Tag Archives: Incorporation

Share Structure: do you need so many classes?

I frequently encounter early-stage startups with too many share classes.  If you have read previous posts, you know that I advocate for a simple share structure for early-stage companies (usually common and, if needed, non-voting common).  If more complex structures are required in the future, they can be created then.

When you are considering your startup’s share structure, consider creating only those share classes that you know you need now or will need.  To that end, ask the following questions before creating any share class:

1.  What is the share class to be used for?  You need to understand the purpose served by each share class.  Don’t create share classes because a third party tells you to or because you see other companies with similar structures.  Each share class should have a reason for existing.

2.  When is the share class to be used?  If the share class is to be used at some point in the future, consider whether that class will 100% be suited to that hypothetical future event or will it need to be modified to suit that future event?  Further, what is the likelihood of the future event occurring?  If it seems unlikely the shares will be used in the future, consider not creating that class.  For example, I question the value in creating preferred shares to be used for future investors as you currently do not know what terms those hypothetical investors will want on the preferred share class.

3.  Will your share structure agitate investors?  Perhaps you do have a future use for 4 share classes but what is the impact of this share structure on your capital raising activities?  Will startup investors, used to seeing common share structures (and maybe a non-voting common), take issue with your complex share structure?  This especially could be the case where you can’t explain the reason for the structure.  Always consider how outsiders will view your share structure.

In sum: don’t create share classes without a reason – even if your lawyer says so!  A founder should know their company structure and why it was created that way.

Often Forgotten: Registering as a Foreign Corporation

Your company may be a foreign company.  Where your company, for example, has operations or makes sales, outside of its home jurisdiction it may be required to register as a foreign corporation in those other jurisdictions.

The most common situation I encounter is a federally (Canada) incorporated company operating in any Canadian province or territory.  While federal incorporation involves listing the company’s head office, the company is still required to register extra provincially where it is doing business.  For example, a federal corporation with a head office in BC would register extra provincially in B.C.

On the U.S. side, the same applies to a Delaware corporation that has a head offices in another state, for example California, and requiring the company to register as a foreign corporation in that other state.  As such, all Delaware incorporated startups based in California are (or should be!) registered foreign corporations in California.

Each jurisdiction has different rules defining when your company has to register as a foreign corporation.  A head office is only one way to be considered a foreign corporation.  As a founder, it’s less important to understand the exact requirements (that’s the lawyers job) than to understand that doing business in jurisdictions outside of where you are incorporated may require the company to register as a foreign corporation.

The Canadian – U.S. Swap: Moving an Early-Stage Canadian Startup to the U.S.

In previous blog posts I suggested that incorporating in Canada is not a substantial hindrance to receiving U.S. investment.  In some situations, the U.S. investor could require the Canadian company to become a U.S. (likely Delaware) company.  While this sounds simple in practice, how does this Canadian-U.S. company swap work?

While each investment is different, one approach is as follows:

1.  The investor and Canadian company reach an agreement on investment terms.  This agreement also lays out the steps that must be completed as part of the deal (both before the deal is closed, and after) to facilitate the swap.

2.  A U.S. company is incorporated (likely Delaware).  This company will receive investment from the U.S. investor.

3.  The U.S. company acquires the Canadian company through a share exchange whereby shares of the U.S. company are exchanged for shares of the Canadian company.  Through this exchange, the Canadian founders/other shareholders receive equivalent equity in the U.S. company as they had in the Canadian company and the Canadian company becomes owned, 100%, by the U.S. company.

4.  Investment is made in the U.S. company.

There are also additional considerations, such as how the Canadian subsidiary will be used going forward and ownership of intellectual property.  Ultimately, the steps above aim to show you that a Canadian incorporated startup can be later swapped for a U.S. company to satisfy an investor.

Common Shares – Never too Simple

To summarize the last few blog posts: I advocated that Canadians should incorporate in Canada and, if located in B.C., incorporate in B.C. instead of federally.  The next decision to make concerns the company’s share structure.

I recommend incorporating your startup with a single class of common shares – simple.  Often I am asked about more complex share structures, such as a preferred class, a non-voting class or a section 85 class.  While there are situations where I recommend creating these classes, do not request their creation without understanding why you need them.

Preferred shares, while desired by investors, typically are not created until the investment is secured as you do not know the structure of the preferred shares the investors will want and each investor is different.  There are types of preferred shares that can be molded for future investors (blank cheque preferred) but I tend to stray away from these shares as they are divisive among investors and lawyers.

Non-voting shares can be used for friends/family investors and awarding employees without diluting your voting power.  Erring on the side of simplicity, I recommend using common shares for these purposes but tying the common shares to a voting rights/trust agreement (or proxy agreement) that restricts how those shares are voted.  This maintains corporate structure simplicity while achieving the same goals.  Again, if you don’t have an exact reason for creating these shares, then I recommend against it.

Section 85 shares are used for a tax-deferred transfer of valuable assets to the company.  For example, if you owned an expensive mainframe and wanted to transfer it to the company (without loaning money to the company in order to buy your own mainframe).  Most startups do not have valuable assets to transfer to the company so this structure is not needed.  Instead, simply have the company buy the assets for a reasonable sum.

Finally, I always recommend creating a share structure familiar to investors.  To that end, a common share only structure is frequently seen in U.S. and Canadian startups and will be familiar to those investors.

SUMMARY:  Like any other item you buy, only buy a company structure when you understand why you need it.