“Fresh Start” – Is a company bound by pre-incorporation agreements?

“Fresh Start” – Is a company bound by pre-incorporation agreements?

Written by

Tal Schiller
July 11, 2018

Promises should be kept. However, what would you say of a new start-up whereby promises need not be kept? In the entrepreneurial world, it is customary for an entrepreneur to perform various actions on behalf of a company to be incorporated, even before its incorporation. Thus, for example, an entrepreneur would often hire employees, preform transactions and execute agreements on behalf of a company to be incorporated in the future, upon economic feasibility. However, such actions will not bind the company unless it subsequently adopts them, as a company has discretion to decide whether to see itself bound by legal actions taken on its behalf prior to incorporation.

The Israeli Companies Law sets that a company may approve an act of an entrepreneur preformed on its behalf or in its place prior to incorporation, where a post-approval is considered an approval given in advance to carry out action, provided that a right acquired by a third party in good faith and for consideration prior to the approval is not jeopardized. If the company does not approve the act after its incorporation, it will not be obligated by it. Thus, a person entering a contract with an entrepreneur, for example, takes a risk that the contract will not obligate the company. In a case decided by the Supreme Court in May, 2018, an entrepreneur entered a land sale agreement on behalf of a company to be incorporated and a question arose as to whether the transaction is valid because the company did not exists at such time. The Court held that the fact that a company entered a transaction prior to its incorporation does not negate the validity of the transaction; certainly when (as in the case discussed) the company later approved the transaction within reasonable time. Note, though, that because a company may not approve the act performed in its name by the entrepreneur, entering a contract or any other legal action with a company in incorporation is not free of risks, both for the third party and for the entrepreneur who is exposed to legal claims in case the company does not later approve the entrepreneur’s actions.

In a different case, also decided in May, 2018, this time by the Labor Court, it was held that if a company adopts an employment contract entered into by the entrepreneur, the employment period commences upon the entrepreneur's original contract with the employee. In that case, the entrepreneur entered an agreement with three software developers and agreed with them that at the first period no employer-employee relationship will exist and in exchange the software developers received options in the company to be incorporated. The Labor Court held that even if an employee receives options, employer-employee relationship may still be created.

Note also, that in the course of activity prior to the incorporation of a company, intellectual property may be created which will later be transferred into the company upon its establishment and may create a tax event. In light of the above, it is certainly important that lawyers familiar with the field accompany the start-up process from the earliest stages and even before the company is established.