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Craig K. Sherburne, Barrister & Solicitor, Registered Patent Agent (US & Canada)

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  • Business Value Sharing

    Business Value Sharing

    So, you have a business idea, founders, and now you are looking at bringing more people on board. How do you share the fruits of your labor with them?

    The first thing to recognize, is that the tools available to us are varied and flexible. As usual, the more options you have the more difficult it is to determine what to do.  I am going to limit the discussion on tools available, and instead address the broader concerns people have when they are structuring,, creating, and sharing business value. First, here are some of the ancillary considerations you should be keeping in mind:

    • Control of the business,
    • Succession management for the business,
    • Protection of your assets from creditors or seizure from third parties,
    • Impact on your estate, and
    • Taxes

    Each of these could be a 2000-word treatise just to touch on the broad considerations, but it is enough for now to simply point out that the distribution of business value has a direct impact on, and is itself impacted by, the above five matters. 

    Value of a Business

    I believe it is important to get a common understanding on the “value of a business”.  Many assume that a business value is a single thing:  if you own 10% of a business, then you own 10% of the value.  While that can be true, business value is composed of four separate elements:

    • The share of profits of the business,
    • The share of assets of the business distributed on its winding up,
    • The share of the proceeds on the sale of the business, and
    • The control you have on the operation of the business.

    We can separate out and structure the corporation, its shares, and the agreements between the corporation and the shareholders such that we can deal with the four difference elements of business value separately and differently.  For example, we can create a situation where someone has no control of the business but receives all profits from it; while another entity has full control of the business, receives no profits from the business, but would receive all proceeds on the sale of the business.  It is exactly this flexibility that makes corporate structures so useful, but also can lead to challenges.

    Compensation: Time vs. Capital

    We can use corporate and contractual tools to separate out the four elements of business value, but to what end?  Before we can address that, we should further clarify the common drivers of sharing business value:  time and capital investment in the business.  But that too is over-simplified, because there are really six different elements to consider for most sharing of business value:

    • Past investment of time in the business
    • Past investment of capital in the business
    • Current investment of time in the business
    • Current investment of capital in the business
    • Future investment of time in the business
    • Future investment of capital in the business

    While this appears trite, when you are sharing business value, it is important to not just recognize what you are apportioning value for but also to ask whether there are better ways to apportion the value based on what you are compensating for. For example, awarding a new employee profit share now and forever on the basis of what they might do for you tomorrow and a year from now looks like absolute nonsense when framed in that way. Yet many companies will turn over a significant percentage of the company to a new employee based on what they are expected to do. Instead, we can look to one of the tools in our “legal toolbox” and create an option agreement, where the new employee is provided the right to acquire a percentage of the company’s shares (which for simplicity’s sake we can consider as correlating to a share of the profits, control, proceeds on sale and assets on winding up).

    All of this provides context for what I, as a lawyer, need to have in hand to provide options on how to structure the company now, and in the future. I can even further break this down to assist both in my framing of options as well as framing the discussion between business founders:

    • In consideration of Founder 1’s current and past investment of time and capital in the business; Founder 1 will receive
      o A1% of the profits of the business
      o A2% of the assets of the business on its winding up
      o A3% of the proceeds on the sale of the business; and
      o A4% of the control of the business
    • In consideration of Founder 2’s current and past investment of time and capital in the business, Founder 2 will receive
      o B1% of the profits of the business
      o B2% of the assets of the business on its winding up
      o B3% of the proceeds on the sale of the business; and
      o B4% of the control of the business
    • In consideration of Founder 1’s planned future investment of time and capital in the business; Founder 1 will receive
      o C1% of the future profits of the business
      o C2% of the future assets of the business on its winding up
      o C3% of the future proceeds on the sale of the business; and
      o C4% of the future control of the business
    • In consideration of Founder 2’s planned future investment of time and capital in the business, Founder 2 will receive
      o D1% of the future profits of the business
      o D2% of the future assets of the business on its winding up
      o D3% of the future proceeds on the sale of the business; and
      o D4% of the future control of the business

    Where,

    • A1+ B1=100%
    • A2+ B2=100%
    • A3+ B3=100%
    • A4+ B4=100%
    • C1+D1=100%
    • Etc.

    While there are many ways in which these sharing arrangements can be accomplished, we will be looking to the operational, family, tax and risk circumstances of the business and the founders (and sometimes even the families of the founders) to determine the right legal, contractual, and corporate structures for them.  It is often the most efficient spending of time to explain to your counsel what you hope to achieve, and then allow your lawyer, often in consultation with your accounting, estate and tax advisors; to determine the best path forward.

  • Considerations for Raising Capital in Canada: A Discussion

    Considerations for Raising Capital in Canada: A Discussion

    A common question I receive from clients is “How do I raise capital?”, and the answer starts with finding someone willing to invest in your company.

    Most of us are familiar with the idea of company shares: we buy them and sell them in the Stock Market, or as business owners we may have issued shared in a company. However, many business owners fail to appreciate the implications of Canadian securities laws when it comes to issuing shares in their company and taking investment.

    First, the basic law in Canada when it comes to the sale of shares or securities in a company is this:  No one can sell a share, or a security, without filing a “Prospectus” with Canada and regulators before selling the share.  A prospectus is an impressively long document that provides a full description of the business of the company, its financial position, and the details of the investment being offered to the investor.  A prospectus includes certifications from executive officers of the company stating that material disclosures in the prospectus are true, and if there are material misstatements in the prospectus, then the executive officers may be individually liable to the investors. 

    In other words, a prospectus is a big deal.

    For most other companies, they can not afford the time, or cost, to prepare and file a prospectus; which would be a significant impediment to a business raising capital.  This has been addressed by every Province in Canada, through a series of exemptions available for businesses to raise capital without the need for a prospectus: these are referred to as “Prospectus Exemptions”. There are a large number of possible exemptions, but most businesses rely on only 4 or 5. 

    Provincial Securities Laws and Regulations

    Before we address specific exemptions we should consider which Province’s securities laws apply.  Even though there have been great strides in consolidating and unifying the securities laws and regulations between the provinces, there are still subtle and important differences that can arise within Canada, and therefore understanding which Province’s law applies, is important.

    A province’s securities laws and regulations will become relevant to the sale of a security (which we refer to by the more encompassing term of a “distribution of a security”) should it be found that there was a “real and substantial connection” with the province, or a province thereof, to the relevant transaction.  There are several factors considered under Canadian law, with no bright line established for when the “real and substantial connection” test is met for the distribution of a security, though the following are considered to be presumptive (though not determinative) connecting factors that entitle a court (or the provincial securities regulator) to assume jurisdiction over the distribution:

    • The issuer of the security is resident in the Province;
    • The issuer carries on business in the Province;
    • The distribution of the security occurred in the Province; or
    • The purchaser is resident in the Province.

    Should the distribution of a security occur within the jurisdiction of a province, then absent an exemption, the distribution must be associated with a prospectus filed, received, and approved by the relevant provincial securities regulator.  It is possible that more than one province’s laws apply. Once we have determined the provincial laws that apply, we can turn to which prospectus exemptions may support the business’ capital raising efforts. 

    Prospectus Exemptions

    There are a number of prospectus exemptions available under Canadian law. One of the most well-known exemptions, applicable to publicly traded companies, is the “continuous disclosure” exemption. This exemption is for companies that prepare, issue, and regularly update the information contained in their prospectus in a public manner.

    Instead, most small, private companies rely upon five different exemptions from the prospectus requirements, described in National Instrument 45-106 “Prospectus Exemptions”.  These can be broken into three general categories:

    1. Relating to the Nature of the Purchaser

    The “Accredited Investor”, “Minimum Amount Investment”, and “Friends, Family and Business Associates” exemptions apply a test to the person acquiring the securities. Respectively, the exemption requires either the investor’s financial status, the nature of their investment (being no less than $150,000.00), or the nature of their relationship to the security issuer.  None of these three exemptions require pre-approval from the securities regulator, but they do require reporting  the distribution within 10 days of the transaction to the securities regulators.  Depending on the exemption relied upon, and the province in which the distribution was deemed to have occurred, an additional “risk acknowledgement form” may be required to be executed by the investor.

    2. Relating to the Nature of the Issuer

    The “Offering Memorandum” exemption requires the preparation and delivery of an offering memorandum containing prescribed information on the issuer, to the investor at the time of the distribution.  There are restrictions on the amount that may be raised, rights of recission for the investors, and differences in the mandatory content of the memorandum depending on the province in which the distribution must be made.  There are also mandatory reporting obligations, which include providing a copy of the offering memorandum and all associated marketing materials to the relevant regulatory authority(s). 

    3. Relating to the Nature of the Purchaser and the Issuer

    Finally, the “Private Issuer” exemption requires both the issuing company and the investor to meet select criteria.  Should both the company and the investor meet the criteria, then there is no obligation to file a prospectus and there is no obligation for the issuer to report the transaction to the relevant regulatory authority.  This is an attractive prospectus exemption for many small start-up companies in Canada, given the reduction in costs and time associated with reporting obligations. 

    The qualifications for the different exemptions may be summarized as follows (this is a general summary, there may be differences between provinces)

    • Accredited Investor
      • Means Test, Income:
        • An individual whose net income before taxes exceeded CDN$200 000 in each of the 2 most recent calendar years or whose net income before taxes combined with that of a spouse exceeded CDN $300 000 in each of the 2 most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year.
      • Means Test, Assets:
        • an individual who, either alone or with a spouse, beneficially owns financial assets having an aggregate realizable value that, before taxes but net of any related liabilities, exceeds CDN $1 000 000;
        • an individual who beneficially owns financial assets having an aggregate realizable value that, before taxes but net of any related liabilities, exceeds CDN $5 000 000;
        • an individual who, either alone or with a spouse, has net assets of at least CDN $5 000 000,
        • a person, other than an individual or investment fund, that has net assets of at least CDN $5 000 000 as shown on its most recently prepared financial statements.
      • Or, a person in respect of which all of the owners of interests, direct, indirect or beneficial, except the voting securities required by law to be owned by directors, are persons that are accredited investors.
    • Minimum Amount Investment
      • An entity, that is not an individual, purchases securities of value not less than CDN $150,000, and the entity was not created for that purpose.
    • Friends Family and Business Associates
      • A director, executive officer or control person of the issuer, or of an affiliate of the issuer,
      • Close family of a director, executive officer or control person of the issuer, or of an affiliate of the issuer,
      • A close family of the spouse of a director, executive officer or control person of the issuer or of an affiliate of the issuer,
      • A close personal friend of a director, executive officer or control person of the issuer, or of an affiliate of the issuer,
      • A close business associate of a director, executive officer or control person of the issuer, or of an affiliate of the issuer,
      • A founder of the issuer or close family of a founder of the issuer,
      • Close family of a founder of the issuer,
      • A person of which a majority of the voting securities are beneficially owned by, or a majority of the directors are, persons described above.
    • Private Issuer
      • Corporate test
        • The company has less than 50 shareholders (not counting employees),
        • There are restrictions on the transfer of its securities contained in the constating documents or security holder’s agreements, and
        • It has only ever distributed securities to those who meet the investor test
      • Investor test
        • “Accredited Investors”;
        • friends, family, and business associates, or
        • Persons in which the majority of the voting securities are owned by the above.

    Note: the above are general descriptions, and not intended to be relied upon.  There are subtle differences between the definitions of, for example, friends and family between provinces; as well as the test for qualifications under the “Private Issuer” exemption.  Please remember, reference to knowledgeable Canadian legal counsel for relevant distributions for assessment of the availability of the exemption, as well as assistance in preparing the necessary reporting to the appropriate regulatory authority, is highly recommended.

  • To Corporate or Not To Corporate – Part 2

    To Corporate or Not To Corporate – Part 2

    Read Part 1 Here

    Meet Bob!

    Let’s start with a hypothetical example, undertaken by our Hypothetical Client:

    Archibald Reginald Wilkins, the third; or “Bob”, to his friends.

    Bob decides he wants to start a business going door-to-door selling two things: Lemon-Lime Flavoured Soda, and Lemon-Lime Flavoured Laxative. To save costs on bottling and labeling, he elects to use the same type of can, and general form of label on both the laxative and soda; but because he is not a fool, he places a sticker with words “Not Laxative” on the bottom of the soda cans.

    Now, Bob wants to have his profits under “Bob’s Soda and Laxative” taxed separately from his day-to-day income. He also recognizes that it is possible that his business might get sued, but he thinks the most likely culprit is the pro-constipation activists in his city. So, Bob pops down to his local registries office, pays them and receives 5 pieces of paper, the first of which proclaims the creation of “Bob’s Sales Inc.”. With this in hand, Bob places 12 cases of soda and 12 cases of laxative in his wagon, and he starts knocking on doors to sell soda and laxatives.

    Unfortunately, Bob failed to realize that although he was a shareholder of Bob’s Sales Inc. and therefore isolated from the liabilities of the company, he was also the sole director, officer and maybe even agent of Bob’s Sales Inc. While he is not liable as a shareholder, he is entirely liable as the director of a company engaging in a risky behavior, and as officer of the company he may be carelessly supervising the application of the “Not Laxative” label at the warehouse, and as an agent, he may be negligently selecting and passing on the wrong cans to his customer. When a customer’s “Anniversary Balloon Ride” goes tragically wrong following a celebratory soda at 1,500 feet; Bob’s Sales Inc. is certainly a target for a lawsuit, but so is Bob, not as a shareholder, but as the director, officer and agent of the company.

    Bob obtains the benefit of separate taxation of Bob’s Sale Inc., but that might not be a benefit. If Bob’s Sales Inc. realizes substantial losses year-over-year, then it is not possible to use those losses to offset his individual income, as “Bob” the Individual is taxed separately from the company (I have heard the cool kids refer to this as having “trapped losses”). If Bob would have operated his soda and laxative sales as an individual (sometimes called a sole proprietorship) he could have offset his losses in the sales business against his employment income. Further, Bob doesn’t necessarily obtain the benefit of isolating his assets as an individual against lawsuits against the company; as he was the sole director, officer and agent of the company. Finally, when Bob tries to get any loans from Bob’s Sales Inc. (even a credit card) every bank insists that Bob, as an individual, guarantee the debts of the company; so Bob is essentially borrowing the money of the corporation against his own credit and assets.

    So this provides some elements of how a corporation might not be of use to Bob, but lets look at some reasons why a corporation might be of benefit to Bob.

    Let’s consider what happens when Bob wants to finance the business not through loans, but rather by offering up a portion of the profits in exchange for money (which is not a decision to be taken lightly, as there are significant laws and regulations that govern this, all related to issue of a security). How can Bob go about this?

    Bob could enter into a contract with the lender, the terms of which provide the lender to receive repayments of the loaned amount along with a pre-determined percentage of the profits, and if Bob’s business fails, they would receive the assets used in the business as repayment towards the loan. Its even possible that if the loan is large enough, the lender would like to have a voice in the operation of the business. This can all be provided under a contract between Bob and the Lender.

    But, if we remember back, in Part 1, the rights of shareholders capture many of those key elements, and prevent us from having to spend thousands of words in a contract to capture those elements. Bob can create a corporation and provide for classes of shares that allow sharing of the profits of the corporation, receipt of the assets of the corporation in case it winds down or closes, and even a voice with respect to the operation of the corporation through a vote at Shareholders meetings. We can even tweak the documents that describe the corporation and its structure (called the “Articles” of a corporation) to allow for the lender to get preferential treatment when it comes to a receipt of the profits, or distribution of the assets on wind-up.

    The use of a corporation provides a robust toolbox for Bob to include others in his business, in this case a lender can become an investor; and incorporation may simplify that process. Further, since corporations can hold property, the investor has more certainty as to what assets are part of the business (being those owned by the corporation) versus that property owned by Bob.

    The ability to use shares to distribute the profits of the corporation, also provides an additional tool for Bob to use, for example if Bob had a dependent, or a life-partner that he wanted to distribute some of the proceeds to. This can be particularly attractive when profits increase with Bob’s business, since in Canada we have tax rates that change as your revenues increase; with Federal tax of 15% paid on the lowest tax bracket ($47,630.00 as of 2019) and 33% paid in the highest tax bracket (over $200,000 as of 2019). If Bob had $300,000.00 of profits to distribute in the year, he might have an advantage of receiving $150,000.00 himself, and then having $150,000.00 received by his life-partner.

    Incorporating does have its uses, even if you are operating a “one-person show”: the inherent structure of a corporation provides alternatives to raising capital for your business venture, a way to distribute the profits of the venture, as well as some protection against liabilities incurred by your business.

    In the end, the question of whether you should be using a company structure for your business comes down to the specifics of what you do, how you plan on doing it, and where you want to go with what you are doing. But, I hope the preceding provided some background to help you frame the questions you need to consider.

    If you want more information, or want to discuss how we can help you with your business needs, feel free to Contact Us.

    – Craig K. Sherburne

    Content is not intended as a legal opinion; and readers are cautioned not to act on the information provided without seeking legal advice on their unique circumstances.

  • To Corporate or Not To Corporate – Part 1

    To Corporate or Not To Corporate – Part 1

    “Should I make a company?”

    This is one of the most frequent questions I receive; and the answer depends on the type of business you are intending to operate, your plans on financing it, and your exit strategy. But before we can even get to that answer, I find it is important to provide a general understanding of what makes up a company, and the roles, responsibilities and liabilities, of the individuals involved in the company.

    Which is somewhat telling, in that the number one question is NOT “what is a company anyways?”. See, people think they know what a company is, which is not the case: I hate to tell you this, but television and movies might, just maybe, have lied to you. But that is the topic for another day. For now, I want to address some of the critical (And generally known) aspects of what a company is, and why you might want to incorporate.

    Lets start with what a company (which I might refer to as a “Corporation” at times) is considered to be. A company is considered, under law, to be a “person” capable of holding property, entering into contracts, and conducting business. It is important to recognize the difference between being “considered a person under law” and “is a person under law”. A company has no arms, no mind, no pockets to hold things, no hands to sign contracts; but all the same is considered under law as being capable of doing those things. A company therefore needs to have someone (I will refer to them by their legal term, “Individuals”) doing things for, and on behalf of, the corporation. Individuals are living and breathing, with minds to think things and a physical existence capable of doing things.

    Those Individuals that can do things for, or on behalf of a corporation, fall into three categories: Officers, Directors, and Agents of a corporation. Directors tend to be the “brains” of the Corporation, providing the big picture direction to the day-to-day operators of the Company; which are usually the Officers (for example, the President, Chief Operating Officer, a Vice President) of the Company, who in turn retain and provide instruction to agents of the Corporation (for example, a corporation’s lawyer, or accountant, or its employees).

    If someone is acting on behalf of a Corporation, it falls under one of these three categories; with the power to act on behalf of the corporation, and the scope of that power, flowing like a water from the top of the waterfall (the Directors), with those powers the Directors wish to delegate to the Officers, and likewise those powers of the Officers wish to delegate to the Agents (subject to the Directors allowing such delegation). Everything starts with the directors; but it is not uncommon, particularly in very small companies, such as entrepreneurial start-ups, for the shareholder, director and officer of the company to all be the same individual.

    You should note that “shareholder” was not one of those three categories of individuals that can do things for, or on behalf of, a company. The shareholder is a mostly passive role when it comes to operation of a company, with at least one, and maybe up to three things it can do with respect to the corporation: vote at a meeting of shareholder, participate in the sharing of the profits of the company, or receiving a portion of the assets of the company on its winding up. Because of the passive role of the shareholder, a shareholder generally does not share in the liabilities of, or become liable for, the actions of the company. There are a few, very specific examples of a shareholder having some liability for the acts of the corporation, but they are rare, specifically created by statute, and usually related to environmental protection laws.

    So, after all that, we can see why people might want to start a business as a corporation: it is considered its own “person” under law, and therefore is taxed separately from the individuals that may be its shareholders. It also provides a layer of “isolation” between the actions of the corporation, and the assets of the shareholder: if a corporation is sued, then that does not mean that the shareholders will be sued as well, as they are generally isolated.

    And armed with this knowledge, many entrepreneurs launch themselves headlong into business, comforted by the knowledge that they went to their local registry offices and incorporated, or they paid their accountants to do the same; and therefore they are safe! Here is the problem … many times they aren’t, because they forgot (or weren’t aware of) the first thing we talked about: the three categories of who can do things for a Corporation.

    In part 2, we will use an example to identify why a corporation might not be the solution you think it is.

    – Craig K. Sherburne

    Content is not intended as a legal opinion; and readers are cautioned not to act on the information provided without seeking legal advice on their unique circumstances.