Category Archives: Incorporation

Founder Leaving the Company

While founders embark on the journey of launching a company with an abundance of optimism it may be the case that their relationship does not last as long as the company, leading to the question of how to handle a founder leaving the company? This situation goes one of two ways: (1) the company and its founders entered into agreements that address this situation and the process set forth in these agreements is followed; or (2) no agreements are in place and the company and founder are left to try and work out a resolution (difficult if the departure was not amicable).

In this post we will detail two agreements to put in place early-on in a company’s life that could ease a founder’s departure:

1. Reverse Vesting Agreement. A reverse vesting agreement subjects a founder’s shares to repurchase by the company if the founder leaves/is fired from the company within a particular period of time. Each time shares “vest”, meaning that a particular period of time has elapsed and a certain number of shares cease to be subject to the company’s repurchase right. Typical terms are described as “4 years with a 1 year cliff”. This means that the agreement lasts for 4 years and that 1/4 of the shares vest after 1 year and are no-longer subject to the company’s repurchase right. After the cliff, shares typically vest in monthly or quarterly instalments for the remaining 3 years. The repurchase price is a nominal amount, typically the amount the founder paid for the shares upon incorporation (ex. $0.00001/share).

BENEFITS: If the founder leaves within the vesting period, the company can exercise its repurchase right and repurchase those unvested shares. This is especially useful if a founder leaves early, such as within the first year and allowing the company to repurchase all the founder’s shares. Without this agreement, a founder could leave the company within the first year yet retain all their shares.

COMMON MISTAKES: (1) Too short of a term, for example 2 year vesting term when the founder is needed for at least 3 years in order to complete the product; and (2) setting the repurchase price too high resulting in shares that are too expensive for an early-stage company to repurchase.

2. Shareholders Agreement. A Shareholders Agreement addresses the relationship among the shareholders and the company and may often contain clauses addressing founders specifically. Relevant to a founder’s departure, the Shareholders Agreement may contain a section permitting the company and/or the shareholders (or maybe the other founders) to repurchase the departing founder’s shares. The Shareholders Agreement would contain a mechanism for valuing the shares and a process for completing the repurchase. Additionally, even if the shares were not purchased or no purchase mechanism exists, it may contain a voting trust serving to transfer the votes held by the founder’s shares to a company designee.

BENEFITS: By including a repurchase mechanism, the Shareholders Agreement can kick-in following expiration of a Reverse Vesting Agreement, providing a way to easily repurchase shares of a departing founder once that agreement has expired. Additionally, the voting trust ensures that the founder receives the financial benefit in the future of any shares they retain but by transferring the votes associated with those shares to a company designee it ensures that only people actively involved in the company can vote on company matters.

COMMON MISTAKES: (1) Drafting the Shareholders Agreement to only apply to initial shareholders and not containing provisions whereby the agreement automatically applies to new shareholders; and (2) not creating a clear process for valuing shares and a process for resolving any dispute over share value.

In summary, if you plan for shareholder problems at the start you will be well equipped should those problems arise in the future. While founders may not want to dwell on a divorce when they are optimistic about the future they will be glad they did if things turn for the worse down the road.

The Two Questions I ask new Startups and Studios

Each week I meet with prospective clients that are excited to be launching a new startup or video game studio.  Regardless of the differences between these clients, I inevitably end up asking two important questions at the start of every meeting:

1.  Have you incorporated?

Many clients incorporate without legal counsel, which I have no problem with.  However, by incorporating without a lawyer, prospective clients are often left with a few problems that I am attempting to unearth and that I know will need to be remedied:

A. The company’s paperwork is incomplete.  While a company exists once the filings are made with the state/province/federal government (if a federal, Canadian company), there are a number of resolutions, registers, receipts and other documentation that a company requires in order to have a complete minute book.  The preparation of the foregoing is the bulk of a lawyer’s work incorporating a company and will need to be prepared, especially if the company aims to raise capital as this documentation will be requested as part of standard due diligence.

B.  Too few shares were issued.  If you incorporated a company with 1, 10 or 100 shares, too few shares were issued and should be split or additional shares issued.  This avoids fractional shareholding in the future (imagine offering someone .25% and 10 shares are issued to date) and also makes equity offers to prospective employees more appealing (10,000 shares appear more attractive than 1 share, even if the same percentage ownership results).

C.  Too many share classes created or the wrong share classes created.  I always ask clients their reasons for a particular share class as both client and lawyer should understand the reasons behind the company’s structure.  Since most startups are incorporated with a single, common, share class, I push prospective clients to explain and even justify other classes.  Additionally, if a preferred share class exists, what are the rights and restrictions associated with this class?  Inevitably, no preferred rights and restrictions were specified,requiring the creation of these rights or restrictions or, more likely, deleting the preferred share class.

2.  Have you Transferred IP to the Company?

Clients mistakenly assume that the company they incorporate automatically owns the intellectual property they create.  While someone may be a shareholder (even the sole shareholder) or a director, this does not automatically transfer ownership of intellectual property created by such person(s) to the company.  Indeed, without a contractor, employment or assignment agreement in place, each founder remains the owner of the intellectual property they create.  As a result, the company may not own a core asset and cannot be in a position to license that asset to third parties.  Additionally, by asking this question I am often told about contractors who created intellectual property for a founder or the company without an agreement in place, which will also need to be corrected.

Based on these two questions, I am often able to obtain a full picture of a company and its history and put in place the key documents required to address any issues unearthed.   If you are embarking on a new venture be sure to keep these two questions in mind – doing so may prevent future legal headaches (and fees).  Or, you could read my suggestions on corporate structure and IP assignments here and here.

Investors don’t care where your Startup is Incorporated

Many founders I speak with are concerned about where their startup is incorporated and how this could impact fundraising opportunities in the United States.  In reality, this concern is unfounded.

Any sophisticated investor considers the product/service, team, market potential and other commercialization factors before, if at all, considering where a startup is incorporated.  In some circumstances, an investor may request that the startup alter its jurisdiction of incorporation but whether or not they proceed with the investment is determined 90% by quality of the company over jurisdiction of incorporation.  As relayed to me by Canadian founders, “if an investor passes because you’re a Canadian company, that’s not the real reason for passing“.

Where an investor requires your startup to be incorporated in the U.S. there is a simple process for creating this structure that I discussed in a previous blog post – The Canadian-U.S. Swap: Moving an Early-Stage Startup to the U.S.

Canadian founders should focus on building a compelling product/service and not waste energy worrying about minutia of incorporation.  Sell investors on your company and any issues concerning where your company is incorporated can be worked out between your legal counsel and investors.

Revisiting “Should I Incorporate my Canadian Startup in Delaware?”

It seems Canadians are still wrestling with whether to incorporate their startup in Delaware.  I wrote about this question back in September 2014  and since then the post has racked up over 1,000 views.  Back then, I concluded with this piece of advice, which I still stand by:

Don’t lock yourself into Delaware before you know where your investment comes from.  Based upon the cost and complexity of operating a Delaware startup from Canada, I recommend that you incorporate in Canada at the start.  Where a future U.S. investor requires you to incorporate in Delaware (or another state) your legal advisors can assist with this transition.  Conversely, Canadian investors may prefer to invest in a Canadian company!

Tip:  your product/service is important, not the place of incorporation.