Canada: Ten Ways To Avoid Destroying Value In Your Technology Company — Part III

In the last two editions, we discussed a number of ways technology companies can diminish their value, including failing to secure all copyrights, failing to patent inventions, carelessly giving away access to source code, and hastily granting exclusive distribution rights. In this edition, we look at legal compliance and shareholder issues — two areas where inattention can be costly.

Complying With Law

It is obvious (and presumably does not even need to be mentioned here) that all companies (and individuals) should comply with all applicable laws. This goes, of course, for technology-oriented enterprises as well. And there are a lot of laws to have to comply with nowadays. However, ignorance of the law is no excuse to a breach of it.

Of the myriad laws relevant to tech companies, we focus on two: employment law and sales tax. The first includes many laws that can come into play with your technical staff — we focus below on a subset of them.

A. Overcoming The Overtime Challenge

Tech workers are notorious for putting in long hours on the job. In a tech company (or in respect of the IT workers in a non-tech company), the programmers and developers — the frontline R&D troops — can end up working very long hours, often above 50 per week, week after week for long stretches of time. Project deadlines loom, critical software problems need to be fixed on a priority basis, and with globalization there is always a customer somewhere in the world who needs to be serviced at all hours. Moreover, many techies pride themselves on their "late night" culture, which again adds to racking up hours on the job.

This type of work culture can raise interesting challenges under provincial employment laws, particularly those relating to overtime (in those provinces where such overtime rules apply to tech workers). Where these rules apply, they dictate how many hours people can work a week, and the overtime rates they must be paid if they exceed a certain number of hours.

You need to understand and abide by these rules. The failure to do so can mean that you are racking up a material liability — that only grows as each new week adds to the amount at risk.

How this issue typically comes to light is upon a sale of your company. Before you sell and receive your money, the purchaser is going to insist on a warranty that states that your company complies with all applicable laws — including employment laws. Therefore, if you have an exception to this representation (such as would be the case if you noted that you have not correctly paid overtime rates, etc.) you will likely be stuck with the responsibility for this deficiency, even though the claim only arises after the sale of the company. And that is not where you want to be.

B. Taxing Concern

Another important legal compliance matter — from a technology company's perspective — is the sales tax issue. Many governments around the world, including the Canadian provinces and the US states, levy taxes on the purchase of software licences and related services. But here's the rub — these sales tax rules and related rates can be quite complicated, are not entirely consistent with each other, and can also change fairly frequently.

For example, some jurisdictions levy a sales tax on the "sale" of "software," but exclude the "licensing" of software that will be customized. Others differentiate by the type of software being provided to the client (for example, application software versus operating system software). Still others ask to what degree the software is customizable, or is implemented straight out of the box. In yet other countries, it makes a material difference whether the software is shipped on a physical basis as a bunch of software on a CD, or whether it is delivered electronically over the Internet. And assuming some form of sales tax applies, the next question typically is whether it can be recovered, as generally is the case in a "GST-based" type tax system.

All this to say, in short, that many tech companies fail to collect from their clients or customers (and remit to the applicable government agency) the relevant required sales tax. This can lead to a big, big problem upon a sale of the tech company. Essentially, the purchaser does its due diligence, and realizes that not much (or not enough, or sometimes no) money has been remitted in respect of sales tax. As a result, the purchaser will demand an indemnity for this risk area — and will generally receive one (the indemnity being driven by the fact that the risk/liability arose while the seller ran the company).

This risk is further compounded by the fact that the only truly thorough way to neutralize this risk is to invite the taxation authorities to come in and do an audit on your sales tax collection and payment practices. And, of course, nobody really wants to do this unless they really have to.

The lesson, therefore, is to work with your tax advisor early on to determine the relevant tax rules for the particular type of product you sell, and then to comply with these rules from the beginning by collecting the relevant amounts from your customers from the start. Customers aren't that put off by the payment of upfront tax on their software purchases — what they really don't like is being told years later there is a further amount of tax due under the agreement (some will pay it — reluctantly — others will not). And if they don't pay it, the purchaser of your tech business will expect you to pay it. Ouch!

Corralling Your Shareholders

Finally, we'd like to discuss one further way an omission early on by the tech company (and other early stage companies, regardless of the business space they operate in) can adversely impact value later. It has to do with your ability — or inability — to deliver all the shares of your company to the prospective purchaser.

This issue is important because purchasers of private tech companies ("private" meaning their shares are not listed on a stock exchange) invariably want to acquire 100% of the target company. By doing so, the purchaser can reorganize at will the purchased company, perhaps by transferring its intellectual property to another group company, and ultimately merging or amalgamating the purchased company with an affiliate in the purchaser's family of companies. This sort of activity is made much more difficult if minority shareholders continue to exist in the target company.

Accordingly, it is absolutely critical that as you issue shares of your company to employees, investors (and anyone else), you ensure that each shareholder signs a shareholder's agreement. Such an agreement usually covers a range of topics, but very importantly it needs to include what is colloquially called a "drag along" provision.

Such a clause typically provides that if an offer is made to acquire all of the shares of your company, and shareholders holding the majority of the shares agree to sell their shares into this offer, then the minority shareholders have to sell their shares as well.

Without such a provision, you can be in the invidious position where the holders of a vast majority of the shares agree to sell, but a small group of minority shareholders — or even one such minority shareholder — puts the deal at risk because they do not want to sell. This has happened, and it's a sad situation for sure. Don't let it happen to you!

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.

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