Incorporation

  • “Splitting up the Pie: Considerations for setting initial equity ownership among founders”

    This is a somewhat involved but thorough and very smart post about an issue that confronts almost every founder – how to split the pie. Hat tip to @DavidCrow for noticing it.

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  • An online meeting minutes solution

    This is pretty nifty – Minutes.io is a platform that manages your meeting minutes. Worth a look.

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  • Links for Startups

    Here are some links to useful information for startups. We add material from time to time so check back for updates.

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  • Organization – The Shareholder Agreement

    I’m getting a lot of requests these days for information on and help with shareholder agreements, so I thought a post explaining what they are and how they work would be helpful.

    Background

    But before I start, I’d like to introduce you to two guys I suspect wish they’d had a shareholder agreement in place when they created their company: Craig Newmark and Jim Buckmaster, two of the three early shareholders of Craigslist. As I understand the case, the third shareholder decided to leave the company, and sold his shares to eBay. As far as I can tell, there was no shareholder agreement in place at the time, and so there was no transfer restriction on his shares, and presumably Craig and Jim had no right of first refusal to buy those shares before they were sold to eBay (I have no idea whether they would have bought them, but I assume so). Google “eBay Craigslist lawsuit” to see the (very expensive) results. Good times. For the lawyers. For Craig and Jim, not so much, I’m guessing.

    (Incidentally, Jim keynoted mesh07 and was one of our favourite keynotes ever, and a very gracious guest.)

    Why have a shareholder agreement?

    I think of a shareholder agreement as a smart tactic for making your business as lawyer-proof as possible. It establishes rules to govern the relationship between two or more owners of a company. Without a shareholder agreement in place, the rules that apply are in the applicable corporate statute – for example, if your company was incorporated under the Ontario Business Corporations Act, the rules that apply under the OBCA. The shareholder agreement creates an overlay that addresses issues created or left unanswered by the corporate statute; they work together to create the rules that govern the relationship between the shareholders. In many cases, that structure protects the basic economic interests of the shareholders more effectively than the corporate statute does on its own. And a shareholder agreement that is unanimous has a special status under the law – in many cases it ‘trumps’ the Articles of incorporation and the by-laws, and it automatically applies to transferees of shares of the company and to people to whom new shares are issued. (But as a practical matter, startup shareholder agreements tend to be unanimous in any event.) Why does all of this help to lawyer-proof your business? Because it protects the expectations of the parties, and reduces uncertainty.

    Here are some examples of cases where a shareholder agreement would have been nice to have:

    - if your co-shareholder takes up kite-surfing six months after you incorporate and moves to Australia to turn pro, he’s taking all of his shares with him unless he chooses to sell them to you. And you’re now working, in part, for him.

    - if your co-shareholder’s chute fails to open on her first parachute jump, your new partner could be her sole surviving family member, the son who’s been working on his first screenplay. For eight years.

    - if there are three of you, one who has over 50% of the shares and then you and one other who share the rest equally, one shareholder (hint – it’s not you) will have sole say over the day to day operation of the business. Including firing. You.

    - if Google shows up with an offer to make you rich, rich, rich beyond your wildest dreams, all of the shareholders will likely need to be onside the deal (unless, in some cases, you want to engage in some expensive legal gymnastics) – this is a bad time to discover that one of you has a philosophical objection to wealth or an irrational desire to explore just how much money Google really has.

    There are other reasons to have a shareholder agreement, but you get the picture.

    Common clauses in startup shareholder agreements

    Here’s a quick summary of the clauses that you tend to see in startup shareholder agreements in Ontario (keep in mind as you troll for information on the web about this topic that almost all of what you read is from the U.S., where the rules are similar, but different in important respects):

    - a general transfer restriction that prevents shareholders from transferring their shares to third parties except as permitted under the shareholder agreement. An important part of the deal for many people who create new businesses with partners is the involvement of the partner; it’s not just about starting this business – it’s about starting this business with a particular partner, or at least someone known and trusted. The transfer restriction protects shareholders from having strangers introduced into the business without their approval.

    - permitted transfers to assist with tax planning. These are exceptions to the general transfer restriction – they allow shareholders to transfer shares for tax reasons (for example, to family trusts and corporations).

    - right of first refusal. Also an exception to the general transfer restriction, this permits a sale to a third party as long as the existing shareholders are allowed the opportunity to buy the shares first at the same price.

    - board composition and procedure. These rules establish who will sit on the board (and be responsible for day to day management of the company), when the board meets, etc.

    - budget and financial statement preparation.

    - pre-emptive rights. These rules give shareholders the right to participate in new offerings of shares in the company.

    - repurchase rights. These rules give the company the right to buy shares back from shareholders in certain situations: death, permanent disability, bankruptcy, breach of agreement, and so on.

    - founder stock ‘escrow’. What in the U.S. is described as ‘founder stock escrow’ is typically structured in Canada as a repurchase right – a right of the company to purchase shares back for a nominal amount in the event a founder leaves the company. This right typically vests over time, so that the longer a founder is with the company, the less can be repurchased by the company. These rights protect founders from each other, essentially.

    - vetos over important decisions by the company. These rules can be structured in different ways, but the general concept is to give shareholders holding more than a specified aggregate interest the right to make important decisions – like hiring and firing, financing or selling the company, and so on. (Obviously, in a two equal shareholder company a different approach is needed to resolve disputes. An approach occasionally used in that case is a ‘shotgun clause’ – the right of each shareholder to propose a price at which the other shareholder is required to sell his shares, or buy the other’s shares. Basically, a fistfight – but with wallets).

    - drag-alongs and tag-alongs. A drag-along, also called a carry-along, is the right of a specified majority of shareholders (for example, 2/3) to require the remainder to join with the majority in a sale of their shares to a buyer of the company. A tag-along (also called a piggy-back) is a right of a shareholder to piggy-back on a sale by others (typically, when the sale is of more than a specified % of the total) of their interest in the company.

    - arbitration or mediation clauses. These clauses set out procedures to resolve disputes. I don’t personally put much stock in them. In my experience the disputes worth having aren’t usually about anything an arbitrator is likely to have more expertise or insight on than the founders, and a startup that genuinely needs a mediator is likely doomed anyway by its inability to do what new businesses need to do all the time: resolve differences, under pressure, in a constructive manner. Besides, arbitrators and mediators are not inexpensive, and if there are more than two founders, there is often a majority vote scenario available between them that is a good general purpose dispute resolution tool.

    Conclusion

    All of this sounds hideously expensive, and there are lots of lawyers out there who hope it is. But it doesn’t need to be. There is a pretty uniform set of needs among startups, and any lawyer experienced in this area has at least a few default templates that cover most of the common scenarios – templates that should be available at very little cost, subject to any changes that need to be made to suit your specific needs.

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  • Organization – The Basics

    For many people, organizing the corporation is probably close to the most boring thing they can do without actually having to count all of the sand on a beach. Dull – perhaps, but in many cases quite necessary. It often comes as a surprise to people that when they incorporate a business in Ontario, there is more to do on initial setup than mere incorporation. But incorporation only provides you with the corporate entity – until it is ‘organized’, it has only (essentially) ‘acting’ director(s), and no shareholders, officers, by-laws, and so on. It’s governed by the applicable corporate law (in Ontario, the Business Corporations Act), but many specifics of how corporations work are left out of the applicable corporate statute, and are for the corporation to decide.

    If the corporation is to have only one shareholder, the person who incorporates it – the incorporator – sometimes skips organization – the incorporator generally controls the corporation anyway (because they typically establish themselves as the first director, and that person has the power to issue shares, which in general grounds the power to do everything else). Some people defer organization because they see it as something they can do later, when they need it done for some specific purpose. This delay is often of little or no significance for many – in the short term, whether or not a corporation is organized will generally be of no importance to customers, many suppliers and other third parties, so it is sometimes ignored, at least at the outset.

    But certainly for the corporation that has more than one shareholder, organization can be critical – it establishes important details of key legal relationships between the shareholders, basics without which the potential for costly misunderstandings can increase. And banks will generally require some organizational steps be taken when you open an account. As a result, in many cases it makes sense to get it done when you create the corporation.

    Organization is generally very easy – in simple cases there are a few corporate resolutions to prepare, shares to be issued, a by-law or two to adopt, and director(s) and officer(s) to elect and appoint. There are common forms for much of this, and most lawyers have clerical staff handle it, at a small cost to the client.

    The most complex aspect of organization arises when the corporation needs a shareholders agreement – the form of agreement used when the shareholders want to go beyond the basics of the applicable corporate law and the by-laws in their establishment of the rules that are to govern how the corporation manages its affairs, and how its shareholders are to relate to each other and the corporation. In the near future, I’ll post on shareholders agreements in Ontario, and what purposes they serve.

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