Properly incorporating and structuring is key to position a startup to attract investors and strategic partners and, if desirable, achieve a successful exit. Advance planning allows founders to accomplish this result, and to avoid the time and expense of restructuring later. Here are the answers to 10 questions for founders to consider when incorporating their startup.
1. When's the right time to incorporate?
The three main ways to structure a business are sole proprietorship, partnership and incorporation. Most businesses kick off as a sole proprietorship or partnership with one or more owners/operators responsible for all aspects - including risks and liabilities - of the business. A corporation, on the other hand, is a legal entity separate from its owners (the shareholders). At some point, founders are ready to look at incorporation and its benefits. The time's right to consider incorporation when: the founder(s) have developed intellectual property (IP) (trademarks, copyrights, trade secrets, industrial designs or patents); the business is ready to enter into contracts with customers or suppliers; or it's looking for outside funding.
2. Where should we incorporate?
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. Generally, most venture capital investors are familiar with federal corporations, and incorporating federally from the get-go saves the time and money to switch later. However, the type of business is also a consideration; for example, the nature of a Fintech business' operations might require it to incorporate under specific laws.
3. What can we name it?
Choosing a corporate name isn't always simple: there are legal requirements, and searches are necessary to meet them. And the name doesn't alone give the corporation the right to use that name as a trademark, so the corporation might need to look for additional protection through a trademark registration.
4. How should we structure the shares?
Incorporation requires a startup to decide how to structure its capital. It's often best for startups to create an easy-to-understand capital structure by authorizing an unlimited number of common shares with default shareholder rights, including voting, dividends and distribution of assets. If there are multiple founders, a key decision is the initial equity split between them. There's no legal definition of a "founder"; it's about who's really invested in the corporation, their contributions to it, and who'll stick around to make it a success.
5. Do we need 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 in a way the shareholders wouldn't choose. While sooner is generally better when it comes to putting a shareholders' agreement in place, investors often influence the timing (and the terms) of the agreement.
6. How can we use a Stock Option Plan?
Startups can lack cash to pay top talent (such as employees, directors, consultants and advisors) to help it grow. But they do have equity - often a powerful incentive. A stock option plan is a type of equity compensation plan that startup corporations frequently use as a tool to attract, motivate and retain talent 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. And it's important that the plan terms be well-drafted to protect the founders and all shareholders.
7. How do we protect our IP?
For many businesses, especially early stage startups, their intellectual property (IP) is one of their most valuable (or sometimes only) assets. So understanding how to protect IP is critical, particularly if the goal is to commercialize your IP rights at some time. Founders should usually transfer their IP rights to the corporation upon incorporation to ensure it owns the IP assets.
8. What other contracts are important?
Every business needs a myriad of contractual agreements. Three agreements particularly beneficial to new startup corporations are:
- Founder Reverse Vesting Agreements. This is effectively a repurchase option that entitles the corporation to buy back a founder's "unvested" shares if they leave the corporation.
- Employment Agreements. Eventually, many startups hire employees and become, for the first time, an employer, with all of the legal implications the employment relationship carries. It's wise for the corporation to enter into a written employment contract with each employee, including founders and any other employee-shareholders.
- Contractor Agreements. It's equally wise to have a written agreement with any independent contractor the corporation hires.
9. How do startup corporations typically get financing?
Financing has unique mechanics depending on where the startup is in its financing lifecycle, but at some point founders typically need to consider external funding options. Most startups don't have the necessary assets to borrow from traditional lending institutions or access public equity markets, so many raise funds by offering equity (or equity-like instruments) in their corporation in exchange for capital. Beyond non-dilutive funding (like government programs and tax credits), the three most common financing structures are:
- Equity Financing. Issuing shares in exchange for capital is a common way for startups to raise funds, usually from friends and family, government and early-stage angel and venture capital investors.
- Convertible Debt. A hybrid of debt and equity financing, convertible debt avoids setting a valuation for the corporation like an equity financing would. It remains as debt owed by the corporation until a pre-designated time (typically a set maturity date, the next financing round or a liquidity event), then converts to equity at pre-defined terms. But convertible debt is still debt - and could become payable.
- Convertible Equity (SAFE). Simple Agreements for Future Equity (SAFEs) were created to simplify seed-stage investment. SAFEs are an appealing option particularly for corporations because they have similar advantages as convertible debt but without the disadvantage that the corporation may need to repay the investment at a set maturity date.
10. How do we run the corporation?
Practice good corporate governance from the beginning. 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, including the shareholders, the Board of Directors, the officers, and staff and employees, and their roles in the corporation's governance should be clearly defined.
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.