. Incorporation
3. Subscription of capital
4. Commencement of business

A Public Ltd Company has to complete all the above four stages. But a private company is required to undergo only the first two stages viz, promotion and incorporation.

1- PROMOTION

• Promotion is the first stage in the formation of the company.
• Promotion simply means the sum total of all activities which are necessary for bringing the company into existence.
• It involves discovery of business idea, its investigation and assembling of necessary resources to set-up business as a profitable concern.

Promoters

• Promoter is a person who performs the work of promotion and brings a company into existence.
• Promoter is a person who undertakes to form a new company and carries out all preliminary work in connection with its establishment as a going concern.
• A promoter may be an individual, firm or a company.
• The idea of business opportunity is first born in the mind of a promoter.
• He analyses its prospects by conducting detailed investigation.
• If he is convinced, he arranges men, money and materials to translate his idea into a business unit.
• Meanwhile, he completes the legal formalities, Prepare documents like Memorandum of Association, Articles of Association, settles the preliminary contracts and pays preliminary expenses in connection with the formation of a company.
• In order to perform the task of promotion successfully, a promoter must have several essential qualities.
• Fertile imagination, sound judgment, initiative, resource fullness and organizing ability are the main qualities of a successful promoter.

Types of Promoters

Different types of promoters are

1- Professional Promoters

• Professional promoters are specialists and expert promoters.
• Promotion is their main profession or occupation.
• These promoters are interested in looking out for business opportunities and converting them into business units in return for some remuneration or commission.
• Professional promoters promote company and hand over the control and management to the board of directors.

2- Occasional Promoters

• A person who promotes company once in a while is known as occasional promoter.
• Occasional promoters do promotional work occasionally as part of their work or profession.
• They go back to their earlier profession after establishment of the company.

For eg. Engineers, lawyers etc.

3- Entrepreneur Promoters

• When the owner of the business himself conceives the idea of starting a company, perform preliminary activities himself and gives a practical shape to his idea then he is known as entrepreneur promoters.
• They are both promoters and entrepreneurs.
• After promotion the promoter become the part of the management.

4- Financier Promoters

• Some financial institutions like investment banks or industrial banks may take up the promotion of a company with a view to finding opportunities for investment.
• When banks and other financial institutions act as promoters, they are known as financier promoters.
• In India IDBI, ICICI and many other financial institutions perform the function of a promoter.

Functions of Promoters or Stages in Promotion

The promoter performs the following functions. These functions are also known as steps in promotion stages:

1- Discovery of business idea

• The promotion stage begins with the discovery of an idea to set up a business.
• There may be several ideas in his mind and he has to decide which is the most feasible and profitable one.
• The business idea may relate to commercial use of a new invention or exploitation of an untapped natural resource.

2- Feasibility study

• After analyzing all the concepts related to the idea discovered, the promoter starts doing detailed investigation to give practical shape to the idea.
• He does detailed investigation regarding cost, profitability, production process, demand of the product etc.
• While doing this, the promoter takes the help of a specialists or experts such as charted accountant, engineers etc.
• Feasibility study includes technical feasibility, economic feasibility, financial feasibility etc.

3- Appointment of bankers, brokers, solicitors and under writers

• The promoter appoints the brokers and underwriters to ensure the availability of capital by sale of a company’s securities and solicitors are appointed to deal with then legal matters of the company.
• Bankers are appointed to have smooth financial dealings.

4- Assembling the factors of production

• Once satisfied with practicability and profitability of the proposal, the promoter assembles the factors of production like land, labour, capital and managerial personnel.
• Assembly of resources involves making contracts for purchase of material, land, machinery, recruitment of staff etc.
• Promoters also find out persons who are willing to act as the first directors of the company.

5- Preparation of Preliminary Documents

The promoter takes up the steps to prepare necessary documents of the company which have to be submits to the Registrar at the time of incorporation. The required documents are:-

1. The Memorandum of Association
2. The Articles of Association
3. The Prospectus / Statement in lieu of prospectus.
4. A list of directors – their full address and occupation.
5. A written consent by directors stating that they have agreed to act as directors.
6. A statement of authorized capital
7. A statutory declaration by a Chartered Accountant or an advocate of Supreme Court or High Court that all provisions of the Companies Act have been complied with.

6- Entering into preliminary Contracts

• The promoters enter into contracts with different parties before registration of the company.
• After registration the company approves these contracts.

7- Name approval

• Two companies can’t have identical names.
• It is necessary for every company to gets its name approved from the Registrar so that it does not match with any other companies name.

Legal status of a promoter

• The promoter performs preliminary work relating to establishment of a company.
• As the company is not an existence at the promotion stage he can’t be called as an agent of the company.
• However, a promoter stands in a fiduciary relationship with the company under promotion, ie a relationship involving confidence or trust.
• The relationship of good faith requires the promoters to act honestly and sincerely and in the best interest of the company.
• He should not make any secret profit at the expense of the company under promotion.
• He is personally liable for the obligations under contracts entered into before the incorporation.

Preliminary Contracts:

• During the promotion of the company, promoters enter into certain contracts with third parties on behalf of the company.
• These are called preliminary contracts.
• They are not legally binding on the company.
• A company after coming into existence may, if it so chooses, decide to enter into fresh contracts with the same terms and conditions to honour the contracts made by the promoters.
• A company thus cannot be forced to honour the preliminary contract.
• However, promoters remain personally liable to third parties for these contracts.

INCORPORATION OF A COMPANY

• It is the second stage of the formation of a company.
• Incorporation is the registration of the company as a body corporate under the Companies Act 2013.
• Incorporation is a legal process consisting of the following steps.

Proceeding prior to incorporation

1- Form of a company

• The promoters should first decide upon the form of the proposed company-private or public.
• Registration formalities differ in each case.

2- Name of the company

• As per the companies Act, a company cannot be registered by a name which is undesirable in the opinion of central government.
• Any name which is identical with, or which closely resembles the name of an existing company is undesirable.

3- SEBI’s approval of the draft prospectus

• A draft prospectus has to be submitted to SEBI for scrutiny to ensure that disclosures made therein are adequate to protect investors.

4- Industrial license

• License from central government is necessary to start certain industries.
• So application should submit for this at this stage.

Procedure for incorporation

For the purpose of incorporation, the following documents are to be filed with the Registrar of Joint Stock Companies along with necessary filing fees, stamp duty and registration fees.

• Memorandum of Association– signed by at least seven persons in a public company. It should be stamped and witnessed properly.
• Articles of Association-duly signed by the signatories to the memorandum of association
• List of directors- containing name, address and occupation
• Written consent of directors-to act in that capacity
• Undertaking of the directors-to the effect that they will take up and pay for qualification shares(in case of public limited companies)
• Notice of registered office-showing the address of the registered office of the company.
• Statutory declaration-by an Advocate of Supreme Court or a High Court or a Charted Accountant or a director of the company that all requirements of the Act have been complied with.

After scrutiny, the Registrar issues a certificate called ‘Certificate of Incorporation’.

Effects of Certificate of Incorporation

• This certificate is a conclusive proof of the registration of a company.
• It may be called the birth certificate of the company.
• The date shown in the certificate denotes the date on which the company comes into existence.
• On obtaining this certificate the company acquires an independent entity separate from its members.
• It also an evidence that Memorandum and Articles are within Law and all provisions of the Act in respect registration have been complied with.
• A private Ltd Company can commence business immediately after getting certificate of incorporation.
• But a Public Ltd Company can commence business only after getting the certificate of commencement of business.

Capital subscription (FLOATATION)

• A pubic company can raise the required funds from the public by means of issue of share and debentures.
• For doing the same it has to issue a prospectus and undergo various other formalities.

The following steps are required for raising funds from public:

1- SEBI Approval

• The prior approval of Securities and Exchange Board of India (SEBI) is necessary before going ahead with raising funds from public.

2- Filing of Prospectus

• A copy of the prospectus or statement in lieu of prospectus is filed with the Registrar of Companies.
• It is an invitation to the public to apply for shares or debentures of the company or to make deposits in the company.
• Investors make up their minds to about investment in a company primarily on the basis of the information contained in the prospectus.
• Therefore, there must not be mis-statement in the prospectus and all significant information must be fully disclosed.

3- Application to Stock Exchange

• An application is made to at least one stock exchange for permission to deal its shares or debentures.

4- Appointment of Bankers, Brokers, Underwriters

• Appointment of bakers, brokers and auditors to the issue are made at this stage.
• Raising funds from public is not an easy task.
• The application money is to be received by the bankers of the company.
• The brokers try to sell the shares by distributing the application forms and encouraging public to apply for the shares.
• If the company is not reasonably assured of good public response to the issue, it may appoint underwriters to the issue.
• Underwriters undertake to buy the shares if these are not subscribed by the public.
• They receive a commission for underwriting the issue.

5- Minimum subscription

• In order to prevent companies from commencing business with inadequate resources, it has been provided that the company must receive application for a certain number of shares before going ahead with allotment of shares.
• This is called Minimum Subscription. The limit of minimum subscription is 90% of the size of the issue.

6- Allotment of shares

• Allotment of shares means issue of shares to the applicants on the basis of application submitted by them.
• Before allotment of shares it is to be assured that the company has received the minimum subscription.
• As per rules, allotment of shares is to be made within 120 days of the issue of prospectus.
• A public company may not invite public to subscribe to its shares or debentures.
• Instead, it can raise the funds through friends, relatives etc.
• In such cases, there is no need to issue a prospectus.
• A ‘Statement in Lieu of Prospectus’ is filed with the Registrar at least three days before making the allotment.

IV COMMENCEMENT OF BUSINESS

• If the amount of minimum subscription is raised through issue of shares, a public company applies to the Registrar of Companies for issue of Certificate of Commencement of Business.

Certificate of Commencement of Business granted by Registrar only when the following formalities are fulfilled:

1. The company has filed with the Registrar prospectus or statement in lieu of prospectus.
2. The number of shares allotted is not less than minimum subscription stated in the prospectus.
3. Return of allotment containing names and addresses of shareholders and the number of shares allotted to teach should be submitted.
4. The directors have taken up and paid for their qualification shares.
5. Declaration to the effect that the company was applied for or obtained permission for trading its shares in a recognized stock exchange should be filed.
6. Declaration by the secretary or a director of the company is filed with the Registrar to the effect that all provisions of the Act in respect of allotment of shares and commencement of business have been complied with.

The Registration of companies will scrutinize the above documents and if satisfied will issue Certificate of Commencement of Business. This certificate is conclusive evidence that the company is entitled to do business. With the grant of this certificate the formation of a company is complete and the company can legally start doing business.

Basic documents of a company

1- Memorandum of Association

• The Memorandum of Association is the principal or most important document of a company.
• It is the charter or ‘Magna carta’ of the company. Memorandum of Association defines the objectives of a company and determines the boundary line beyond which the company can’t operate.
• It defines the powers of a company and company’s relationship with outside world.
• The purpose of the MOU is to enable the shareholders, creditors and others who deal with the company to know the scope of
• the company’s operations.
• The MOU sets out the constitution of the company. It is a public document.

Contents of Memorandum of Association

The Memorandum of Association is divided into Six clauses. (1) Name Clause (2) Situation or domicile Clause (3) Object Clause (4) Liability Clause (5) Capital Clause (6) Association Clause.

1- Name of Clause

• This clause contains the complete name of the company.
• The name of the company must be stated in this clause.
• The name should not be identical with, or similar to the name of an existing company.

Alteration of name clause.

The name of a company can be altered only by a special resolution of the company and with the prior approval of the Central Government.

2- Situation Clause or Domicile Clause

• This clause specifies the name of the state in which the registered office of the company is situated.
• This clause determines the jurisdiction of the registrar of joint stock companies and of the court.
• The registered office is the place where all the statutory books and other important documents of the company are kept.
• This address is used for correspondence from Registrar of Companies.

Alteration of Situation clause

The clause can be altered in the following ways:-

1. If the registered office is to be shifted from one state to another, by passing a special resolution and obtaining the sanction from company law board.
2. If the office is to be shifted from one town to another town in the same state, by passing a special resolution.
3. If the office is to be shifted from one locality to another in the same town, by passing an ordinary resolution.

3- Objective Clause

• It is the most important clause of the Memorandum of Association.
• It contains the main object of the company and other secondary objective which the company may pursue.
• This clause defines the scope and limitations of the activities of the company.
• A company can take up any of the activities mentioned in the Memorandum.
• Any acts beyond the powers in the objects clause are ‘ultra vires’ and hence void and illegal.

Alteration of objective clause

• A company has only limited power to alter the object clause of the memorandum.
• A change can be made only for such purpose as mentioned in section 17 of the companies Act, 1956, by a special resolution and obtain confirmation from the company law board.

4- Liability Clause

• This clause defines the liability of the members of the company.
• In case of a company limited by shares, the liability is limited to the nominal values of shares held by a share holder.
• In case of company limited by guarantee, the liability of a member of shareholder is limited to the amount which he has undertaken to pay at the time of liquidation of the company.

Alteration of Liability Clause

The liability clause can be altered in the following ways.

1. Any additional liability on its members can be imposed by passing a unanimous resolution in a meeting of members.
2. The liability of directors, managing director or managers can be made unlimited by passing a special resolution, if the article so permit.

5- Capital Clause

• This clause states the total capital of the company with which the company is registered.
• It is known as authorized, registered or nominal capital.
• Accompany can issue only that number of shares which are authorized by its memorandum.
• The shares may be preference shares or equity share.
• The number of shares in each category should also be mentioned in this clause.

Alteration of Capital Clause. A company can increase its share capital by passing an ordinary resolution. A special resolution and confirmation of the resolution by court is necessary for reduction of capital.

6- Association or Subscription Clause

• This clause is in the form of a declaration.
• It states that the subscribers of memorandum express their willingness to from a company.
• The memorandum must be signed at least two persons in the case of a private company and at least seven persons in case of a public company.
• The signatories must take at least one share of the company.
• The full address and occupations of subscribers and witness must also be given.

Alteration of Association Clause

• The association clause can’t be altered.

Articles of Association

• Articles of Association are the bylaws of a company.
• It contains rules and regulations for the internal management of the company.
• It defines the duties, rights and powers of the management and board of directors.
• They lay down the mode and the manner in which the business of the company is carried on.
• This is known as ‘Doctrine of Indoor Management’.
• The Articles can’t contain anything contrary to the Companies Act and the Memorandum of Association.
• A private company, a company limited by guarantee and an unlimited company must have their own Articles of Association.
• A public company limited by shares need not prepare its own Articles of Association instead; it may adopt ‘Table A’. It is a model Articles of Association given in the Companies Act.
• The Articles of Association should be printed and properly divided into paragraphs. Each subscriber to the Memorandum must sign the Articles of Association in the presence of at least one witness.

Contents of Articles of Association

The Articles of Association usually contains regulations and bye laws relating to the following matters.

1. Share capital and its subdivision into different classes of shares, rights of share holders.
2. Procedure for making allotment of shares and for making calls.
3. Procedure for transfer of shares
4. Procedure for forfeiture, re-issue and surrender of shares.
5. Procedure for conversion of share into stock.
6. Procedure for issue of share certificate and share warrant etc.
7. Procedure for alteration and reduction of share capital.
8. Borrowing powers of the company.
9. Rules regarding appointment, re-appointment, qualification, remuneration, powers, duties etc of directors.
10. Procedure for conducting meetings
11. Procedure regarding quorum, voting right, poll proxy etc.
12. Rules regarding capitalization of profits and declaration of dividends.
13. Matters relating to keeping of statutory books of accounts and their audit.
14. Seal of the company
15. Procedure regarding winding up of the company.

Alteration of Articles of Association

A company can change its Articles of Association at any time by passing a special resolution subject to the following conditions:-

1. The alteration must not be contrary to the Memorandum and the companies Act.
2. It should be in the interest of the company as a whole.
3. It should not violate any existing contract with outsiders.
4. It must not have the effect of increasing the liability of members. If the alteration involves converting a public company into a private company, the approval of the Central Government must be obtained.

Table A

• Table A is a model set of articles given in the Companies Act.
• It is a document containing rules and regulations for internal management of a company.
• If any public company limited by shares does not file its own Articles of Association, then all the provisions of Table A will be applicable to it.
• If a company adopts Table A, there is no need to prepare separate Articles of Association.

Difference between Memorandum and Articles of Association

Basic	Memorandum of Association	Articles of Association
1 Purpose	To define the objects and powers of a company	To lay down rules and regulations for management
2. Status	Fundamental document – Constitution of the company	Subsidiary to Memorandum
3. Drafting	Compulsory for all types of companies	Not compulsory for public company limited by shares
4. Relationship	Regulates the relationship between company and outside world	Define the internal relationship between company and its members.
5. Supremacy	Memorandum is subordinate to the Act only	An article is subordinate to the Memorandum and Companies Act.
6. Alteration	Difficult	Easy

IV Prospectus

• A public company limited by shares can invite the public to subscribe its shares or debentures by issuing a prospectus.
• A prospectus is an invitation to the public to subscribe its shares or debentures.
• It contains all material information required regarding financial aspects of the company and helps people in making decision, whether they should subscribe for shares of the company or not.
• The prospectus contains detailed information of the company including past history (if any) present position and future prospects.
• A copy of prospectus must be filed with the Registrar before it is issued to public.
• Every prospectus must be dated and signed by signatories of Memorandum.

Importance / Purpose of the Prospectus

1. It informs the public about the company and stimulates people to invest money in the company.
2. It provides an authentic records of the terms and conditions on which shares and debentures have been issued.
3. It reflects the business policies and programmes of the company.
4. It serves as an advertisement for the company giving detailed information about its past history, present position and future prospects.

Contents of prospectus

Prospectus must contain the following particulars:-

1. Name and registered address of the company.
2. Main objects of the company
3. Names and addresses of the signatories to the Memorandum and the number of shares subscribed by each of them.
4. Number and kinds of shares and the right attached to them.
5. Details regarding debentures, if any
6. Amount of minimum subscription.
7. Dates of opening and closing subscription list.
8. Amount payable on application, allotment and on calls.
9. Number of shares already issued, if any, during the previous two years other than for cash and consideration received.
10. Names and address of auditors, bankers, brokers etc.
11. Name and address of under writer and underwriting commission.
12. The details of redeemable preference shares to be issued, if any.
13. Names, address and occupation of members of the Board of Directors.
14. Details about listing of shares in shock exchanges.
15. Qualification shares of directors, if any
16. Name and address of Managing Director and their remuneration.
17. Details of borrowing powers of the company.
18. Particulars about reserves and surplus.
19. Particulars about voting rights at the meeting of the company
20. Auditors report on the profit and losses, dividend declared, assets and liabilities of the company during the previous five years.

Liability for mis-statement in prospectus

• A prospectus must be prepared with utmost good faith.
• An investor may be subscribing shares of a company on the belief that the facts contained in the prospectus are correct and true.
• The promoters or directors who are the signatories to the prospectus can be held responsible for the miss statements contained in it for civil and criminal liability.

Statement in lieu of prospectus

• If a public company does not want to make a public issue of shares and if the required capital can be obtained privately, it should file a statement in lieu of prospectus with the Registrar at least three days before the allotment of shares.
• The Performa of the statement in lieu of prospectus is given in part I schedule III of the Companies Act.
• This statement contains almost the same information contained in a prospectus.

Important Terminology

Minimum Subscription

• In order to prevent companies from commencing business with inadequate resources, it is provided that the company must receive the amount of minimum subscription in cash within 120 days from the date of issue.
• It is the minimum amount of capital which in the opinion of directors must be raised by a company through issue of shares before making allotment of shares.
• A public company can’t commence business without raising minimum subscription.
• Normally the limit of minimum subscription is 90% of the size of the issue.

The amount of minimum subscription must sufficient for the following requirements:

1. Payment of preliminary expenses.
2. Payment for assets purchased.
3. Meeting working capital requirements.
4. Meeting other expenses.

If the minimum subscription is not received, the allotment cannot be made and the application money received must be returned to the applicants within the next 10 days (ie.130 days from the date of issue).

Qualification shares

• To ensure that the directors have some stake in the proposed company, the Articles usually have a provision requiring them to buy a certain number shares.
• They have to pay for these shares before the company obtains Certificate of Commencement of Business.
• These are called Qualification shares.

Preliminary contracts

• During the promotion of the company, the promoters enter into certain contracts with third parties on behalf of the company.
• These are called preliminary contracts. These are not legally binding on the company.
• A company after incorporation may, if it so choose, decide to enter into fresh contracts with the same terms and conditions to honour the contracts made by the promoters.
• A company thus cannot be forced to honour a preliminary contract.
• Promoters, however, remain personally liable to third parties for these contracts.

Provisional Contracts

Contracts signed after incorporation but before commencement of business. These become enforceable only after the company gets the Certificate of Commencement of Business.

Statement in Lieu of prospectus

A public company may not issue prospectus. In such a situation, it will have to file a Statement in Lieu of prospectus with the Registrar of Companies. Statement in Lieu of prospectus is used in the following cases:

• If the company has decided that it will not issue shares or debentures to public.
• If the private company is changed into public company.

As a private Ltd Company is not permitted to raise funds from the public it does not require filing a prospectus or statement in lieu of prospectus.