Lead to Win

Lead to Win

Key Legal Issues for Technology Start-ups June 24, 2009

Eric J. SmithFraser Milner Casgrain LLP

© Fraser Milner Casgrain LLP, 2009. See last slide for licensing information.

Lead to WinSlide 2

Key Legal Issues for TechnologyStart-ups

My background

• Technology lawyer, Co-Chair of National Technology Transactions Practice Group, FMC (2001 – Present)

• Vice-President, General Counsel, and Corporate Secretary – Corel Corporation (1996-2000)

• Vice-President of a business advisory services company focused on early stage tech sector (2000-2001)

Lead to WinSlide 3

Agenda

Key Legal Issues for Technology Start-ups

1. Threshold Issues

2. Company Formation

3. Co-Founder Issues

4. Shareholder Agreements

5. Financing the Business

6. Employees and Contractors

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Threshold Issues

1. Ownership of Intellectual Property

2. Duties to Previous Employers/Third Parties:a) Confidentiality

b) Non-solicitation

c) Non-competition

d) Assignment of IP rights

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Choice of Business Organization

Corporation

• Most popular form of business organization

• Separate legal entity from those who own it (shareholders) and those that operate it (directors, officers and employees)

• Income taxed in the hands of corporation

• Shareholders taxed on dividends and capital gains (when selling shares)

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Reasons to use a Corporation

• Limited liability (although shareholders many have to guarantee obligations)

• Can exist in perpetuity (individuals can come and go)

• Flexible investment vehicle – can create different classes of shares

• Can offer shares or options to buy shares to attract and retain personnel

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How Do I Incorporate?

• Conduct name search

• File Articles of Incorporation

• Pay registration fee

• Organize company

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Where Do I Incorporate? Canada vs. Ontario

• Legislation is very similar

• Federal permits head office in any province

• Getting desired name more difficult federally

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Where Do I Incorporate? Canada vs. United States

• Many Canadian tech companies seek financing in U.S.

• Interests of U.S. Investors often conflict with Canadian founders and employees

• Can have impact on decision of where to incorporate (or migrate)

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Canadian–Controlled Private Corporation

Canadian incorporated; private; not controlled by non-residents or public corporations

Advantages:

a) Favourable capital gains treatment

b) Refundable investment tax credits (ITCS)

c) Tax deferred or exercise of stock option

d) Tax deduction on gain from optioned shares

e) Lower tax rate and small business deduction

f) Deduction of allowable business investment loss (for lenders to CCPC)

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Problems For U.S. Investors

• S.116 Income Tax Act

• LLC treatment

• May require complex exchangeable share structure

*See handouts for detailed discussion of issues in this and preceding slide

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Weighing the Options

Canadian incorporation, if:a) Company will qualify as a CCPC

b) Company can fund operations without significant foreign investment

c) BDC or labour sponsored fund may be early investor

d) Cannot afford extra expense of U.S. incorporation

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Weighing the Options - cont’d

U.S. incorporation, if:a) Company will not qualify as CCPC

b) Lead investor is U.S. investor

c) Anticipated exit is acquisition by a U.S. entity

d) Company anticipates shifting bulk of operations to U.S.

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Co-Founder Issues

• Remember threshold issues

• Beware of automatically treating everyone as equals

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Issuing Shares to Founders

• No operating history and usually very few assets

• Founders’ shares usually issued at nominal price (e.g. $0.001 per share)

• If assets being transferred to corporation – s.85 rollover

• Consider tax planning (e.g. income splitting through family trust)

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Issuing Shares to Others

• Contractors/employees/others

• Must comply with securities laws

• Must be paid for (money, property, past services)

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Capital Structure

• Keep structure simple in order to accommodate future financings

• Generally, founders should purchase all shares they desire at time of founding

• As investors acquire shares, founders may lose control over future issuances and stock splits

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Cap Table Example

After Series “A” Financing

Shareholder # of Shares Price Ownership

Founders 2,000,000 $0.001 24.2%

Seed 1,000,000 $0.50 12.1%

Series “A” 3,500,000 $2.00 42.5%

Employees 1,750,000 $0.20 21.2%

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Cap Table Example

After 3 VC Rounds

Shareholder # of Shares Price Ownership

Founders 2,000,000 $0.001 8.2%

Seed 1,000,000 $0.50 4.1%

Series “A” 3,500,000 $2.00 14.4%

Employees 1,750,000 $0.20 7.2%

Series “B” 5,000,000 $2.00 20%

Employees 1,750,000 $0.20 7%

Series “C” 6,000,000 $4.00 25%

Public 3,333,333 $12.00 14%

Total 24,333,333 100%

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Vesting and Buy-back Rights

• Should Founders have to “earn” shares?

• Repurchase option if founder ceases to be participant in business

• Vesting of 3 to 5 years

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Shareholders’ Agreement

• Management of Corporation

• Rights and obligations of shareholders

• Is agreement needed at start-up stage?

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Key Provisions of Shareholders’ Agreement

• No “one size fits all” agreement

• Restrictions on transfer of shares

• Right to repurchase

• Pre-emptive rights

• Right of first refusal

• Drag-along

• Piggy-back

• Composition of Board

• Super-majority approvals

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Financing the Business

• Is money the primary issue?

• Types of financing:a) Debt

b) Equity

c) Hybrid

d) Government loans/grants

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Debt Financing

• Shareholder loans (secured or unsecured)

• Other Individuals

• Banks/Financial Institutions

• Credit cards

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Equity Financing

• Selling of shares from treasury

• Existing or new class of shares

• Investors may demand preferential rights

• Must comply with securities laws

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Convertible Debt

• Debt which is converted upon occurrence of event

• e.g. next equity financing

• Usually has a discount on financing pricing

• With or without security over assets

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Sources of Financing

• Founders

• Friends and family

• Angel investors

• Venture Capital

• Strategic Investor

• Government (Loans, Grants, ITCs)

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Approaching Investors

• Very time consuming

• Research before approaching

• Seek referrals

• Understand your market and competition

• Know how much you need

• Beware of offering memorandum/securities laws

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Employees

Common Pitfalls

• Lack of proper written agreements

• Using inappropriate precedents

• Failure to limit entitlements on termination

• Improper implementation

• Faulty IP and confidentiality provisions

• Over-reaching restrictive covenants

• “Deferring” salary

• Improper termination

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Contractors

• Regarded as a solution to “employment” liabilities

• But contractor may still be an employee

• If employee:– EI and CPP liability

– Fines for not withholding income tax

– WSIB premiums and/or fines

– ESA liabilities and fines

– Termination liabilities

– IP ownership/waiver of moral rights

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Thank you

Lead to Win

Licensing Information

This work is licensed under Creative Commons Attribution – Non-Commercial – Share Alike License. To view a copy of this license, visit creativecommons.org.