What is the Deal with California Close Corporations?

We spill a lot of ink on the Canna Law Blog talking about different types of business entities that cannabis entrepreneurs often use. In most cases though, the choice is between LLC and corporation. It may come as a surprise to some readers that some states have many different subcategories of corporations, including California. Today I want to examine a rare, though sometimes useful entity: the California close corporation.

What is a close corporation?

You’ve probably heard the term “closely held corporation” tossed around quite a bit. The term usually refers to a corporation with few shareholders, or a corporation with shares that are not publicly traded. However, a closely-held corporation is different from a close corporation, which is actually a special type of California corporation formed per section 158 of the corporations code. If you’re wondering what the state calls a run-of-the-mill corporation, the term is “general stock corporation.”

A close corporation has a few key features that distinguish it from a general stock corporation (or one of the other dozen or so corporation types that exist in the Golden State):

• The articles of incorporation and stock certificates must state that the entity is a close corporation
• It can only have 35 shareholders – if there are more than 35 shareholders , the company stops being a close corporation regardless of what the articles or stock certificates say.
• The main governing document is a shareholders agreement which can relax many of the normal formalities that would apply to a general stock corporation. More on that below.

Why choose a close corporation?

Close corporations can be great for smaller ventures where the shareholders want a corporation but do not want the formality baggage that comes along with it. As mentioned, the shareholders can relax many of the normal formalities of a general stock corporation, including by even participating in the management of a close corporation – something reserved to directors and officers of a general stock corporation. Close corporations can also vary distribution provisions much like you’d see with a partnership (LLC).

So for small ventures with only a few shareholders that do not want to adhere to strict corporate formalities but who still want the corporate form, close corporations can offer some unique benefits. But there are still some drawbacks.

When to avoid a close corporation

Close corporations are by definition limited to a fixed pool of individuals (35). This is great if the shareholders want to keep things private, but not so great if they want to fundraise and sell equity. Sure, they could “convert” to a general stock corporation, but that would mean they’d need to fundamentally change the governance of the entity to do so.

Additionally, shareholders in close corporations also need to be concerned with liability issues to the extent they participate in the management of the company. In your average general stock corporation, shareholders have very limited liability, because they simply passively own a piece of the pie. But once that changes and they start running the show, they may have duties to their co-shareholders that could lead to disputes when things go south.

One other thing that may deter founders from forming close corporations is the fact that any shareholder can file a petition to involuntarily dissolve a close corporation. This is different from a general stock corporation where only shareholders with larger percentages of equity could initiate such a proceeding. In other words, in a two-shareholder close corporation where one has 99% of the stock, the 1% shareholder could initiate a dissolution proceeding.

The involuntary dissolution petition issue could probably be handled in a shareholders agreement, but these are often overlooked, even with close corporations. And failing to get a shareholders agreement could be a huge problem that undoes a lot of the benefits of forming a close corporation in the first place.

In future posts, I’ll make sure to outline some of the less common entity types that cannabis companies sometimes explore. But overall, I don’t see close corporations used often in the cannabis industry. There are definitely companies that could benefit from this more “exotic” form of entity, if done correctly.