Formation of a Company

Written and reviewed by Rohit Singh, Computer Science & Commerce faculty at UniDrill (MCA, Osmania University · 6 years teaching). Based on NCERT Business Studies Class XI, Chapter 7.

Can three friends open a bank account for a company that doesn't exist yet?

Neha, Arjun and Farid have an idea for a healthy tiffin service. They want to hire a kitchen, buy equipment and raise money from investors. But a company is a legal person, and until the law creates it, it cannot sign a lease, own a bank account or sue anyone. Somebody has to take the idea through a set of steps until the company is "born". This chapter is the story of those steps.

A company is the preferred form for medium and large businesses because modern business needs large funds and carries high risk, and a company can raise money from many people while limiting each owner's loss. The steps from the first idea to the point where the company is legally ready to start are called the stages in the formation of a company. The people who take those steps and carry the risk are the promoters.

The three stages in one view

Why it works this way. A private company is not allowed to raise money from the public, so it does not issue a prospectus and does not need a minimum subscription. That is why it stops after stage 2. A public company that wants public money must pass through all three.

The formation in one line: idea → Promotion → Incorporation (birth certificate) → Capital subscription (public companies only).

Stage 1: Promotion

Promotion begins when a person, group or company spots a business idea and decides to build a company around it. By taking that decision they become promoters. The Companies Act (Section 69) says a promoter is a person who is named as a promoter in a prospectus or in the company's annual return, or who controls the affairs of the company directly or indirectly, or on whose advice the Board is accustomed to act. A person who advises only in a professional capacity, such as a lawyer, is not a promoter.

A promoter performs six functions.

Choosing the name. Three names, in order of preference, are submitted to the ROC through form INC-1. A name is "undesirable" and will be refused if it is identical or too similar to an existing company's name, if it is misleading, or if it breaks the Emblems and Names (Prevention of Improper Use) Act, 1950, which protects the names and emblems of bodies such as the United Nations, the Government of India, State Governments and the National Flag. A public company's name ends with "Limited" and a private company's with "Private Limited".

The promoter's legal position. Because the company does not yet exist, a promoter is neither an agent nor a trustee of it. Instead the promoter holds a fiduciary position: a position of trust in which they must disclose all profits made on the company's behalf and cannot make a secret profit. If a promoter hides a profit, the company can cancel (rescind) the contract, take back the price paid and claim damages. Promoters have no legal right to be repaid the expenses they incurred before incorporation, but the company may choose to reimburse them, pay a lump sum or commission, or give them shares, debentures or options.

Pause and predict: Neha signs a one year lease for the kitchen "on behalf of Fresh Tiffin Pvt Ltd" a month before the company is incorporated. After incorporation the landlord demands rent from the company. Can the company be forced to pay?

Check your answer: Not under that contract. The company did not exist when it was signed, so it cannot have been Neha's principal and cannot ratify the lease. Neha is personally liable. The company may sign a new lease with the landlord on the same terms.

Stage 2: Incorporation

The promoters apply to the Registrar of Companies of the state in which the registered office will be. The application carries these documents.

The letter approving the name and the notice of the registered office address (which may follow later) are also part of the filing.

The Memorandum of Association (MOA) defines the objects of the company, and no company can lawfully do anything outside it. It must be signed by at least seven persons for a public company and two for a private company. It has five clauses.

The Articles of Association (AOA) are the rules for the internal management of the company: issue of shares, calls, lien, forfeiture, voting rights, appointment of directors, borrowing powers and winding up among them. They sit below the MOA and cannot go beyond it. A company may frame its own articles or adopt the model set given in the Act. Articles usually require directors to hold qualification shares, which gives them a stake in the company.

The statutory declaration may be signed by an advocate, Chartered Accountant, Cost Accountant or Company Secretary in practice who was engaged in the formation, or by a person named in the articles as a director, manager or secretary.

Pause and predict: a company whose objects clause covers only "manufacture of bicycles" starts selling mobile phones, and every shareholder agrees to approve it. Can this be ratified?

Check your answer: No. Selling phones is outside the MOA, so the act is void and not even a unanimous vote can validate it. The company would first have to alter its objects clause by the lawful procedure.

The Certificate of Incorporation. If the ROC is satisfied that the papers are in order, it issues the Certificate of Incorporation, the "birth certificate" of the company. It also allots a Corporate Identity Number (CIN). From the date printed on it, the company is a legal person with perpetual succession and can enter valid contracts. The ROC checks that the documents are in order but is not bound to investigate whether every fact in them is true.

The certificate is conclusive evidence that the registration was regular. Two situations show how strong this is. In one, a certificate carried a date earlier than the day it was actually issued, and the contracts made on the printed date were held valid, because the date printed is the date of birth. In the other, signatures on the MOA were proved to be forged, yet the incorporation stood. Even a company registered with illegal objects is legally born, and the only remedy is to wind it up.

Why it works this way. Hundreds of people deal with a company after it is registered. If any of them could later challenge its existence on a technical defect, nobody could safely trade with a company, so the law fixes the birth once the certificate is issued.

Every individual who wants to become a director needs a Director Identification Number (DIN). The Central Government allots it within one month of the application, and no individual may hold more than one. Before it begins operations, a company must complete commencement formalities within 180 days of incorporation.

Beyond the textbook. For the exam: the company files forms such as INC-1 for the name and a bundle of documents with the ROC. In reality: the process now runs online on the Ministry of Corporate Affairs portal, where one integrated form (SPICe+) covers name reservation, incorporation and the DIN. Also, the "commencement of business" step is now met by filing a declaration that the subscribers have paid for their shares, rather than by receiving a separate certificate. Why it matters: the legal ideas (MOA, AOA, certificate, 180 days) are unchanged, so learn the exam version and treat the portal as the way it is done today.

Stage 3: Capital subscription (public companies only)

A public company that wants to raise money from the public goes through six steps, regulated by the Securities and Exchange Board of India (SEBI), which protects investors through disclosure rules.

Worked example. Fresh Tiffin Ltd, a made-up public company, offers 2,00,000 shares. The minimum subscription is 90% of 2,00,000 = 1,80,000 shares. It receives applications for 1,70,000 shares, which is 85% of the issue. Because 85% is below the 90% required, the company cannot allot any shares and must refund the application money.

Beyond the textbook. For the exam: learn 90%, 10 weeks, 8 days and 30 days as fixed numbers. In reality: the purpose is to protect small investors. Money sits in a separate account until allotment so that the company cannot spend funds from an issue that may fail, and listing is demanded because shares that cannot be sold are of little use to the buyer.

A realistic example: Fresh Tiffin from idea to listing

Neha, Arjun and Farid study the market (feasibility study) and propose three names to the ROC, of which Fresh Tiffin Private Limited is approved. Two of them sign the MOA as subscribers (the minimum for a private company) and they file the AOA, director consents, the statutory declaration and the fee receipt. The ROC issues the Certificate of Incorporation and a CIN, and the company is born. Later, to expand, it converts into a public company and offers shares to the public: it files a prospectus, gets bankers and underwriters, receives at least 90% of the issue, is listed on a stock exchange and allots the shares. The private company only needed stages 1 and 2, and the public offer added stage 3.

Exam traps

60-second revision

Where this chapter connects

• Previous: Social Responsibilities of Business and Business Ethics describes the duties of the company this chapter creates.
• Next: Sources of Business Finance explains how a company raises the money its shares and debentures bring in.
• Also see: Forms of Business Organisation compares the company with the sole proprietorship, partnership and other forms.