As an entrepreneur trying to get your business off the ground, there are many factors to think about and the legal "stuff" may easily be forgotten. In this article, we touch on the top 5 considerations entrepreneurs need to think about when starting out.
1. Structuring your business
One of the first decisions you will have to make when starting up a business is the legal form or structure your business will take. Typically this decision means deciding whether you are going to:
- operate as a sole proprietorship; or
A sole proprietorship is created by you, the natural person, carrying on business. Under the law, you and your business are considered as one. All is needed to start your business is to obtain a business license.
While running a business as a sole proprietorship has its benefits (such as being completely in charge of every aspect of the business and lower set up and maintenance costs), it comes with one major drawback: being "unlimited liability". This means that the individual accepts all risks associated with the business, and is personally liable to the full extent of his/her own property and assets, for all liabilities of the business. "Unlimited liability" also means that it is harder to raise capital, as potential investors could be personally liable for the debts of the business.
The other common type of business structure is a corporation. A corporation is considered to be a separate legal entity from its shareholders and it provides for "limited liability" which generally means that it limits personal liability of each shareholder to the amount of share capital each shareholder has contributed to the business.
In addition to allowing for "limited liability", which makes corporations a very suitable vehicle through which to raise capital, incorporating means that there can be differing degrees of ownership, different classes of shares with different rights and restrictions, transferability of ownership, and greater tax planning. Maintaining a corporation can however be more costly and administratively burdensome (separate accounting and tax filings are required for a corporation) as corporations are heavily regulated (especially publicly trading corporations).
Incorporation can be done: (i) at the federal level (under Canada Business Corporations Act); or (ii) at the provincial/territorial level (under Business Corporations Act (British Columbia) for example). The main advantage of federal incorporation is that the approved name for the corporation enjoys protection across Canada as opposed to just within the jurisdiction of incorporation, if the corporation is incorporated provincially. Federal incorporation however will mean additional administrative and legal costs as extra-provincial registration will also be required for a federally incorporated company in the jurisdiction it operates.
2. Term Sheets
Once you have structured your business, you will have your idea tested (hopefully) and you will need capital. One typical way is to look for parties that will invest in start-ups such as angel or venture capital investors ("VC"). At this point, you will hear the term "Term Sheet" a lot.
At its simplest form a term sheet is a summary big picture document of key terms agreed upon between the entrepreneur and the VC in contemplation of a financing and will cover, at a minimum, "economics issues" (valuation of the company, i.e. how much money for what percentage of the company) and "control issues" (who will run the company). The term sheet is an important document, as it signals that the VC is serious about an investment and will serve as a roadmap for the relationship between the parties.
Provisions included in a term sheet are typically non-binding and at least subject to due diligence, other than confidentiality and exclusivity provisions which require the parties to keep the information disclosed VC between them confidential and only negotiate with each other for a specified agreed upon period of time (typically 30-60 days), which are usually binding on the parties.
3. Shareholders Agreements
Following the execution of a non-binding term sheet, the VC will typically work with the entrepreneur to complete its due diligence and prepare definitive legal documents, which typically includes a shareholders agreement.
A shareholders agreement is a contract between all of the shareholders of a company and the company itself. It attempts to: (i) structure the relationship between the shareholders of a company, (ii) create certainty and set the expectations between the parties, and (iii) anticipate and address many of the potential future disputes. A shareholders agreement can also be an effective way to set out the details of how a business will be run. It is important to think about the business and the shareholders and their specific needs when drafting this document and anticipate what is needed in each case. This document, while containing certain typical provisions, can be tailored to the specific needs of each group (i.e. there is no "simple standard shareholders agreement).
4. Rights that VC or major investors look for when investing in a business
So what are these rights that are negotiated in a term sheet and then ironed out in a shareholders agreement?
Other than terms relating to economics (valuation of the company) and control (who will make decisions and run the company), the following are some of the rights VC and major investors look for when investing in a new company:
- Liquidation preference - preference in getting paid out first in the event of liquidation of the company;
- Participation rights - right to participate in future financings to maintain percentage ownership;
- Veto rights - right to prohibit certain material or significant changes for the company;
- Anti-dilution rights - protection against the company issuing shares at a valuation lower than the valuation represented by the VC investment;
- Vesting - a VC will want to make sure that the founders are motivated to stay and grow the company, as a result, they will likely request that shares owned by the founders become subject to vesting based on continued employment (and then become "earned") over a period of time. Typical vesting for founders is monthly vesting over a 36 to 48-month period, with the first 12 months of vesting delayed until 12 months of service are completed. A form of vesting that is usually acceptable to VCs is the so-called "double trigger" acceleration vesting, where vesting accelerates and shares are considered "earned" if the company is acquired and if the buyer terminates the founder's employment without cause after such acquisition;
- Drag along and tag along - a drag-along provision is a clause that allows majority shareholders to force the minority shareholders to join in on a sale of their shares. This prevents small shareholders from creating a roadblock to an acquisition by objecting or exercising appraisal or dissenters rights under applicable law. Tag-along rights on the other hand allow minority shareholders to sell their stakes in a company if a majority shareholder wishes to sell its stake in a company. Tag-along rights are usually good for minority shareholders because they allow the shareholders to capitalize on a deal that another shareholder is able to strike. These clauses (tag-along and drag-along) balance each other out and are typically either both included or left out of a shareholders agreement; and
- Information rights - right to obtain certain information such as financial information.
5. Confidentiality Agreements
A Confidentiality agreement ("CA"), also called a non-disclosure agreement or an NDA, is an agreement that applies to the confidential information that is being shared and controls and limits its disclosure and its use. It is intended to prevent an idea or technology from being stolen and copied. Confidentiality agreements are commonly entered into during the negotiation stage of mergers, financings, corporate takeovers and joint ventures in order to allow parties to reduce the risk that confidential information will be divulged.
When you are starting out and wanting to share your ideas with another party you will want to consider if a CA should be entered into so that everyone is aware of the confidential information that is being disclosed (for example proprietary technology, customer lists, secret sauce) and the limitations (only shares with employees that have a need to know and certain key advisors) and standards (reasonable precautions) that they are being placed under with respect to use and disclosure of such confidential information.
Top 5 takeaways:
- Setting up the business properly from the start helps with future planning; going back to clean up is more expensive and causes delays.
- It makes sense to incorporate as the business starts to take off and definitely before you look for angel or venture capital investors to invest in your business.
- When negotiating with a VC, think about the top rights that are important to "you" as a founder of the business and only focus on those.
- A well thought-out shareholders agreement is the best dispute resolution tool in the long run so it is worth the effort and cost.
- In a CA, think about and tailor the definition of "Confidential Information" to your business; this brings all parties' attention to what exactly needs to be protected and what measures are needed to protect it.