Canada: Do It Right, Not Over: 10 Key Considerations When Incorporating Your Start-up

Last Updated: November 20 2017
Article by Julie Robinson and Rohan Rajpal

Corporations are the leading business vehicle in modern commerce. For start-ups, properly structuring and incorporating is critical to avoid disputes and protect the corporation (and the founders) and its assets if they do come up, and avoid the time and expense of doing it over later. It's also critical to best position the business to attract investors and strategic partners and, ultimately, achieve a successful and profitable exit (by acquisition or otherwise) if that is the ultimate goal. Doing it right means thinking and planning ahead.

Here are ten key considerations every founder should think about when incorporating their start-up.

  1. Timing

The three main ways to structure a business are sole proprietorship, partnership and incorporation. Most businesses kick off as a sole proprietorship or partnership: one or more owners/operators responsible for all aspects – including risks and liabilities – of the business. But at some point, founder(s) are ready to look at incorporation and its benefits. A "corporation" is a legal entity separate from its owners (the shareholders). It alone is responsible for its debts, obligations, and actions, and if it fails to make good on them, generally the shareholders aren't personally responsible. There can also be tax advantages to incorporation, especially after a business is profitable. The time is right to consider incorporation when:

  • The founder(s) have developed intellectual property (IP) (trademarks, copyrights, trade secrets, industrial designs or patents), because it's more beneficial for one owner (the corporation) to control and further develop those assets.
  • The business is ready to enter into contracts with customers or suppliers, because both may be reluctant to enter into contracts with individuals and because incorporation offers liability protection for the founders under those contractual obligations.
  • The business is looking for funding, because most investors and government grant and similar programs require incorporation to fund.
  1. Incorporating Jurisdiction 

A business can  incorporate under provincial laws or under federal laws. There are differences between them and between provinces, and each has pros and cons. The right choice depends on your objectives. Discuss these key considerations with your legal team to help you make that decision:

  • Investor-readiness. Investors may have a preference; switching later will cost time and money.
  • Target Market. Both provincially and federally incorporated businesses can generally carry on business anywhere in Canada, but the amount of red tape to do so varies. 
  • Flexibility. Provincial and federal incorporation offers differing flexibility in structuring your shares, limiting members' liability, restricting directors' powers, and liability allocation. Some also place residency restrictions on directors. 
  • Registered Office, Reporting & Business Name. There are differing requirements for locating the registered office, annual reporting requirements, and business name search and approval.
  1. Naming 

Choosing a corporate name might not be as simple as it sounds: there are legal requirements. A corporation name must be: distinctive; not cause confusion with an existing name or trademark; include a legal element (e.g. Ltd., Corp., Inc.); and not include any unacceptable (to the relevant registering authority) terms. A NUANS report determines whether the proposed name has already been registered as a corporation name or as a trademark. But remember that obtaining the name doesn't alone give the corporation the right to use that name as a trademark.

  1. Share Structuring 

Incorporation will require a start-up to decide how to structure its capital.

Type. There are two ordinary types of shares: common and preferred. Preferred shares have certain rights, or "preferences", over common shares such as dividends, redemption rights or conversion features.

Shareholder Rights. Within each type of shares, there can be as many classes as desired. A corporation can have one type of shares with all the basic shareholder rights attached, or multiple classes with a combination of attached rights and privileges. The default shareholder rights include voting, dividends, and distribution of assets. Founders typically take common shares with all of these basic rights.

Number. For start-ups, it's often best to create an easy-to-understand capital structure by authorizing an unlimited number of common shares with default voting, dividend and distribution rights. The corporation can add a new class with preferential characteristics later if needed, such as to satisfy the condition of an investor.

  "Founder(s)" Shares. If there are multiple founder(s), a key decision is the initial equity split between them. Typically, the founder(s) get their shares for "free" (for a small amount of cash) upfront. As a trade-off, the founder(s) often also work in the corporation for no or minimal compensation and only get paid when (and if) the corporation receives funding or revenue. This requires a decision about who is – and who is not – a "founder". There's no legal test or definition; it's a decision about who's really invested in the corporation, their contributions to the business, and who's going to stick around to make it a success.

  1. A Shareholders' Agreement

All shareholders can benefit from  a shareholders' agreement: a written agreement among some or all of a corporation's shareholders defining the relationship, rights, and obligations between the shareholders and the corporation, and addressing potentially contentious issues before problems arise. Without one, corporate laws govern the relationship; but their default provisions might not cover everything the shareholders want, or they might do so but in a way the shareholders wouldn't choose. Deciding when to put a shareholders' agreement in place isn't easy because it might not be useful if the business plan isn't fleshed out or the co-founders aren't yet committed. But investors will likely want to see one in place before they consider financing the corporation – and active investors might want to discuss modifying it to give them board participation and other rights. A shareholders' agreement includes many terms and conditions. For start-ups, some of the key ones include:

Board of Directors. Practically, the initial Board of Directors is comprised solely of the founder(s), but the shareholders' agreement will specify the total number of directors required. Specifying a maximum rather than either a minimum or a specific number of directors offers the most flexibility; otherwise, the departure of directors can impede the Board's ability to act at all. The agreement also specifies the right of shareholders to designate board nominees. Start-ups in particular must remember that investors typically expect to have – and even insist on – board representation.

Share Transfer Restrictions. The agreement will also typically place restrictions on shareholders' ability to transfer shares. This is of particular concern to start-up shareholders:  in most cases, the corporation is closely-held (at least initially) and the founders will want control over with whom they work. There are a number of mechanisms to do this; one key way is with a right of first refusal. This protects shareholders (but can deter third party purchasers) by generally requiring a shareholder who gets an offer from a third party purchaser to give the other shareholders notice of the offer, who then have the right to match the third party offer within a specified time.

Drag & Tag Rights.  A start-up's exit plan might involve selling the corporation (or part of it) to a third party. Drag-along and tag-along rights in a shareholders' agreement can facilitate the sale and protect the shareholders' interests. A drag-along gives the controlling shareholder(s) (often the founder(s) and/or significant investors) the power to ensure minority shareholders can't stop them from selling the corporation when they receive a legitimate third party offer: if a third party offers to buy the corporation, the drag-along right allows the controlling shareholder(s) to force all other shareholders to either sell their shares or approve the resulting change of control of the business. Conversely, a tag-along allows all (or specified) shareholders to "tag along" with a shareholder that's selling to the third party, giving shareholders the opportunity achieve liquidity for their investment.

Pre-emptive rights. Pre-emptive rights allow existing shareholders to avoid dilution of their ownership stake when the corporation decides to issue new shares by giving them first crack at purchasing the new shares at the offered price. Investors will often request these rights, but founder(s) might also want them.

  1. A Stock Option Plan

Start-ups often lack cash to pay top talent to help the corporation grow, but they do have equity – often a powerful incentive to attract talent. A stock option plan is a tool for a corporation to attract, motivate and retain talent, such as employees, directors, consultants, advisors, and so on, with the promise of equity at a fixed price in exchange for the option-holder's commitment to the corporation for a certain period of time.

Option Defined. An option gives the holder a right to purchase a certain number of shares in the future at a pre-determined price (the "exercise price").

Number. The Board of Directors determines the size of the "stock option pool". The number of options available is usually around 10% to 20% of the company's fully diluted capital. Plans typically give the corporation discretion to ensure retention of its outstanding shares in the event of employee departures by giving it rights to cancel options in exchange for giving option-holders a specified financial value.

Granting Options. The Board of Directors approves the date the options are granted, the total number of shares subject to the option, the exercise price, the vesting commencement date and schedule, the expiry date and any unique terms. The corporation and the person receiving the options then sign a written option agreement specifying those details.

Exercise Price. Typically, the Board of Directors determines the exercise price at the shares' fair market value when the options are issued, although this isn't always the case. The option-holder's goal is to exercise the option at a later date when it is "in the money": when the share's fair market value exceeds the exercise price.

Option Vesting. The option-holder only gets to exercise their options when they've "vested". Vesting conditions vary, but are often tied to the option-holder's continued involvement with the corporation according to a pre-determined "vesting schedule". The vesting schedule outlines the percentage of options the option-holder can exercise after a specified amount of time. A typical vesting schedule for start-ups includes a one year "cliff": options only begin vesting one year after they are granted, and then vest on a prorated basis periodically (usually monthly, quarterly or annually). This helps the corporation ensure those entitled to options don't benefit prematurely by cashing-in before contributing to the corporation. Once vested, an option stays vested until it expires; if an option-holder fails to exercise their options before the expiry date, their unexercised options are cancelled and returned to the corporation's option pool. Stock option plans typically set out what happens to vested and unvested options if the option-holder is removed, or removes themselves, from their role or becomes disabled, retires or dies. 

Exercising Options. There's no obligation on the option-holder to exercise the option(s). But if they don't exercise before the options expire, the option-holder will forfeit the options and will be unable to exercise them.

  1. Intellectual Property

For many businesses, particularly early stage start-ups, their intellectual property (IP) – such as trade secrets, patents, trade-marks, copyright and industrial designs, and confidential information, like market research, financials and customer information – is one of their most valuable (or sometimes their only) assets. So understanding how to deal with and protect that IP is important. When a start-up is looking to incorporate, there are a few key issues the founder(s) must decide.

IP Transfer from Founders. Typically, the founder(s) developed the IP so are often the initial owner(s) of it. When the founder(s) decide to incorporate, they transfer their rights in that IP to the corporation, usually upon or immediately after incorporation. This ensures the corporation owns the IP assets, and any continued development of it – which will be key to future investors.

Proprietary Information and Inventions (or "IP") Agreements. These agreements between the company and its founders, employees, contractors, and so on protects the corporation's IP and other proprietary information by ensuring the corporation retains ownership of its IP and sets out each party's confidentiality and non-disclosure obligations to the corporation.

  1. Complementary Additional Agreements

Here are three key additional agreements particularly beneficial to start-up corporations.

Founder Reverse Vesting Agreements. This is effectively a repurchase option under which the corporation can buy back a founder's "unvested" shares if they leave the corporation. A founder reverse vesting agreement should address these two key issues:

  • Vesting period.Decide whether a cliff (an amount of time before the vesting starts) is needed for founders. And decide the vesting period: from what date does it run, and for how long. Corporations will typically use a two to four year vesting period, similar to stock options.
     
  • Triggering events. Determine what situations will trigger the buy-back option. Typical events include the founder's employment termination, resignation, disability or death. The buy-back price might depend on the event: for example, a corporation could buy back the founder's shares for a nominal amount if the corporation terminates the founder's employment for cause, but must pay fair market value if it terminates without cause.

Employment Agreements. It's wise for the corporation to enter into a written employment contract with each employee – including the co-founders and any other shareholders who are also employees.

Contractor Agreements. A start-up corporation might choose to hire independent contractors rather than employees to do some work, as a cost-control measure, to obtain specialized services, or services it needs for a limited time. Characterization of a person as an employee or independent contractor is important because it carries certain consequences for both the corporation and employee / contractor. And it's just as wise for the corporation to enter a written agreement with its contractors.

  1. Financing

The mechanics of financing a start-up have unique features and characteristics depending on where the business is in its financing lifecycle. Typically, start-ups contemplate incorporation at the "seed" or "pre-seed" stage. In its infancy, founders often self-finance the corporation's operations with their own funds and sweat equity ("bootstrapping"). Once that's been exhausted, or if the start-up is poised to grow and needs a capital injection to do so, founders need to consider external funding options. Most start-ups don't have the necessary assets to borrow capital from traditional lending institutions or obtain access to public equity markets, so many raise funds by offering ownership of their corporation in exchange for capital. The three most common structures to do so are:

Equity Financing. The issuance of shares in exchange for capital (i.e. equity financing) is a common way for start-ups to raise funds, usually raised from friends and family, government funds and early stage angel and venture capital investors. The corporation typically issues common shares or, in some cases, preferred shares at the pre-seed and seed stages; investors favour preferred shares in later financing rounds (Series A and Series B) that usually correspond to a higher level of maturity and development than the pre-seed and seed round of financing. Key advantages of equity financing are that the corporation generally doesn't have to repay the capital raised, and it provides an initial benchmark for valuation of the corporation. However, a valuation of the corporation can be difficult to establish at an early stage and can also be a disadvantage: if it's too low, it dilutes the founders' stake; if it's too high, it makes the investment expensive, which can limit the pool of potential investors. Equity financing can also require founders to forego a certain amount of control over the corporation.

Convertible Debt. An alternative kind of financing that avoids some of the disadvantages of equity financing is convertible debt: a hybrid of debt and equity financing. Convertible debt remains as debt owed by the corporation until a pre-designated time (typically on either reaching a set maturity date, the next financing round or a liquidity event), then converts to equity at pre-defined terms. Convertible debt usually carries an interest rate, and its terms can include automatic or optional conversion of the debt into equity and provisions for repayment of the debt if it's not converted into equity (dangerous to the start-up if it doesn't have sufficient cash-flow). A key advantage of convertible debt is that it defers the valuation of a start-up and, as an incentive for early-stage investors, often carries a discount or cap (maximum) on the valuation used for conversion. For investors, a cap ensures that those who took greater risk by investing at an earlier stage can lock in their ownership share, and avoid dilution by a higher than expected valuation in a subsequent financing round. For start-ups, however, minimizing discounts and caps is advantageous because they could result in unintended dilution to the founders and be unattractive to later investors. Some investors prefer convertible debt over equity because it gives them the right to participate in a future financing round under the same terms and conditions as those negotiated by later-stage investors. For founders, the corporation's ability to raise capital when it chooses without setting a valuation precedent and diluting their shareholdings too early is advantageous.

Convertible Equity (SAFE). Simple Agreements for Future Equity (SAFEs) were created to simplify seed-stage investment. SAFEs are similar to convertible debt in that the funds are invested upfront and are subsequently exchanged for equity on a later event, such as  on a future-priced round of financing. Since SAFEs aren't debt instruments, they don't have maturity dates or interest rates, and founders (or their corporations) aren't required to pay back the investment. Most SAFEs also have a discount and/or valuation cap. SAFEs have the same advantages as convertible debt but without the disadvantage that the corporation may need to repay the investment, so they are an appealing option for both investors and start-ups.

  1. Corporate Governance 

" Corporate governance" generally describes the processes, practices and structures through which a corporation manages its business and affairs and works to meet its objectives. The corporation will have a number of key stakeholders, each with a defined role to play:

Shareholders. The shareholders are the corporation's owners, and share in its profits and growth. The voting shareholders manage the corporation through the election of directors and any rights they receive under a shareholders' agreement; they aren't otherwise entitled to participate in the corporation's business.

Board of Directors. It's the directors who oversee the company's day-to-day operation, including appointing its officers, and set the overall strategy and business plan. Initially, there are typically very few directors (usually the founders), but as the corporation grows, so too will the number of directors. Eventually, a company might benefit from having one or more independent directors. Many start-ups also have "Advisory Boards", but they're different: "official" directors must meet legal requirements and fulfill legal duties; advisory board members don't have the same legal requirements and duties as "official" directors.

Officers. The directors appoint the corporation's officers. Officers are responsible to carry out the corporation's day-to-day operations, and can fill any position in the corporation the directors want them to fill (president, CEO, CFO or any other position). Any individual can be an officer; they can, but need not, be shareholders, directors, employees or independent contractors. However, like directors, officers must meet legal requirements and fulfill legal duties.

Staff/Employees. The "staff" are the employee and independent contractor positions who carry out the company's day-to-day operations under the officers' management, and who may (or may not) also be shareholders.

This is an update of our article,  Do It Right, Not Over: 5 Key Pre-Incorporation Considerations, published on March 29, 2017.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions