10 Legal Considerations When Incorporating Your Startup
November 16, 2017
By Julie Robinson, Partner at McInnes Cooper
Corporations are the leading business vehicle in modern commerce. For startups, properly structuring and incorporating is critical to avoid disputes and protect the corporation (and the founders) and its assets if they do come up, and avoid the time and expense of doing it over later. It’s also critical to best position the business to attract investors and strategic partners and, ultimately, achieve a successful and profitable exit (by acquisition or otherwise) if that is the ultimate goal. Doing it right means thinking and planning ahead.
Here are ten key considerations every founder should think about when incorporating their startup.
The three main ways to structure a business are sole proprietorship, partnership and incorporation. Most businesses kick off as a sole proprietorship or partnership: one or more owners/operators responsible for all aspects – including risks and liabilities – of the business. But at some point, founder(s) are ready to look at incorporation and its benefits. A “corporation” is a legal entity separate from its owners (the shareholders). It alone is responsible for its debts, obligations, and actions, and if it fails to make good on them, generally the shareholders aren’t personally responsible. There can also be tax advantages to incorporation, especially after a business is profitable. The time is right to consider incorporation when:
- The founder(s) have developed intellectual property (IP) (trademarks, copyrights, trade secrets, industrial designs or patents), because it’s more beneficial for one owner (the corporation) to control and further develop those assets.
- The business is ready to enter into contracts with customers or suppliers, because both may be reluctant to enter into contracts with individuals and because incorporation offers liability protection for the founders under those contractual obligations.
- The business is looking for funding, because most investors and government grant and similar programs require incorporation to fund.
- Incorporating Jurisdiction
A business can incorporate under provincial laws or under federal laws. There are differences between them and between provinces, and each has pros and cons. The right choice depends on your objectives. Discuss these key considerations with your legal team to help you make that decision:
- Investor-readiness. Investors may have a preference; switching later will cost time and money.
- Target Market. Both provincially and federally incorporated businesses can generally carry on business anywhere in Canada, but the amount of red tape to do so varies.
- Flexibility. Provincial and federal incorporation offers differing flexibility in structuring your shares, limiting members’ liability, restricting directors’ powers, and liability allocation. Some also place residency restrictions on directors.
- Registered Office, Reporting & Business Name. There are differing requirements for locating the registered office, annual reporting requirements, and business name search and approval.
Choosing a corporate name might not be as simple as it sounds: there are legal requirements. A corporation name must be: distinctive; not cause confusion with an existing name or trademark; include a legal element (e.g. Ltd., Corp., Inc.); and not include any unacceptable (to the relevant registering authority) terms. A NUANS report determines whether the proposed name has already been registered as a corporation name or as a trademark. But remember that obtaining the name doesn’t alone give the corporation the right to use that name as a trademark.
- Share Structuring
Incorporation will require a startup to decide how to structure its capital.
Type. There are two ordinary types of shares: common and preferred. Preferred shares have certain rights, or “preferences”, over common shares such as dividends, redemption rights or conversion features.
Shareholder Rights. Within each type of shares, there can be as many classes as desired. A corporation can have one type of shares with all the basic shareholder rights attached, or multiple classes with a combination of attached rights and privileges. The default shareholder rights include voting, dividends, and distribution of assets. Founders typically take common shares with all of these basic rights.
Number. For startups, it’s often best to create an easy-to-understand capital structure by authorizing an unlimited number of common shares with default voting, dividend and distribution rights. The corporation can add a new class with preferential characteristics later if needed, such as to satisfy the condition of an investor.
“Founder(s)” Shares. If there are multiple founder(s), a key decision is the initial equity split between them. Typically, the founder(s) get their shares for “free” (for a small amount of cash) upfront. As a trade-off, the founder(s) often also work in the corporation for no or minimal compensation and only get paid when (and if) the corporation receives funding or revenue. This requires a decision about who is – and who is not – a “founder”. There’s no legal test or definition; it’s a decision about who’s really invested in the corporation, their contributions to the business, and who’s going to stick around to make it a success.
- A Shareholders’ Agreement
All shareholders can benefit from a shareholders’ agreement: a written agreement among some or all of a corporation’s shareholders defining the relationship, rights, and obligations between the shareholders and the corporation, and addressing potentially contentious issues before problems arise. Without one, corporate laws govern the relationship; but their default provisions might not cover everything the shareholders want, or they might do so but in a way the shareholders wouldn’t choose. Deciding when to put a shareholders’ agreement in place isn’t easy because it might not be useful if the business plan isn’t fleshed out or the co-founders aren’t yet committed. But investors will likely want to see one in place before they consider financing the corporation – and active investors might want to discuss modifying it to give them board participation and other rights. A shareholders’ agreement includes many terms and conditions. For startups, some of the key ones include:
Board of Directors. Practically, the initial Board of Directors is comprised solely of the founder(s), but the shareholders’ agreement will specify the total number of directors required. Specifying a maximum rather than either a minimum or a specific number of directors offers the most flexibility; otherwise, the departure of directors can impede the Board’s ability to act at all. The agreement also specifies the right of shareholders to designate board nominees. Startups in particular must remember that investors typically expect to have – and even insist on – board representation.
Share Transfer Restrictions. The agreement will also typically place restrictions on shareholders’ ability to transfer shares. This is of particular concern to startup shareholders: in most cases, the corporation is closely-held (at least initially) and the founders will want control over with whom they work. There are a number of mechanisms to do this; one key way is with a right of first refusal. This protects shareholders (but can deter third party purchasers) by generally requiring a shareholder who gets an offer from a third party purchaser to give the other shareholders notice of the offer, who then have the right to match the third party offer within a specified time.
Drag & Tag Rights. A startup’s exit plan might involve selling the corporation (or part of it) to a third party. Drag-along and tag-along rights in a shareholders’ agreement can facilitate the sale and protect the shareholders’ interests. A drag-along gives the controlling shareholder(s) (often the founder(s) and/or significant investors) the power to ensure minority shareholders can’t stop them from selling the corporation when they receive a legitimate third party offer: if a third party offers to buy the corporation, the drag-along right allows the controlling shareholder(s) to force all other shareholders to either sell their shares or approve the resulting change of control of the business. Conversely, a tag-along allows all (or specified) shareholders to “tag along” with a shareholder that’s selling to the third party, giving shareholders the opportunity achieve liquidity for their investment.
Pre-emptive rights. Pre-emptive rights allow existing shareholders to avoid dilution of their ownership stake when the corporation decides to issue new shares by giving them first crack at purchasing the new shares at the offered price. Investors will often request these rights, but founder(s) might also want them.
- A Stock Option Plan
Startups often lack cash to pay top talent to help the corporation grow, but they do have equity – often a powerful incentive to attract talent. There are several forms of equity compensation plans; the one that’s the best fit for a particular corporation will depend on its unique circumstances and on what it hopes to achieve. Stock option plans are commonly used by startups. A stock option plan is a tool for a corporation to attract, motivate and retain talent, such as employees, directors, consultants, advisors, and so on, with the promise of equity at a fixed price in exchange for the option-holder’s commitment to the corporation for a certain period of time.
Option Defined. An option gives the holder a right to purchase a certain number of shares in the future at a pre-determined price (the “exercise price”).
Number. The Board of Directors determines the size of the “stock option pool”. The number of options available is usually around 10% to 20% of the company’s fully diluted capital. Plans typically give the corporation discretion to ensure retention of its outstanding shares in the event of employee departures by giving it rights to cancel options in exchange for giving option-holders a specified financial value.
Granting Options. The Board of Directors approves the date the options are granted, the total number of shares subject to the option, the exercise price, the vesting commencement date and schedule, the expiry date and any unique terms. The corporation and the person receiving the options then sign a written option agreement specifying those details.
Exercise Price. Typically, the Board of Directors determines the exercise price at the shares’ fair market value when the options are issued, although this isn’t always the case. The option-holder’s goal is to exercise the option at a later date when it is “in the money”: when the share’s fair market value exceeds the exercise price.
Option Vesting. The option-holder only gets to exercise their options when they’ve “vested”. Vesting conditions vary, but are often tied to the option-holder’s continued involvement with the corporation according to a pre-determined “vesting schedule”. The vesting schedule outlines the percentage of options the option-holder can exercise after a specified amount of time. A typical vesting schedule for startups includes a one year “cliff”: options only begin vesting one year after they are granted, and then vest on a prorated basis periodically (usually monthly, quarterly or annually). This helps the corporation ensure those entitled to options don’t benefit prematurely by cashing-in before contributing to the corporation. Once vested, an option stays vested until it expires; if an option-holder fails to exercise their options before the expiry date, their unexercised options are cancelled and returned to the corporation’s option pool. Stock option plans typically set out what happens to vested and unvested options if the option-holder is removed, or removes themselves, from their role or becomes disabled, retires or dies.
Exercising Options. There’s no obligation on the option-holder to exercise the option(s). But if they don’t exercise before the options expire, the option-holder will forfeit the options and will be unable to exercise them.
- Intellectual Property
For many businesses, particularly early stage startups, their intellectual property (IP) – such as trade secrets, patents, trade-marks, copyright and industrial designs, and confidential information, like market research, financials and customer information – is one of their most valuable (or sometimes their only) assets. So understanding how to deal with and protect that IP is important. When a startup is looking to incorporate, there are a few key issues the founder(s) must decide.
IP Transfer from Founders. Typically, the founder(s) developed the IP so are often the initial owner(s) of it. When the founder(s) decide to incorporate, they transfer their rights in that IP to the corporation, usually upon or immediately after incorporation. This ensures the corporation owns the IP assets, and any continued development of it – which will be key to future investors.
Proprietary Information and Inventions (or “IP”) Agreements. These agreements between the company and its founders, employees, contractors, and so on protects the corporation’s IP and other proprietary information by ensuring the corporation retains ownership of its IP and sets out each party’s confidentiality and non-disclosure obligations to the corporation.
- Complementary Additional Agreements
Here are three key additional agreements particularly beneficial to startup corporations.
Founder Reverse Vesting Agreements. This is effectively a repurchase option under which the corporation can buy back a founder’s “unvested” shares if they leave the corporation. A founder reverse vesting agreement should address these two key issues:
- Vesting period.Decide whether a cliff (an amount of time before the vesting starts) is needed for founders. And decide the vesting period: from what date does it run, and for how long. Corporations will typically use a two to four year vesting period, similar to stock options.
- Triggering events. Determine what situations will trigger the buy-back option. Typical events include the founder’s employment termination, resignation, disability or death. The buy-back price might depend on the event: for example, a corporation could buy back the founder’s shares for a nominal amount if the corporation terminates the founder’s employment for cause, but must pay fair market value if it terminates without cause.
Employment Agreements. It’s wise for the corporation to enter into a written employment contract with each employee – including the co-founders and any other shareholders who are also employees.
Contractor Agreements. A startup corporation might choose to hire independent contractors rather than employees to do some work, as a cost-control measure, to obtain specialized services, or services it needs for a limited time. Characterization of a person as an employee or independent contractor is important because it carries certain consequences for both the corporation and employee / contractor. And it’s just as wise for the corporation to enter a written agreement with its contractors.
The mechanics of financing a startup have unique features and characteristics depending on where the business is in its financing lifecycle. Typically, startups contemplate incorporation at the “seed” or “pre-seed” stage. In its infancy, founders often self-finance the corporation’s operations with their own funds and sweat equity (“bootstrapping”). Once that’s been exhausted, or if the startup is poised to grow and needs a capital injection to do so, founders need to consider external funding options. Most startups don’t have the necessary assets to borrow capital from traditional lending institutions or obtain access to public equity markets, so many raise funds by offering ownership of their corporation in exchange for capital. The three most common structures to do so are:
Equity Financing. The issuance of shares in exchange for capital (i.e. equity financing) is a common way for startups to raise funds, usually raised from friends and family, government funds and early stage angel and venture capital investors. The corporation typically issues common shares or, in some cases, preferred shares at the pre-seed and seed stages; investors favour preferred shares in later financing rounds (Series A and Series B) that usually correspond to a higher level of maturity and development than the pre-seed and seed round of financing. Key advantages of equity financing are that the corporation generally doesn’t have to repay the capital raised, and it provides an initial benchmark for valuation of the corporation. However, a valuation of the corporation can be difficult to establish at an early stage and can also be a disadvantage: if it’s too low, it dilutes the founders’ stake; if it’s too high, it makes the investment expensive, which can limit the pool of potential investors. Equity financing can also require founders to forego a certain amount of control over the corporation.
Convertible Debt. An alternative kind of financing that avoids some of the disadvantages of equity financing is convertible debt: a hybrid of debt and equity financing. Convertible debt remains as debt owed by the corporation until a pre-designated time (typically on either reaching a set maturity date, the next financing round or a liquidity event), then converts to equity at pre-defined terms. Convertible debt usually carries an interest rate, and its terms can include automatic or optional conversion of the debt into equity and provisions for repayment of the debt if it’s not converted into equity (dangerous to the startup if it doesn’t have sufficient cash-flow). A key advantage of convertible debt is that it defers the valuation of a startup and, as an incentive for early-stage investors, often carries a discount or cap (maximum) on the valuation used for conversion. For investors, a cap ensures that those who took greater risk by investing at an earlier stage can lock in their ownership share, and avoid dilution by a higher than expected valuation in a subsequent financing round. For startups, however, minimizing discounts and caps is advantageous because they could result in unintended dilution to the founders and be unattractive to later investors. Some investors prefer convertible debt over equity because it gives them the right to participate in a future financing round under the same terms and conditions as those negotiated by later-stage investors. For founders, the corporation’s ability to raise capital when it chooses without setting a valuation precedent and diluting their shareholdings too early is advantageous.
Convertible Equity (SAFE). Simple Agreements for Future Equity (SAFEs) were created to simplify seed-stage investment. SAFEs are similar to convertible debt in that the funds are invested upfront and are subsequently exchanged for equity on a later event, such as on a future-priced round of financing. Since SAFEs aren’t debt instruments, they don’t have maturity dates or interest rates, and founders (or their corporations) aren’t required to pay back the investment. Most SAFEs also have a discount and/or valuation cap. SAFEs have the same advantages as convertible debt but without the disadvantage that the corporation may need to repay the investment.
- Corporate Governance
“Corporate governance” generally describes the processes, practices and structures through which a corporation manages its business and affairs and works to meet its objectives. The corporation will have a number of key stakeholders, each with a defined role to play:
Shareholders. The shareholders are the corporation’s owners, and share in its profits and growth. The voting shareholders manage the corporation through the election of directors and any rights they receive under a shareholders’ agreement; they aren’t otherwise entitled to participate in the corporation’s business.
Board of Directors. It’s the directors who oversee the company’s day-to-day operation, including appointing its officers, and set the overall strategy and business plan. Initially, there are typically very few directors (usually the founders), but as the corporation grows, so too will the number of directors. Eventually, a company might benefit from having one or more independent directors. Many startups also have “Advisory Boards”, but they’re different: “official” directors must meet legal requirements and fulfill legal duties; advisory board members don’t have the same legal requirements and duties as “official” directors.
Officers. The directors appoint the corporation’s officers. Officers are responsible to carry out the corporation’s day-to-day operations, and can fill any position in the corporation the directors want them to fill (president, CEO, CFO or any other position). Any individual can be an officer; they can, but need not, be shareholders, directors, employees or independent contractors. However, like directors, officers must meet legal requirements and fulfill legal duties.
Staff/Employees. The “staff” are the employee and independent contractor positions who carry out the company’s day-to-day operations under the officers’ management, and who may (or may not) also be shareholders.
Please contact your McInnes Cooper lawyer or any member of the Startup Team @ McInnes Cooper to discuss this topic or any other legal issue.
McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.
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