Latest Blog Posts

  • Award-season for entrepreneurs

    MaRS posts on a variety of programs offering funding to entrepreneurs.

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  • Canada’s Anti-Spam Bill Passed

    Just before Christmas, Parliament passed Canada’s new anti-spam and anti-spyware law, commonly referred to as FISA, or the “Fighting Internet and Wireless Spam Act” (Industry Canada release here). The law will be bought into force later this year to give Canadians time to prepare. Broadly, the law prohibits the sending of commercial messages without recipient consent, and prohibits the installation of computer program’s without consent. It’s quite a complex piece of legislation and carries stiff penalties – you should consider its applicability to your practices and make the necessary adjustments before it comes into force.

    Much has been written about the new law – some of my favourite pieces are by my friend David Canton here, here and here, by Simon Fodden here, and by some of the larger law firms – McCarthy’s here and Davies here, for example. I’ll be saving pieces on the legislation to this tag.

    Please contact us if you have questions.

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  • In praise of transactional attorneys

    A nice post calling out a valuable skill set.

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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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  • Staffing – Employees vs. Independent Contractors

    I’m often asked whether it’s better for the company to work with people as employees or as independent contractors (also called contractors or consultants – the differences are of style, not meaning). Consulting is common in the technology business in Canada, particularly during any recession, and as businesses staff up it’s an important question to ask.

    Like most everything else, the answer is “it depends”. If you need occasional help, or a discrete task performed, using the services of an independent contractor can make a lot of sense – there’s no fussing with payroll, there are no employment benefits, existing teams are not disrupted, and there is often very little overhead involved. But the employment relationship is generally better suited for situations involving more permanence, and the law reflects this in a variety of ways. Here’s a summary, then, of legal considerations you should take into account when making this decision.

    1. Employers are required to make certain source deductions – like income taxes, Canada pension plan contributions and employment insurance premiums – from salary and wage payments to employees, but not from payments to contractors, who are responsible for paying their own. Companies that in this regard treat personnel as independent contractors when they are in substance employees face the risk of being challenged on that determination, with a possible outcome being assessed for unpaid amounts, plus penalties and interest. Independent contractor agreements typically include indemnities under which the contractor agrees to make the client whole if this happens – but good luck collecting on the indemnity, which typically only becomes relevant because the contractor is having trouble paying its taxes and therefore is probably unable to satisfy a demand under an indemnity.

    2. The employer’s obligation at common law to give reasonable notice on termination can be involved as well. This is because a staff member who was originally brought on as a contractor might in substance be an employee instead, or might over time in substance become an employee, in the eyes of the law.

    An example of a scenario in which this could become an issue would be a staff member arguing after termination that on termination they were actually in substance an employee and not an independent contractor (even though they were described as an independent contractor in company records, in their agreement, and even though source deductions were not made) and therefore entitled to more notice of termination than agreed to in the independent contractor agreement. This claim is typically only worth making for longer-term staff members – people for whom the difference between termination notice for employees at common law and contractual termination notice under an independent contractor agreement can be significant.

    How do you know who is an employee? The law generally looks at the person’s substantive relationship to the business (after all, if it were as easy as just picking the right job description, it would be easy for employers to avoid a whole host of legal obligations to employees.) The cases take a variety of approaches, but in substance if a person has only one client, works in the client’s office, works full-time, uses the client’s computers and other tools, works when and on projects directed by the client, and with the client’s employees, there is a pretty strong case to be made that the person is in substance an employee and not a contractor. And team members who start out as contractors can certainly see their relationship to the company evolve over time in this direction.

    3. If a person who is in substance an employee is compensated as an independent contractor instead, certain amounts such as overtime, vacation pay, statutory notice and severance payments can be due to the person, and if not paid can result in substantial fines against the company and its directors.

    4. The rules are somewhat complex but the result is that in Canada, employees receive preferential income tax treatment of the gains from a stock option grant. The differences between this treatment and the approach taken with contractors can be significant.

    5. The default rules in Canada concerning who owns the intellectual property created for the company treat employees and contractors differently. Under the Copyright Act, for example, the employer generally owns copyrights created in the course of an employee’s employment. Under patent and other forms of intellectual property law the rules are somewhat different, but the essential point is that the result one gets can differ depending on the status of the team member.

    For most companies, however, this is not an issue because they require each new team member to agree to a form of agreement that gives to the company ownership of intellectual property created in the course of employment.

    6. Finally, the rules on SRED tax credits treat employees and consultants differently. Mark MacLeod has the details.

    For a variety of reasons, the choice between treating team members as employees and independent contractors can mean very different results. And treating people who are in substance employees as independent contractors instead can have unexpected and adverse results. It’s a distinction you should take seriously, and consider early.

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