Goodlawyer Master Class
Lesson 1: Business Law
What's a Business?
Incorporation Ins and Outs
Topic 1: What's a Business?
A business can exist in many different structures, but the most common ones are sole proprietorships, partnerships, and corporations. Each has advantages and disadvantages, but at Goodlawyer, we almost always suggest incorporating (which we’ll get to in a minute).
First are sole proprietorships, which are the simplest form of business organization. There are no legal documents or forms to fill out to start a sole proprietorship. You and your business are, in the eyes of the law, one in the same. If you decide to just start selling the ice cream you make in your garage to strangers on the street, then congratulations! You just started a sole proprietorship.
A sole proprietor has total control over their business. Decision making doesn’t have to travel up a chain of command and get caught up with red tape.
Sole proprietors can be agile and quickly adapt to new circumstances.
Navigating taxes as a sole proprietor is usually less complex. Because the business and business owner are the same legal entity, revenue generated through the business is treated as the taxpayer’s total income. That means you are only taxed once on your business income.
Business owner has unlimited liability when it comes to injury or harm caused by their business. All of your business assets, and personal assets like vehicles or home can be on the line.
It’s difficult to grow a business as a sole proprietor. A businesses looking to expand their operations needs investments. Because you can’t separate a business owner from their business, raising money becomes difficult as equity ownership is the preferred financing method among investors. And if you’re scaling a sole proprietorship with large revenues instead of investments, you probably don’t want to be paying personal income tax on it.
Though some provinces may have slightly different rules, the general definition of what makes up a partnership is “two or more persons, carrying on business together with a view to profit”. If two ice cream aficionados decide to combine forces selling ice cream to make some money, that would automatically create a partnership — no forms or documents required here either. Like sole proprietorships, partnerships can be very informal, but the main difference is obvious: two heads are better than one, and partnerships require at least two individuals.
Being able to share workloads.
Unlike sole proprietorships, partnerships can be structured under a partnership agreement which sets out the rules and responsibilities that partners have to follow. These agreements are still flexible and allow partnerships to have similar agility as sole proprietorships.
There are specific types of partnerships called Limited Liability Partnerships that are available for professional services like doctors, lawyers, accountants, etc. As the name suggests, these partnerships have the benefit of limited liability, which means only business assets are on the line, not personal assets.
If you’re operating as a general partnership (i.e. a not a Limited Liability Partnership), you still have unlimited liability.
Depending on your partnership agreement, one partner’s decision can bind all other partners to that decision.
While profits are shared by all partners, losses are shared equally as well.
Simple lapses in judgement, not to mention a partner going rogue, can greatly affect the success of not just your business, but your personal life.
The most common structure for a business is a corporation. Like partnerships, rules surrounding corporations can vary slightly between different provinces, but the essential elements of incorporation are the same everywhere. The distinguishing feature of corporations is the concept of a separate legal entity. Instead of the entrepreneur being one in the same as their ice cream business, upon incorporation the ice cream business would now stand as its own person separate from the various aficionados who make up the company’s organizational structure. In the eyes of the law, a corporation is its own person with rights and obligations, hence the name… corporations... corporeal. Get it?
All corporations have limited liability. Any lawsuit or claims made against the company can only go after the company assets. This safeguards the property that belongs to the companies shareholders, directors, executives , ext.
Corporations are also able to expand and scale more effectively. Corporations are conducive to raising money and protecting investors by shielding their personal property from liability.
During the early stages, it’s hard to be a profitable business; any losses your business incurs in those first years can be carried forward and reduce the amount of tax you pay in later years.
Canada-Controlled Private Corporations have considerably lower tax rates than non-CCPC companies. CCPCs will only pay 10% tax for revenue up to $500,000. Where an individual making $500,000 will pay close to 45%.
Corporations can be structured in more flexible and dynamic ways depending on their size and stages of business your company is going through.
Incorporations are more complex, cost time and money, and require regular maintenance by law. To a business owner who doesn't understand the nuances of a corporation, the launch and upkeep can be a major burden.
Remember the potential tax benefits that we mentioned? It could be a con too! Because a company is a separate legal entity, that means they have to pay their own corporate taxes on top of those of a business owner. As a business owner, your income isn’t completely and wholly the company’s, so another tax step is expected.
A business owner can find themselves losing portions of ownership in their business. When investors and other players put their skin in the game, founders will have to trade some of their autonomy for business growth.
Topic 2: Incorporation Ins and Outs
Although companies have a ton of flexibility in their size, structure, and business model, some core elements remain the same. First, Shareholders and Directors are legally required to be present in companies, with the option to include Officers, and every corporation must have up-to-date Corporate Documents (AKA minute books).
Shareholders, Directors, and Officers
Shareholders are the owners of the company but can also be employees, directors, officers, or hands-off investors. Shareholders don’t necessarily have to be involved in corporate operations and management, but can if they choose. One of the most important responsibilities given to shareholders is the ability to vote on significant decisions at corporate meetings. Although some aspects of the meetings are run-of-the-mill, shareholders, as a group elect the Board of Directors — the mind and management of the company.
Directors call the shots regarding everything substantive that the corporation does. The directors decide what flavour of ice cream they want to sell next and what area of the city they want to expand operations to. Although the number of directors in a corporation can vary, best practices are to elect an odd-number to avoid ties and stalemates in the decision making process. Though directors on the Board have immense power, individually, they cannot make decisions (unless there is a sole Director). Directors can only act in “quorum”, meaning that a majority has to be reached in order for that decision to stand. No quorum, no action. In larger companies, directors often delegate some of their responsibilities and the operational aspects of corporate management to officers, i.e. the C-Suite level.
Officers, commonly Chief Executive Officers, Operating Officers, and Technology Officers serve as proxy managers for the directors who appointed them. Most operational tasks are under the purview of the officers, as they are in charge of the execution of the directors’ overall direction of the company. If the directors want to pursue strawberry as the new ice cream flavour, the officers will round up everything needed to make that happen. It’s worth noting that the director(s) of a corporation can also hold executive positions.
Because a corporation is a separate legal entity, there are rules and formal documents that have to be filled out, filed, and maintained to keep your company in good standing. Some documents are static and never change like articles of incorporation, while some are more dynamic and require regular upkeep like meeting minutes and information sent to shareholders. Smart, organized, and effective record keeping can make a world of difference, and starting off on the right foot is key in ensuring prolonged success.
The key paperwork needed at the outset of a corporation includes the following:
Articles of Incorporation: These are the first official documents involved in incorporations. They describe the legal structure of the business, and include: the company name, how the company organizes its shares, rights to transfer shares, and how many directors the company will have.
Bylaws and Resolutions: Bylaws (and subsequent resolutions to those bylaws) are documents made by directors that regulate the company and its internal affairs in all manner of topics. Director meetings and protocols can be laid out, delegation of responsibilities to officers, committees can be formed, and shareholder meetings detailed. Simply put, a corporation’s bylaws define the rules for the internal governance of the corporation.
Shares: Shares give their owners (i.e. shareholders) a variety of rights in relation to the company. A share is a bundle of rights which includes the right to vote in shareholder meetings, the right to participate in company issued dividends, and the right to participate in asset acquisition upon the dissolution of the corporation. Shares can be broken up into different “classes” like Class A, B, and C which come with various rights and privileges in relation to the other share classes. For example, a corporation can issue Class A and Class B shares, where Class B shares have a priority to dividends compared to Class A. Investors who have no interest in managing the company can elect for Class B shares if they’re looking for steady dividend income.
Shareholder Agreements: These are agreements governing the relationship between the shareholders of a particular company. Shareholder agreements give private (and sometimes public) companies a way to promote positive behaviours from the shareholders. These documents are generally quite complex and can vary on the nature of your corporate structure and the goals of your company. We always recommend talking to a lawyer for this one.
When to Incorporate
Hopefully, you’re starting to realize that most new ventures are best operated through a corporate vehicle. We get that some entrepreneurs are hesitant to go through the formal incorporation process when their idea hasn’t even gotten off the ground — a perfectly reasonable thought to have. It is also perfectly reasonable to work through the initial stages of your business without incorporating, but there are three key “triggers” that indicate your business is ready for an incorporation.
First, is when you’re starting to sell products or provide services. This trigger ties back to the idea of limited liability and downplaying your risk as a business owner. During the idea and brainstorming stages of your business, the only real damage that can happen is internal, meaning that anything that goes wrong only affects you or your group of founders. When the business starts selling products or providing services to real customers, your risks expand dramatically.
Second, is when you start hiring employees. If your business is still in the R&D phases, but you start realizing that you’ll need an extra set of hands, you’ll want to begin the incorporation process. The idea of a separate legal entity is important here in that you will want to pay any employees out of the company’s bank accounts instead of your own pocket. Contracts for services should always be undertaken with the company itself, instead of a single individual (you). Plus, any intellectual property created throughout the employment can be assigned to the company.
Third, is when your company is beginning to raise capital. Raising capital as an individual or partnership is difficult outside of a close network of friends, family, and other associates that personally trust you and your business enough to part ways with their cash. When a company starts gaining traction and expanding, an infusion of capital is necessary to scale. However, sophisticated investors will not be satisfied with providing debt because debt has fixed returns. Equity (i.e. shares available through incorporation) can be issued for financing, it provides an adequate benchmark for valuing a company, and the investor receives an unlimited upside proportional to the company’s growth.
Finally, if your business is looking to get government grants, you need to be incorporated to be eligible for just about all of them. Some are available to sole proprietors and partnerships, but the vast majority require your business to be a corporation.
Topic 3: Founder proofing
Founderproofing is the simple idea that a company’s founders will protect the business from any possible conflicts, mistakes, or unexpected departures of the founding team. This is generally done through legal mechanisms and shareholder agreements. It may be a new concept to many, and discussing how to resolve conflicts is probably one of the last things a new team of entrepreneurs wants to think about. However, like with all legal issues, pushing problems aside until they become too big to ignore will cause more headaches than if they were properly addressed from the start.
When a company is started, the shares are split amongst its founders in whatever fractions they agree to. By design, these shareholders have considerable voting power in determining which direction the company is going, as shareholders, directors, and officers of a start-up are usually one in the same. As the company inevitably increases in size and investors and other players are thrown in the mix, disagreements as to how to run the company may arise. Another truth is that not all founders remain in their original roles long-term, so smooth transitions in and out of the company should be prioritized from the start.
To illustrate, picture a founding team where the shares are split 40:30:30. The two shareholders who held 30% each voted to move forward with a financing round which involved share dilution and transfers to the investing party. The 40% shareholder was extremely unhappy with this decision, as they believed they would be able to expand without the help of the investors. Although the investment was beneficial for the company, the 40% shareholder decides to leave the business while still holding their shares. In the absence of any kind of legal agreement preventing this behaviour, almost half the value of your company is on the outside because of a disagreement. Even if the 40% shareholder decided not to leave, voting on matters that require a certain percentage of the outstanding shares could bring company decisions to a grinding halt because of the concentrated power held by a single party.
You might be thinking that we’re exaggerating or that these scenarios are over-the-top. Maybe you can’t imagine a world where your co-founders would ever jeopardize the business you’ve all worked so hard to build — you get along great and you’ve been through thick and thin together. But no business is immune to disagreements and having to make difficult decisions. So what’s the best way to founderproof?
Start Early: We’ve said it time and time again: plan ahead! Having clauses in your shareholders agreement encouraging positive behaviour and restricting negative ones goes a long way in figuring out what to do when you run into these situations.
Apportion Different Equity Amounts: One of the biggest mistakes that founder teams make is to split equity (shares) equally among each founder. It makes sense in principal; everyone in the venture together, no one being “worth” more than the other, etc. In practice however, the wise business decision is to sit down with the founding team and outline each person’s roles and responsibilities. Very quickly, it will become evident that some founders will be devoting more of their time into the business, or some founders will have the necessary skills to materialize whatever idea you went into business with. Having apportioned equity properly will mitigate hold-up risks and allow smoother transitions into different organizational players.
Avoid High-Risk High-Reward Structures: Whatever agreements your company has in place should encourage predictable and rational behaviour. High-risk high-reward structures usually take the form of performance incentives where large portions of shares vest at a single time. If a CEO knows that in three months time, they will receive a large chunk of stock, they will do everything in their power to make sure they hit that three month milestone. Picture a scenario when a CEO in this situation makes a series of big mistakes that, while not completely fatal to the company, will nonetheless have a large impact. The better business decision will be for the CEO to own up to their mistake and get help from the rest of the company to limit the negative effects. If the CEO is self-serving however, they’ll actively work to cover the mistake up, limiting the amount of time they can dedicate to other company matters and placing the business in a worse position than if they were to come clean. Again, this behaviour happens more than one realizes and planning from the start can help to mitigate it.
Set up a Formal, Effective Board of Directors: The astute reader will have come across a common theme to this section: founders are human beings, and as human beings founders have the tendency to become very fickle and emotional — particularly when dealing with the company they helped create. Having an impartial, effective Board of Directors takes away many of the risk factors and triggers that could lead to founder issues. As the Board of Directors sets the direction of the company, founders can spend their time developing the great idea they wanted to create in the first place, while leaving the business and logistical elements to experienced and neutral third parties. That’s not to say that the founder(s) will lose their entire voice in company operations, Boards can be set up in a variety of ways in which equitable distribution of responsibility can be achieved.
Hats off to you for making it to the end of this onslaught of dry legal material! Hopefully by now you have a general idea of what your business needs to look like, and you have an idea of how to get there. Before you go, we want to leave you with the main takeaways:
1. Get incorporated
Protect your self and set your company up for success by incorporating.
2. Start early
Waiting to take business law serious can lead to future problems. The best time to address them is now.
3. Get a lawyer
Knowing the complexities of law is a necessary part of protecting your company.
4. Prevent the headache
Goodlawyer has a network of lawyers ready to take on your legal needs. Letting you focus on your building company.