Lesson 1: Business Law

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.

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.

1. 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.
   
   

2. 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.
   
   

3. 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.
   
   

4. 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.