Lessons from Small Businesses

Great article by marketing expert Seth Godin on how small businesses actually have an advantage over larger ones.

http://sethgodin.typepad.com/seths_blog/2009/08/lessons-from-very-tiny-businesses.html

John Maxwell on Leadership

As important as any legal consideration to an innovator is the topic of leadership.  Companies succeed or fail not only because of good products / business plans / legal advice, but also because of the leadership of the founders and their strategic vision for the organization.  One of my favorite leadership writers is John C. Maxwell (www.johnmaxwell.com).  For great leadership tips check out his blog www.johnmaxwellonleadership.com.  

Understanding Your Role as a Director

In setting up numerous companies for entrepreneurs, I've discovered that many people do not understand the duties and responsibilities that are incurred when one becomes a director.  This post will outline some of the basic laws in Alberta concerning directors and their obligations to a corporation.

In Alberta, a corporation needs at least one director (except for a distributing corporation which must have at least three directors, two of whom are not officers or employees of the corporation or its affiliates).  A director can be anyone who is 18 years of age or over with the legal capacity to manage their own affairs.  Dependent adults and individuals who are of unsound mind, or mentally incompetent, or individuals who are bankrupt cannot be directors.  Also, entities other than individuals (such as corporations) cannot be directors.  Unless the articles or constating documents otherwise provide, a director does not have to be a shareholder of the corporation.  Further, at least one-quarter of the directors of a corporation must be ordinarily resident Canadians.  However, the Business Corporations Act (Alberta) provides that an act of the directors is valid notwithstanding non-compliance with this residency requirement.  Subject to the articles, the bylaws or any unanimous shareholder agreement, the directors of a corporation can fix the remuneration of the directors, officers and employees.  However, a director does not have the inherent right to compensation for acting as a director, and may be paid only if the shareholders, or the articles, bylaws or a unanimous shareholders agreement so authorize. 

The first directors of a corporation are named in a notice of directors filed with the articles of incorporation.  Thereafter directors are elected by ordinary resolution at annual meetings.  If the articles or a unanimous shareholders' agreement of a corporation so provides, directors can hold office for terms of up to three years and it is not necessary that all directors elected at a meeting hold office for the same term.  If a term is not expressly stated, a director holds office until the close of the next annual meeting at which directors are elected.   If directors are not elected at a shareholders' meeting, the incumbent directors continue in office until their successors are elected.  Also, if a meeting of shareholders fails to elect the minimum number of directors required, by reason of disqualification or death of a candidate, the directors elected at that meeting might exercise all the powers of the directors if those directors so elected constitute a quorum.  A corporation, shareholder or director may apply to the Court to settle any controversy over the election or appointment of directors.  The Court has the power to declare the result, to order a new election or appointment, to determine voting rights of shareholders and of persons claiming to own shares and to restrain a director whose election is challenged from acting pending determination of the dispute.  A person elected or appointed a director who was not present at the meeting when he or she was elected or appointed, must consent in writing before election or appointment or within ten days after the election or appointment unless the person has acted as a director. 

Subject to any unanimous shareholders agreement, the directors manage the business and affairs of the corporation.  However, they will be relieved of their duty to manage a corporation's affairs to the extent that any unanimous shareholders agreement restricts their powers.  In exercising and discharging their duties, every director is in a fiduciary relationship with the corporation and must act honestly and in good faith with a view to the corporation's best interests.  Further, directors must exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.  

Pursuant to the fiduciary relationship, a director must disclose any material interest that the director has in a contract of the corporation.  A director with a material interest may not vote on any resolution to approve the contract unless the contract is one relating to security for money lent to or obligations undertaken by him or her or by a body corporate in which he or she has an interest, for the benefits of the corporation or its affiliate; a contract relating primarily to his or her remuneration as a director, officer employee or agent of the corporation or an affiliate; indemnity or insurance given by the corporation to a director; or a contract with an affiliate.  If a director or officer fails to disclose a material interest, a court may set set aside the contract on application of the corporation or a shareholder.

Being a fiduciary is also important because it can give rise to personal liability for the director in certain circumstances.  Liability can be imposed on directors who take part in specified acts that are contrary to the Business Corporations Act (Alberta) such as issuing shares for a deficient consideration other than money, the payment of more than a reasonable commission on the sale of shares and the approval of various payments when a relevant liquidity or solvency test is not satisfied, including the payment of dividends, the repurchase of shares, the making of loans to shareholders, directors or officers and the indemnification of directors.  Directors are also jointly and severally liable to employees of the corporation for all debts not exceeding six months wages payable to each employee for services performed for the corporation while they are directors, although a director is not liable for debts for wages if either the director believes on reasonable grounds that the corporation can pay its debts as they become due or if services of employees were performed while the corporation was in receivership or in liquidation.    However, a director is not liable for wages unless the corporation has been sued for the debt within six months and execution has been returned unsatisfied in full or in part; the corporation is being or has been dissolved and a claim for the debt has been proved within six months of the commencement of proceedings; bankruptcy proceedings have been commenced and the debt has been proven within six months after the date of the assignment or receiving order. 

In addition to statutory liabilities from business and employment legislation, a director can also incur personal liability for the non-payment of corporation income tax and can also be liable for breaches of environmental legislation.  Further, as a director, an individual is deemed to be an insider of the corporation and therefore is subject to the insider trading laws in the securities legislation and also, in the case of a corporation that is a reporting issuer, a director can attract personal liability for misrepresentations in disclosure documents.  

A director present at a director's meeting is deemed to have consented to resolutions passed or actions taken unless, the director requests that an abstention or dissent be entered in the minutes; the director sends written dissent to the secretary of the meeting before the meeting is adjourned; the director sends a dissent by registered mail or delivers it to the registered office of the corporation immediately after the meeting is adjourned; or the director otherwise proves that he or she did not consent to the resolution or action.  A director who votes for or consents to a resolution or action is not entitled to dissent.  A director is not liable however (except in respect of liability for wages) for relying on financial statements of the corporation represented to the director by an officer of the corporation or in a written report of the auditor of the corporation to fairly reflect the financial condition of the corporation; or an opinion or report of a lawyer, accountant, engineer, appraiser or other person whose profession lends credibility to a statement made by him or her.  

As stated, generally speaking, a director can have significant power concerning the direction and affairs of a corporation.  As such, this power gives rise to a unique and fiduciary relationship between the individual director and the corporation.  This relationship can lead to liability under certain circumstances.  Therefore, it is important to keep your legal adviser apprised of any corporate circumstances that can expose you, as a director, to personal liability.

The Legal Structure of Your Business

When you decide to start a business, one of the first decisions that you must make concerns the legal structure under which the business will operate. There are typically four ways in which you may carry on a business: as a sole proprietorship, a partnership, a joint venture or a corporation.

Sole Proprietorship

A sole proprietorship is the simplest, and cheapest, form of business organization to start and to maintain. It is a non-incorporated business entirely owned by one person. The owner retains absolute control over business decisions and is the sole owner of any profits from the business. Its liabilities are the personal liabilities of the business owner. As the business the sole proprietor undertakes the risks of the business for all assets owned. It does not matter whether the assets were for personal use or part of your business. You include the income and expenses of the business on your personal tax return.

As as result, there could be significant tax advantages to structuring your business as a sole proprietorship, particularly in the initial stages of your business if you are to incur business losses. However, one of the most significant downfalls of a sole proprietor structure is that there is no limited liability protection, and the proprietor could lose personal assets beyond those invested in the business. Therefore, before venturing as a sole proprietor it is important to discuss your liability exposure with a lawyer. Also, in a sole proprietorship structure, it may be difficult to raise capital, as the only form of financing is what the proprietor is able to borrow as an individual, and the ability to raise debt financing is contingent on the value of personal assets that the proprietor can provide as collateral.

Partnership

A partnership is established when two or more people agree to pool their financial, managerial, and technical resources in order to operate a business for profit. Partnerships are most commonly found in professions such as law and accounting. The definition of a partnership, as enumerated in provincial legislation, is the relation which subsists between persons carrying on a business in common, with a view to profit from the business. Each partner owes every other partner a duty to act in the best interests of the partnership.

Like a sole proprietorship, a partnership is not taxed as a business that is separate from its owners. The income from the partnership is included as part of the partners’ personal incomes and taxed accordingly. Partnerships may be created either by agreement between the parties, or by the conduct of the parties. However, where a partnership is the desired form of business structure, it is recommended that the partners draw up a written Partnership Agreement. This can help greatly in the settlement of any disputes that may arise in connection with the business of the partnership. Because two or more people will be in business together, they can combine their finances in order to invest more than either could have done individually. A partnership will most likely be able to borrow more than a sole proprietorship because creditors will have the collateral of two or more people instead of only one to secure their lending. Partners can also pool their talents so that each person can focus on his or her area of expertise in the business.

Like a sole proprietorship, partners in a partnership (other than a limited partnership) are also exposed to unlimited liability incurred by the business. However, unlike a sole proprietorship, each partner can legally bind every other partner, so a partner can be held personally liable for any debts, obligations or wrongful acts of another partner. As a result, management decisions may be more complex and more difficult to make, particularly when disagreements among partners occur. Start-up costs can be as high as, or even higher than, the cost of incorporating, once a properly drawn partnership agreement is taken into account.

Limited Partnerships are a special form of partnership, often used where investors want the tax treatment that comes from a partnership relationship, without incurring personal liability for all of the partnership debts. When a limited partnership is formed, one of the partners (usually a corporation with no assets, formed and controlled by the promoter of the investment for this sole purpose) is designated as the "general partner" and all other investors are usually designated as "limited partners". The partnership agreement then makes the general partner responsible for managing the business of the partnership. The limited partners are simply “silent” investors with no say in the business activities of the partnership. Any income earned by the limited partnership are directed to and taxed in the hands of the partners, and any losses incurred by the limited partnership are allotted amongst the partners and may become a deduction from the taxable income of such partners.

A limited partner is restricted in their ability to deduct losses and in aggregate cannot deduct losses which exceed the amount they have invested (the ability of a limited partner to deduct losses is restricted and professional tax advice should be received with respect to such restrictions). In the event the limited partnership is unable to meet its obligations, only the general partner will be liable for the debts of the partnership. The liability of a limited partner would be limited to the amount of capital the limited partner invested in the partnership. However, if the limited partner participates in the management of the partnership, that partner could lose his or her "limited liability" and may become liable for the debts of the partnership, the same as the general partner.

Joint Venture

A joint venture exists when two or more people agree to contribute goods, services or capital to one business enterprise. Currently, joint ventures are governed by the contract between the parties involved. A joint venture agreement outlines joint venture terms, contributions of each party, management structure and how the profits will be divided. It should also define the contributions of everyone involved, the management structure and the sharing of profits. You should retain the assistance of a lawyer in drafting and structuring your joint venture agreement.

Joint ventures avoid the partnership disadvantage of joint and several liability, and also allows each joint venturer to regulate their own tax deductions. That's a big advantage for joint ventures. However, a joint venture has sometimes been defined by the absence of key partnership elements. This means small businesses intending to enter into a joint venture agreement must thoroughly understand partnership elements and avoid using them in order to avoid being deemed a partnership rather than a joint venture. What might have started out being a joint venture could lose its joint venture advantage by being deemed a partnership, and inherit the disadvantages of a partnership instead. Again, because of the potential pitfalls in using this structure it is important to retain the assistance of legal counsel.

Incorporation

A corporation is a legal entity that has its own legal personality, distinct from its owners (called shareholders) and the individuals who manage and run its affairs and business (called directors and officers). The creation of a corporation occurs following the proper filing of the Articles of Incorporation (sometimes also called a Charter or Certificate of Incorporation) with the relevant federal or provincial government authority. The Articles of Incorporation contain information such as where the registered office of the corporation is located, the share structure of the corporation, the rights, privileges and conditions attached to each class of shares, the number of corporate directors and the restrictions, if any, on the transfer of shares and the type of business conducted by the corporation. There are many advantages of a corporate structure.

The primary advantage to incorporating a business is that, except in limited cases corporate shareholders are not liable for the debts and obligations of the corporation. A shareholder’s liability is limited to the amount of money which has been invested in the corporation by the shareholder. Except in some very limited circumstances (which are described in a previous blog entry), creditors have rights only against the corporation and not against the shareholders. The continued existence of the corporation is not dependent upon the life of its shareholders, directors and officers and will not be affected by changes in deaths or retirements of its officers since the corporation is considered a separate legal "person". This advantage allows for the orderly transfer of shares of the corporation. Also, because of its independent legal status, it may own property in its own right, enter into contracts and initiate a lawsuit (or have a lawsuit initiated against it).

Another advantage of a corporation is that it can issue various classes of shares (in addition to other debt instruments such as bonds) in order to raise capital. This is an attractive feature to investors because it allows for partial ownership of the corporation. There may also be tax advantages to incorporating your business, such as lower income tax rates and the carrying forward of losses from previous years to offset profits in subsequent years. It is also possible to separate the owners, directors and employees of the business within a corporation, whereas a sole proprietor is the owner and manager of the business, and cannot be his or her own employee.

There are however some disadvantages in using a corporate form. The cost to incorporate your business (i.e., government fees and legal fees) can be high when compared to the start-up costs associated with sole proprietorships and partnerships. There are also a number of ongoing legal requirements that a corporation must comply with in order to maintain its standing. Corporations are required to file annual returns with the government. If you incorporate federally, you will be expected to file one for the federal government, and one for provincial government. For provincial corporations there would be one annual filing for the province only. A corporation is required to maintain corporate records, elect directors, hold directors and shareholders meetings, and provide shareholders with financial information, among other duties. There are additional duties if a corporation offers its shares to the public. Income generated by a corporation is taxed at both the corporate level and shareholder level. A corporation must pay taxes on its income and the shareholders must pay taxes on the dividends (i.e., profits they receive from the corporation, although they receive a dividend tax credit to offset the taxation cost). Taxes may be minimized by offsetting the corporation's business expenses (i.e., salaries) with its income.

Franchising 101

Franchising is a very popular form of entrepreneurship in Canada.  After all, buying into a proven business concept makes sense to a lot of people.  The basic underlying principle in all franchises is that the franchisor retains control over the franchisee's business in return for the use of the name, and by virtue, obtaining the advantage of the franchisor's goodwill. Franchisors retain a significant level of control over the franchisee, which distinguishes this relationship from that of a licensing arrangement, where there is little or no control.  The franchise's advertising and purchasing power is also a benefit to a local franchisee, and the research, development and training provided by the franchisor are likely beyond the financial capacity of an individual franchisee.

However, before you buy into a franchise you should consider a couple things.  First, location, location, location.  A poor location can significantly curtail your profits.  Second, the high level of compensation paid to the franchisor could eliminate many of the advantages that a franchise offers.  Third, the degree of control to which you are subject, as franchisee, can be troublesome and restrictions on transfer can affect the franchisee's marketability.  Finally, a franchise model can lead to an element of uncertainty as the franchise agreements are generally for a specific term.  

In Alberta, every franchisor must give every prospective franchisor a copy of its disclosure document, and a franchisee has the right to rescind all franchise agreements with a franchisor if the franchisor fails to provide a disclosure document within the time restrictions set out in the Franchises Act.  Before you jump into a franchise, make sure it's in the right location and has the right business model, and make sure you do your due diligence and go through your franchise agreement in detail. 

Exceptions to the Principle of Limited Liability for Shareholders

An often cited advantage of incorporation is that it provides shareholders with a shield from personal liability arising out of the operation of the business.  However, in Alberta, there are certain exceptions to the principle of limited liability and personal liability to a shareholder could occur under certain instances, for example, when:

• A shareholder signs a personal guarantee for the corporation's debts
• A shareholder has contracted personally without giving adequate notice to a third party that he or she was acting as an agent for the corporation
• Loss occurs as a result of a shareholder's personal act or negligence of a shareholder
• A shareholder has not fully paid for his or her shares
• Money or property was paid or distributed to a shareholder as a consequence of a reduction of capital contrary to the Business Corporations Act (Alberta)
• A shareholder has assumed powers of a directed under a unanimous shareholders agreement
• A shareholder has received over-payments on liquidation
• A court has "lifted the corporate veil"

Unanimous Shareholder Agreements: Considerations for Venture Start-Ups

A common discussion that takes place among founders of a venture start-up is the question of whether a unanimous shareholders agreement (USA) should be established. Generally speaking, a USA is an effective means of controlling the terms on which shareholders may sell their shares in the start-up entity. Most USAs will provide certain pre-emptive rights to purchase shares sold by other shareholders and may also include rights of first refusal, shot-gun provisions and other useful contractual rights. However, for growth companies, that is, companies whose products or services are likely to take off quickly and therefore the need to raise capital at various stages will become increasingly relevant, a USA has it downfalls.

Under many jurisdications, a USA removes power over the company from the directors and confers it on the shareholders. The number of shareholders in a growth company could quickly increase. Under its terms, subsequent shareholders become party to the USA and therefore incur, as shareholders, power over decision making functions for the company. In most cases, a growth company will include a number of passive investors who generally don't wish to be included in the day to day operations. A multiplicity of parties to a USA can lead to a cumbersome decision making process which in turn could be a competitive disadvantage to the growth company.

The automatic inclusion of new shareholders as parties to the agreement can lead to other problems (sometimes significant) when considering the share transfer rights contained in the USA as they apply to a company that is growing quickly. New shareholders may include venture capital investors or other institutional investors with signficant financial resources. Shareholders without financial means run the risk of being bought out by these wealthier shareholders right as the business is on the cusp of really taking off.  Also, an offer to purchase shares, exercised under a traditional shot-gun clause, could lead to unexpected share shuffling.  For example, if one shareholder makes an offer to the other shareholders, some of the shareholders may agree to sell their shares to that shareholder, while concurrently, the other shareholders would opt to buy the offering shareholders shares.

All in all, each situation is different, and before entering into a USA you should take a look at your business and its prospects for growth, and with the help of your professional adviser set up an arrangement that is in the best interests of your business.