Technology Start Ups Jun 15 Final

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Fraser Milner Casgrain llp

LEGAL GUIDE

Technology Startup Guide

Technology Startup Guide

Fraser Milner Casgrain llp

LEGAL GUIDE

Table Of Contents
INTRODUCTION THRESHOLD ISSUES WHEN STARTING A TECHNOLOGY BUSINESS Duties to Previous Employers and other Persons Ownership of Intellectual Property CHOICE OF BUSINESS ORGANIZATION Sole Proprietorship Partnership General Partnership Limited Partnership Joint Venture Corporation How Do I Incorporate? Where Do I Incorporate? CBCA vs. OBCA Incorporation Canada vs. United States ADVANTAGES OF CANADIAN INCORPORATION Canadian-controlled Private Corporations (CCPC) Company Advantages Founder Advantages Employee Advantages What if the Company Cannot Qualify as a CCPC? Eligible Investors Lower Costs Advantages Of U.S. Incorporation Merger & Acquisition Transactions Special Considerations for U.S. Investors Corporate Considerations Weighing the Options Exporting a Canadian Company to the U.S. Capital Structure ISSUING SHARES TO FOUNDERS Dividing the Ownership Pie Valuing Founders Shares Income Splitting Shares Held Directly by Family Members Shares Held By a Family Trust Shares Held by a Holding Company Tax Planning and Valuation Vesting and Buy-back Rights 1 2 2 3 5 5 5 6 6 7 7 8 8 8 9 9 9 9 10 11 11 12 12 12 12 13 15 16 17 17 19 19 19 19 20 20 21 21 22

SHAREHOLDER AGREEMENTS General Key Provisions of a Shareholder Agreement Unanimous Shareholder Agreement Management of the Corporation Board of Directors Observer Rights Procedural Matters Covenants of the Corporation Dealing with Shares Restriction on Transfer of Shares Permitted Transfers Right to Repurchase Pre-emptive Rights Right of First Refusal Co-sale or Piggy-back Rights Drag-along Rights BOARD OF DIRECTORS, OFFICERS AND ADVISORS Qualifications of Directors Directors and Officers Liability General Duties Under Common Law and Corporate Statutes Fiduciary Duty Minimum Standard of Care Delegation and Reliance Specific Statutory Liabilities Actions in Contravention of the Business Corporations Statutes Employee-related Liabilities Tax Legislation Advisors Corporate Governance FINANCING THE BUSINESS Is Your Company Ready to Raise Money? Stages of Funding Types of Financing Debt Financing Debt Financing by Banks and Other Financial Institutions Debt Financing by Shareholders and Other Individuals Equity Financing Hybrid Sources of Financing Founders Friends and Family

23 23 23 23 24 24 24 25 25 25 25 25 25 26 26 27 27 28 28 28 29 29 29 29 29 30 30 30 30 31 32 32 32 33 33 33 34 34 35 35 35 35

Angel Investors Venture Capital Government Investment and Assistance Strategic Investor Anatomy of a Financing Approaching an Investor Structuring the Deal Seed Financing Series A Financing Issuer Valuation Funding and Milestones Use of Proceeds Securities Offered Board Composition Dividend Preference Voting Rights Liquidation Preference Redemption Right Conversion Rights Anti-dilution Protection Protective Provisions Pre-emptive Rights Right of First Refusal Co-sale or Piggy-back Rights Drag-along Rights Registration Rights Repurchase Option on Founder Stock Employment Agreements Employee Stock Option Plan Expenses and Legal Fees Exclusivity Closing the Deal Typical Documentation Typical Due Diligence Securities Law Compliance Application of Securities Laws General Requirements Registration and Distribution Exemptions Private Issuer Exemption Founder, Control Person and Family Exemption $150,000 Exemption

35 36 36 37 37 37 38 38 39 39 39 41 42 42 42 42 43 43 43 43 44 44 45 45 45 45 45 46 46 46 46 46 46 47 47 48 48 49 49 49 50 51

Accredited Investor Exception Trades to Employees, Senior Officers, Directors, and Consultants Offering Memoranda SR&ED Tax Incentives Program Incentives Deduction of Current and Capital Expenditures Investment tax credit refunds Qualifying SR&ED Expenditures General Expenditures Recent Developments: Stock Options Eligibility What projects qualify as SR&ED? What work qualifies as SR&ED work? Applying Processing Targets CRA Claimant Services Maximizing Benefits Provincial Incentives EMPLOYEES AND CONTRACTORS The Hiring Process Termination Clause U.S. Contracts Restrictive Covenants Confidentiality and Intellectual Property Provisions Vacation Entitlements Salary Contract Implementation Engagement of Contractors Is it an Employment Relationship? Intellectual Property Rights Changes to the Employment Relationship Unilateral Modifications Enforceability of New Terms Termination of Employment Mass Termination Insurance Benefit Coverage Cause Equity Compensation Vesting after Termination of Employment Corporate Law Restrictions Securities Law Compliance Regulatory Compliance

51 52 52 52 53 53 53 53 53 54 54 54 55 55 56 56 56 57 58 58 58 59 59 60 60 60 60 61 61 62 62 62 62 63 63 63 64 64 64 64 65 65

Workplace Safety and Insurance Act Compliance Joint Health and Safety Committee Human Rights Compliance Privacy Legislation Compliance Confidentiality Employee Policies PROTECTION OF INTELLECTUAL PROPERTY The Importance of Intellectual Property Understanding Intellectual Property Rights Trade Secrets/Confidential Information What is a Trade Secret? The Duty of Confidence Non-disclosure Agreements Implementation of a Non-Disclosure Agreement Venture Capitalists and Non-Disclosure Agreements Patents What are Patents? Essential Attributes of a Patentable Invention Reasons for Seeking Patent Protection What Should be Patented? The Sniper Strategy The Shotgun Strategy The Family Tree Strategy When to File a Patent Application Partial Patent Application Where to File Copyright What is Copyright? Rights Conferred by Registration Trade-marks General Registration Rights Conferred by Registration Licensing of Trade-marks Industrial Design General Registration Rights Conferred by Registration Marking Integrated Circuit Topography Law Maintaining Ownership of Intellectual Property The Problem of Joint Ownership

65 65 66 66 66 66 68 68 68 68 68 68 69 70 70 71 71 71 72 72 72 72 72 72 73 73 73 73 74 74 74 75 75 75 76 76 76 76 76 76 77 77

Introduction
As legal advisors to technology startup founders and investors, and to technology companies themselves, we are constantly amazed by the broad spectrum of questions, issues and opportunities that arise when establishing, operating and fi nancing a technology business. Individuals who are responsible for charting the businesss direction are presented with the task of not only ensuring that the technology or services being developed meet the needs of customers, they must also understand and address the needs and concerns of other stakeholders such as shareholders, investors, regulators, employees and contractors. This guide is intended to assist founders, executives and investors in performing this daunting task. In developing this guide, we were mindful that not every issue facing technology startups could be addressed in a publication of this size. For this reason, we have focused on those issues for which we are most often called upon by our clients for advice. Also for reasons of economy, while most of the discussions contained in this guide are quite detailed, we have not attempted to address every issue that might arise under a particular subject heading. In addition, except where otherwise noted, this publication focuses on the law as it currently exists in the Province of Ontario. This does not mean, however, that this guide will be of no use to those involved with technology businesses outside of Ontario. Rather, it is our experience that the issues addressed in this publication are the same issues that are faced by technology businesses across Canada. Only the manner in which some of the issues are dealt with by provincial legislation differs. This publication is intended as a general guide and should not be regarded as legal, accounting or other professional advice. While we hope that this guide will serve as a useful educational tool, the law is always evolving and must be considered in the context of the circumstances of each given situation. The advice of a professional experienced in advising technology startups should be sought when expert advice is required. This edition of Technology Startups: A Practical Legal Guide for Founders, Executives and Investors will not be the fi nal word. As new developments warrant, future updates will be published. For this reason, we ask that you kindly provide us with your feedback, and in particular, suggest topics and areas of concern that should be addressed in future editions. For the most up-to-date content please visit www.techstartupcenter.com October 5, 2010

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Threshold Issues When Starting A Technology Business


Starting a new business is an exciting prospect. Being your own boss, turning your ideas into reality and (hopefully) earning sizable profits have motivated many to take the entrepreneurial route and strike out on their own. Before doing so, however, there are a myriad of issues to consider. Do you have the right personality and resources to build a successful business? Will you need to bring in partners or investors? Is there a large enough market for your product or service? Who will your customers be? These are but a few questions that most entrepreneurs know they must consider before starting their business. What some entrepreneurs fail to consider, however, are some of the less obvious legal issues that could derail an otherwise well thought-out business plan.

Duties to Previous Employers and other Persons


Before starting a new venture, many technology entrepreneurs were at one time the employee of another business. In many cases, it was while working for a previous employer that the entrepreneur first conceived the idea for his or her new business. In this case, a careful review of the previous employment relationship, including any letter of hire, employment agreement, and other agreements signed by the entrepreneur, should be conducted to identify any restrictions that may hamper the entrepreneurs ability to launch his proposed business. Such restrictions may include the assignment of intellectual property, obligations of confidentiality, and non-compete and non-solicitation covenants: IP Assignments - When hiring employees, many businesses require employees to sign an intellectual property assignment agreement. These agreements provide that the employee agrees that any inventions, ideas, work product or other developments conceived or authored during the course of the employees engagement with the employer will be owned by the employer. Even in the absence of a written assignment agreement, the Copyright Act provides that where the author of a copyrightable work was employed by another person under a contract of service, and the work was made in course of his employment, the employer is deemed the first owner of the copyright in such work, unless otherwise agreed to by the parties. As a result, if the entrepreneurs new business is in any way dependent on work performed for a previous employer, the previous employer may have a claim against the entrepreneurs business for infringement of its intellectual property rights. The ownership of intellectual property rights vis--vis previous employers will therefore be of the utmost importance not only to the entrepreneur, but to potential investors in the business. Confidentiality Obligations - Even where intellectual property rights are not an issue, the founder of a new business must consider his other obligations to former employers. Under the common law, employees owe a duty to maintain the secrets and confidential information of an employer, whether or not there is a written agreement to that effect. As a result, the disclosure and use of such information for the purpose of operating a new business, especially where the new business is competitive with that of a former employer, may result in legal action against the founder and/or his new business.

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Non-Competes/Non-Solicits - In addition to obligations regarding the non-disclosure of confidential information, many employment agreements also include covenants from the employee not to compete with the business, or to solicit employees, customers or suppliers of the former employer for a period of time after the employees employment is terminated.1 Where ones relationship with the former business was that of a fiduciary (e.g., director, officer), the fiduciary will owe additional duties to his former employer, which may include a duty of non-solicitation. An entrepreneur must also be mindful of these restrictions when recruiting others - such as co-founders, employees or contractors - to help grow the new business. This is especially critical if a group of former employees seeks to start a new business together, particularly if the departure of the group was not welcome news to the former employer. Although it is not unusual for an entrepreneur to begin planning a new venture while working for someone else, he must be careful not to use the resources of his former employer for the benefit of his new enterprise. Similarly, he should avoid working on the new business during the hours in which he is expected to be performing his work duties for his former employer. Surprisingly, we have found that even the most tech-savvy employees leave behind a trail of e-mails and other electronically stored information which reveal the extent to which they were working on matters related to a new enterprise while still employed in their former job. While restrictions of the type described above are most commonly associated with an employment relationship, similar restrictions can also arise in other services for another company as an independent contractor. In this case, the contract entered into by the founder and the contracting company may contain an assignment of intellectual property, confidentiality obligations and/or non-compete or non-solicit obligations. Similarly, if founders are, or were, shareholders in another company, a shareholder agreement may contain obligations or restrictions that affect the new business. With proper and timely legal advice, founders can often find ways to accommodate restrictions imposed by former employers and others.

Ownership of Intellectual Property


The ownership of intellectual property is not always easy to determine. As a result, if the new businesss products or services are dependent upon certain key intellectual property assets, a full understanding of the entrepreneurs rights to use such assets is essential. In addition to the rights of former employers, areas of concern we most often encounter are: rights of academic institutions to inventions and works resulting from academic research; rights of government entities, or restrictions on use, resulting from financial and other government assistance given to an inventor or author; rights of other persons resulting from contracting or consulting services provided by individuals involved in new business; potential for patent infringement (where independent development is not a defense);
1 See Chapter 8, Section 8.1(c) for further discussion regarding non-compete/non-solicit convenants.

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licence rights obtained from other parties that are not sufficient to permit the new business to operate in its intended fashion (or that place onerous conditions on the exercise of such licence rights); and the use of inventions or works that were conceived of or developed jointly with one or more other parties. In each case, it is imperative to perform a thorough analysis of intellectual property ownership. This analysis should be performed early on in the proposed venture so that any questions surrounding the ownership of the businesss technology can be identified and addressed. Clean ownership of intellectual property will be extremely important to potential investors and acquirers.

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Choice Of Business Organization


When starting a new business, one of the first decisions to make is the type of organization that will be used in operating the business. Most technology businesses operate as a corporate entity. To understand the advantages of incorporation, however, it is useful to understand the other common forms of business organization.

Sole Proprietorship
A sole proprietorship exists where an individual is the sole owner of a business and there is no other form of business organization, such as a corporation, used as a vehicle to carry on the business. In a sole proprietorship, all benefits from the operation of the business accrue to the sole proprietor. Similarly, all obligations associated with the business are the personal responsibility of the sole proprietor. As a result, all income or losses of the business are attributable to, and taxed at the rate applicable to, and all assets of the business are owned by, the sole proprietor. Some of the advantages of operating as a sole proprietorship include relatively low start-up costs, the ability to offset losses from the business against other sources of income, fewer formalities and filing requirements, and control over the direction of the business. Notwithstanding the foregoing, individuals who intend to operate a business as a sole proprietorship must still be aware of federal, provincial and municipal licensing requirements associated with the type of business in which they are engaged. In addition, a sole proprietor who engages in business in Ontario using a name or designation other than the individuals own name must register a declaration in prescribed form with the Ministry of Government Services. As mentioned above, the principal disadvantage of operating a business as a sole proprietorship is the unlimited personal liability of the proprietor (which can generally only be limited by contract or insurance). This means that all of the personal assets of the proprietor are at risk, whether or not they are used in, or related to, the operation of the business. Other disadvantages of operating a business as a sole proprietorship include: lack of status and credibility in the eyes of potential business partners; difficulty in attracting investment; limited ability to use a share of ownership in the business as a retention and incentive tool for employees; ineligibility for many government loan and grant programs (which are available only to corporations); and ineligibility for employment insurance benefits in the event of a failure of the business.

Partnership
A partnership consists of two or more people (whether individuals or corporations) carrying on a business in common with a view to profit. In Ontario, no special filings are required to form a partnership and the law considers a common venture of this type to be a partnership whether or not there is a written agreement between the partners. For this reason, if the formation of a partnership is not intended, it is important to exercise caution when joining forces with others on any business venture. In Ontario, two types of partnerships are recognized. The first is a general partnership, in which the liabilities of each partner for the debts and obligations of the partnership are unlimited and are joint and several. The second type of partnership is a limited partnership, in which the liability of one or more of the partners is limited to that partners contribution (money and/or property, but not services) to the partnership, and the liability of one or more partners is unlimited. Generally, for both general and limited partnerships,

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the income or losses of the partnership are determined, for income tax purposes, at the partnership level and then allocated to the members of the partnership. Such income or losses are then taxable in the hands of the partners.

General Partnership
While a general partnership may carry on its business under a firm name and can sue or be sued under such name, a general partnership is not considered a separate legal entity. Much like a sole proprietorship, in a general partnership, each partner is jointly and severally liable with the other partners for the obligations of the partnership to the full extent of the partners personal assets. Under the Ontario Partnerships Act, a set of rules has been established which govern the partners dealings with one another and the partnerships dealings with third parties. Generally, the rules governing the partnerships dealings with third parties cannot be altered by contract. The central rule in this regard is that, when acting in the normal course of the partnership business, one partners actions bind all the partners. The exception to this rule is when the third party knows that the partner has no authority to act for the partnership in the relevant matter or when it is apparent that the partner is not acting within the scope of the normal business activities of the partnership. Partners often find that the default rules set out in the Partnerships Act governing their dealings with one another are not adequate or do not reflect the intentions of the partners. For example, under the Partnerships Act, all profits of the partnership are to be divided equally among the partners. This arrangement may be suitable where all of the partners are making equal contributions to the business, but where this is not the case, the partners may wish to alter the division of profits by a specific arrangement between the parties. Another example of a default provision that may not be consistent with the intentions of the parties are terms which allow the partnership to be dissolved by any one of the partners upon notice to the others. These examples illustrate the importance of being familiar with the prescribed rules under the Partnerships Act and, where the rules do not reflect the intentions of the partners, entering a written partnership agreement that sets out each partners rights and obligations. Often, it may be advantageous from a tax perspective to operate as a partnership while operating losses are being incurred, as any such losses are attributed to the individual partners and can be offset against income from other sources. However, careful consideration needs to be given to the personal liabilities of partners when using a partnership structure.

Limited Partnership
Unlike a general partnership, which may be created by the conduct of the parties, in Ontario a limited partnership is created by complying with the provisions of the Limited Partnerships Act (Ontario) and is governed by such legislation, together with the relevant provisions of the Partnerships Act, the Business Names Act and the common law. The limited partnership must consist of one or more general partners and one or more limited partners. One person can be both a general and a limited partner. A person includes an individual, a sole proprietor, a partnership and a corporation. A limited partner is much like a passive investor in a corporation, sharing the profits of the limited partnership in proportion to the contribution made by the partner (unless varied by a limited partnership

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agreement). This form of partnership is used primarily for public financings where passive investors are involved and it is desirable for profits and losses to flow through to the investors. In Ontario, a limited partner may give advice to the partnership or act as an agent or employee to the limited partnership. If, however, the limited partner takes part in the control or management of the business, then the partner will no longer be considered a limited partner and will be subject to the unlimited liability of a general partner. General partners in a limited partnership have the same rights and obligations as in general partnerships except that certain actions of the general partner require the prior consent of the limited partners. It is common to have a corporation as the general partner because of the limited liability feature of the corporation. In Ontario, a limited partnership is only legally created when a declaration in prescribed form, signed by all of the general partners, is filed with the relevant registrar. The declaration must state the name of the limited partnership, the name and address of each general partner and the general nature of the business of the limited partnership. As with general partnerships, it is possible to have a written limited partnership agreement in order to deal with matters not dealt with by the governing legislation or, where permitted, alter the effect of certain provisions of such statutes. It is very common for a limited partnership to be used as a vehicle through which to invest in technology companies. This is due, in part, to the ability to use a limited partnership to flow gains and losses to the limited partners while offering the limited partners the protection of limited liability.

Joint Venture
A joint venture is not a specific type of business organization, but rather, an association of two or more individuals, corporations or partnerships (or some combination of these), for the purpose of carrying on a single undertaking or a specific business venture. A joint venture may take the form of a partnership, a limited partnership, the co-ownership of property or a corporation. Generally, the parties to a joint venture will enter into a written agreement (whether a partnership agreement, a limited partnership agreement, a co-ownership agreement or a shareholder agreement) which establishes the respective rights and obligations of the parties with respect to the venture.

Corporation
Many technology businesses start their life as a sole proprietorship or partnership. As it becomes clear that the business is viable, the founders then choose to incorporate. The timing of incorporation is critical and should be determined with the assistance of your lawyer. A corporation is a legal entity that is separate from those who own it (shareholders) and operate it (directors, officers and employees). Corporations may own property, carry on business, possess rights and incur liabilities. Corporations can also continue in existence well after their original shareholders have passed away. Generally, shareholders of a corporation have no authority to deal with the assets of the corporation and cannot make legal commitments which bind the corporation. The shareholders maintain control

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of the corporation by voting their shares to elect the directors who are, in turn, responsible for the management of the corporation. As the corporation is a separate entity, the shareholders of a corporation are not liable for the obligations of the corporation and their liability is usually limited to the amount of their capital investment in the corporation (unless the shareholders guarantee the obligations of the corporation). The income or loss generated by the corporation accrues to the corporation and not the shareholders. A corporation is taxed as a separate legal entity at the rate of tax applicable to the corporation. Shareholders generally pay tax only on taxable dividends received from the corporation and on capital gains when they sell their shares. In addition to limited liability for its shareholders, the corporate form is attractive because of its flexibility. For example, it is possible to use various classes of shares and share conditions to provide shareholders with different levels of economic participation, control and risk-taking. Once established, a corporation can obtain additional funds by the sale of treasury shares (equity) or by the issuance of debt. A corporation can exist indefinitely, making it easier for individuals to come and go without disrupting the business. In addition, the use of the corporate form provides the ability to offer shares, or options to buy shares,

How Do I Incorporate?
The formal steps required to incorporate a corporation are straightforward and, in Ontario, can be effected very quickly. A corporation is created by filing the appropriate incorporating documents and name search results in the jurisdiction in which you plan to incorporate (see Where Do I Incorporate? below), together with the applicable fee. Once all filing requirements have been met, a certificate of incorporation will be issued.

Where Do I Incorporate?
For many founders, choosing the jurisdiction in which to incorporate is fairly straightforward. For a Canadian-based technology company, however, the decision can become much more complicated. Factors that must be taken into consideration include various regulatory and tax matters, as well as the residence of existing or prospective investors.

CBCA vs. OBCA Incorporation


In Ontario, it is possible to incorporate a company under the federal Canada Business Corporations Act (the CBCA) or the provincial Business Corporations Act (Ontario) (the OBCA). Although the CBCA is similar to its provincial counterpart, there are a number of reasons to favour incorporating under the CBCA. The advantages of CBCA incorporation include: the ability to have the corporations head office in any province of Canada; less administrative burden if the corporation intends to do business in provinces other than Ontario; more lenient residency requirements for directors (25% of directors must be Canadian versus a majority for an Ontario corporation); and a perceived higher level of prestige, especially when conducting business outside of Canada. One of the disadvantages of incorporating under the CBCA is that it may be more difficult to obtain a business name, as a name search must be conducted across the country rather than just within the province and the name must be approved by Industry Canada (i.e. Industry Canada must be satisfied that the name

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is not similar to the corporate name or trade-mark of another corporation)2 . In Ontario, government approval of the corporate name is not required; however, except in very limited circumstances3, one cannot use a name that is identical to that of another corporation. In either case, however, obtaining a corporate name does not, in and of itself, grant to the corporation the right to use the name as a trade-mark. As a result, even where a name is available for use as the corporate name, it is important to consider other potential conflicts which may arise from the use of the name.4

Canada vs. United States


Canadian technology companies often seek to attract investment from foreign and, in particular, U.S. investors. While U.S. capital is often welcome, the interests of U.S. investors are sometimes in conflict with the interests of Canadian founders and employees. These competing interests can make the decision of whether to incorporate in Canada or the United States a difficult one, as many investors prefer, and in some cases insist, that the corporation be incorporated under U.S. law. While there is often great pressure to get started with an incorporation when forming a new business, founders must carefully weigh the pros and cons of Canadian versus U.S. incorporation, as it is difficult and costly to change course after the original incorporation.

ADVANTAGES OF CANADIAN INCORPORATION


Canadian-controlled Private Corporations (CCPC)
A CCPC is a Canadian-incorporated, private corporation that is, throughout the year, not controlled, directly or indirectly, by one or more non-residents of Canada or public corporations (or any combination thereof). Control is not merely a question of voting control it is also a matter of de facto control (being any direct or indirect influence that, if exercised, would result in control in fact of the corporation) or day-to-day management of the corporation, whether through a shareholders agreement, option to purchase shares, convertible debt or other means. There is no bright-line test for what constitutes de facto control of a CCPC. Provided that it is founded by Canadian resident individuals, a typical startup company incorporated in Canada would qualify as a CCPC. To the extent that it can then secure venture capital or other equity financing from Canadian sources, that company can continue to be a CCPC well past the startup stage. There are numerous advantages to a Canadian business maintaining its CCPC status.

Company Advantages
For years, the federal government has promoted jobs and investment to Canada with investment tax credits (ITCs) under the Scientific Research and Experimental Development (SR&ED) Program. ITCs can be used to reduce tax otherwise payable by the corporation or may, in certain circumstances, be refundable to the
2 3 For companies that intend to conduct business across Canada, it is advisable to conduct a Canada-wide name search before choosing a corporate name so that potential conflicts can be identified. Sections 6 and 10 of the regulations made under the OBCA provided for limited circumstances where an identical name can be used. These include where the other corporation was incorporated outside of Ontario and has never carried on business in Ontario, the corporation seeking to use the identical name is the successor to the business of the other corporation, the corporations are affiliated or associated with one another or are controlled by related persons and where there is an amalgamation of the two companies. e.g. the use of the corporate name to market and promote the goods or services of the corporation may infringe the trade-mark rights of another person who holds trade-mark rights in a mark that is similar to the corporate name. See Chapter 9, Section 9.6 for further discussion of trade-marks.

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corporation where the corporation is not taxable. Only SR&ED performed in Canada qualifies under the program. If a company is a qualifying CCPC throughout the year with $500,000 or less of taxable income5 in the previous year, it can generally receive an ITC of 35% of qualified SR&ED expenditures (subject to an expenditure limit of $3 million6). For CCPCs, this is a refundable claim, and to the extent that the company does not otherwise have to pay tax, it may be entitled to a full cash refund on qualified current expenditures, and a 40% cash refund on qualified capital expenditures7. Qualified SR&ED expenditures in excess of the expenditure limit will be eligible for an ITC at a rate of 20%. In comparison, the ITC rate for qualified SR&ED expenditures of non-CCPCs is 20% for both current and capital expenditures. A claim by a non-CCPC is non-refundable, i.e., it can only be applied against tax otherwise payable by the company. The enhanced rate (35% vs. 20%) and refundability feature applicable only to CCPCs can provide a very important source of cash-flow for development-stage companies, giving months of additional runway before other sources of capital are exhausted. Once a CCPC is earning income from active business, it is eligible for the small business income tax rate, which provides that the first $500,000 of active business income will be taxed at a lower rate of federal tax.8

Founder Advantages
One of the most important advantages to the founders of a CCPC is the one-time $750,000 capital gains exemption (which is not really an exemption, but rather a deduction from income). When the founding shareholder disposes of certain qualifying shares, the shareholder will generally realize a capital gain to the extent that the proceeds of disposition of the shares exceed the adjusted cost base of such shares plus any reasonable costs of disposition. Where the disposition is of qualifying shares, the first $750,000 (or where the exemption has been previously used by the individual, the unused portion of the $750,000 exemption) of capital gains realized by an individual on the sale of shares of a CCPC will not be subject to income tax, so long as the shares were held by the taxpayer for at least 24 months. Clearly, this is a significant tax benefit for first-generation entrepreneurs who have not used up the exemption. Splitting founder shares with a spouse can result in even greater tax savings. The $750,000 capital gains exemption is only available for sales of certain qualifying shares of CCPCs, and therefore not available for the sale of shares of U.S.-incorporated companies. In addition, changes were introduced in 2000 to encourage reinvestment by successful entrepreneurs. Pursuant to these changes, a capital gain realized from the sale of shares of an eligible small business corporation (which must, among other things, be a CCPC at the date of the sale) may be deferred to the extent that the proceeds are reinvested in shares of another eligible small business corporation,

5 6

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If the CCPC was associated for Canadian tax purposes with any other corporations during the year, the taxable income of those corporations will be included in determining whether the CCPC is below the $500,000 threshold. The expenditure limit must be shared by all CCPCs that are associated for Canadian tax purposes. The expenditure limit, is reduced where the CCPCs taxable income (together with the taxable incomes of all corporations with which it was associated during the year) is between $500,000 and $800,000 and is eliminated if taxable income exceeds $800,000. See Chapter 7, Section 7.6 for further discussion regarding SR&ED. The $500,000 of active business income eligible for the small business income tax rate must be shared by CCPCs that are associated for Canadian tax purposes. The small business income tax rate is 11%.

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subject to restrictions on the carrying value of the assets of both CCPCs both before and after the respective shares were issued. This reinvestment can be made in the year of disposition or within 120 days after the end of that year. Unlike the U.S. capital gains reinvestment scheme, this deferral is only available to individuals (who will typically be angel investors or second-generation entrepreneurs) and cannot be passed through professional investment corporations, trusts or partnerships. To qualify for the deferral, the shares of both CCPCs must have been issued by the corporation to the individual, and therefore shares acquired by purchase rather than from treasury, will not qualify.

Employee Advantages
For many early stage technology companies, stock option plans remain a key tool for recruiting and retaining key executives and employees. Canadian employees (like their U.S. counterparts) are becoming increasingly savvy in assessing the value of equity incentives. Not only is option price and percentage ownership important, a stock option plan should also be tax effective. This is where a CCPC has two clear advantages. First, on the exercise of an employee stock option granted by a CCPC, tax is generally deferred until the option-holder disposes of the underlying shares. For a non-CCPC, owing to recent changes to the Income Tax Act (Canada), a limited (maximum of $100,000) deferral of the income inclusion is available for shares that are listed on a prescribed stock exchange. Otherwise, there is generally an income inclusion on exercise of the employee stock option of a non-CCPC (i.e., tax becomes payable for the taxation year in which the exercise occurs, even if the underlying shares have not been sold), which can result in cash-flow difficulties for the option holder if he or she does not wish to sell the shares in the same taxation year. The second benefit applicable only to employee stock options of a CCPC is a special 50% deduction on a gain realized from the sale of underlying shares, so long as at least two years have elapsed from the date of exercise. A similar 50% deduction is available in respect of shares of a non-CCPC, but is subject to additional conditions, including a requirement that the strike or exercise price of the option must be not less than the fair market value of the underlying shares at the date of the grant9. This means that non-CCPCs including all U.S.-incorporated companies cannot grant cheap or below fair market value stock options to Canadian employees while maintaining the tax effectiveness of the stock option plan. Moreover, shares of companies which are not publicly traded are notoriously difficult to value. If an option grant must be at fair market value to secure the tax deduction, boards of directors are advised to be conservative in determining the fair market value of underlying shares, or risk depriving employees of the tax benefit. Where a company has both U.S. and Canadian employees, this means that the option pricing may end up being driven by Canadian income tax considerations. In practice, this has caused frustration to the boards of non-CCPCs with operations on both sides of the border, particularly where directors wish to take a less conservative, U.S.-style approach to the fair market value determination.

What if the Company Cannot Qualify as a CCPC?


Clearly, if a company will be majority owned by Canadians and can otherwise qualify as a CCPC, there are strong arguments to incorporate in Canada to secure CCPC status. If, however, founders are non-residents

This deduction would alternatively be available in respect of shares of a CCPC, where the 2-year holding requirement is not met, however an employee cannot claim both deductions.

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of Canada, or an early source of investment is from non-resident investors, it is possible that the company will not be able to meet the CCPC ownership requirements, or will cease to be a CCPC shortly after incorporation. Still, there are reasons to consider Canadian incorporation, although as a whole, they are less compelling than the arguments for companies that can qualify as a CCPC.

Eligible Investors
First, certain pools of capital are only available to Canadian-incorporated companies. For example, under the Income Tax Act (Canada) and the Community Small Business Investment Funds Act (Ontario), laboursponsored venture capital corporations (LSVCCs) and labour-sponsored investment funds (LSIFs), respectively, are only permitted to invest in companies incorporated in Canada (and that meet certain other requirements). This class of investor includes large and active Canadian venture capital funds such as GrowthWorks. As may be expected given its mandate, Business Development Bank of Canada is also restricted from investing in companies incorporated outside Canada. Note, however, that it is still possible for LSVCCs and similarly restricted investment funds to invest indirectly in a U.S.-incorporated company by purchasing a class of exchangeable shares in a Canadian subsidiary. On the downside, this results in a complex corporate structure and will generate considerably higher legal and accounting expenses for the company.

Lower Costs
Another potential advantage to incorporating in Canada is lower legal and accounting costs. In many respects, U.S.-incorporated companies operating primarily in Canada must comply with a dual regulatory regime that requires guidance from both U.S. and Canadian advisers. Unless carefully managed, this can slow the pace of decision making and result in headaches for management. For cash-strapped startup companies without immediate aspirations of recruiting or seeking investment south of the border, it can be difficult to justify the expense and hassle of incorporating in the United States.

Advantages Of U.S. Incorporation


Federal and provincial governments have gone to great lengths to make Canadian corporations statutes internationally competitive. As a result, in terms of corporate governance, Canadian-incorporated companies operate fairly efficiently on a day-to-day basis. Depending on a companys long-term business plan and investors potential exit scenarios, however, there are a number of factors that may weigh in favour of U.S. incorporation. Some difficulties which can be avoided by incorporating in the U.S. only tend to arise when a company is sold; again, the problem is navigating Canadian income tax laws.

Merger & Acquisition Transactions


Many successful Canadian companies are acquired by complementary businesses or competitors in the U.S. In the technology sector, acquisition transactions are often structured as stock deals or cash-and-stock deals, in which some or all of the purchase price for shares of the target is stock of the acquiring company. Share-for-share deals do not present a problem where shares of a U.S.-incorporated target are sold to a U.S. purchaser, since a roll-over for Canadian shareholders is available under the Income Tax Act (Canada) in respect of the sale. This means that selling shareholders will generally not be taxed until the shares acquired on the exchange are subsequently sold. Roll-over treatment, however, is not available for share-for-share

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deals in which shares of a Canadian-incorporated target are sold in return for shares of a U.S. purchaser. This means that tax on any gain realized on the sale will be payable by Canadian shareholders at the time of the take-over, unless the special steps discussed below are taken. This creates problems if, for example, there is no public market for the shares of the U.S. purchaser, or the shares cannot be traded as a result of resale restrictions, or if the acquiror is itself at an early stage of growth and disposing of the shares to cover tax liability is an unattractive option. As a result, if the target in a cross-border share-for-share deal is incorporated in Canada, Canadian shareholders of the target can end up with a significant tax liability for which they have no immediate means to pay. Typically, this problem has been avoided by structuring acquisitions of Canadian companies as exchangeable share deals in which the stock portion of the purchase price is paid by issuing shares of a newly incorporated Canadian subsidiary of the U.S. purchaser, which shares are directly or indirectly exchangeable for shares of the U.S. purchaser. This results in tax deferred treatment for Canadian resident shareholders on the sale of the Canadian target until the selling shareholder exchanges the shares of the Canadian subsidiary for stock of the purchasing U.S. company. Indeed, this structure is common enough that a number of large public companies have listed tracking shares on the Toronto Stock Exchange to facilitate acquisitions of Canadian-incorporated companies. Compared to a garden-variety share-for-share exchange transaction, however, an exchangeable share transaction is costly, time-consuming and complex. In addition, not every U.S. acquirer is familiar with exchangeable share deals, and the prospect of having to jump through extra hoops may discourage a purchaser from pursuing a marginal transaction. Exchangeable share structures also create their own securities and tax law problems. The Canadian E-Business Roundtable described the situation succinctly in their September 2000 submissions to the House of Commons: In many cases, the original Canadian investors in the merged company end up with reduced liquidity for their investment relative to their U.S. counterparts and thereby become second class citizens in the company. In 2000, the Canadian government announced a proposal to introduce draft legislation that would implement a rollover for share-for-share acquisitions of Canadian targets by U.S. acquirers. However, the draft legislation has yet to be released.

Special Considerations for U.S. Investors


Certain amendments to the Canada-U.S. Tax Treaty which came into force in 2008 provide for the reversal of a long-standing position taken by the Canada Revenue Agency (CRA) on the applicability of treaty benefits to flow-through entities like a U.S. LLC. Formerly, the Canada-U.S. Tax Treaty contained no provisions which required to recognize the flow-through status of a limited liability company (LLC) incorporated in the U.S. Because the U.S. resident members of the LLC were taxed directly on their income and gains under U.S. tax law, and not the LLC itself, the CRA took the position that the LLC was not resident in the U.S for Treaty purposes. This status meant a U.S. LLC did not qualify for the limits on the rate of Canadian withholding tax on payments of dividends, interest and royalties, or the exemption from Canadian tax on capital gains realized on certain types of treaty-protected property (which may include shares of a Canadian corporation that do not derive their value principally from Canadian real property). One effect in particular was that the sale by the LLC of shares of a Canadian company led to a tax on the gain in Canada levied on the LLC as a corporation, and a tax on the gain in the U.S. on individual residents required to include the gain.

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This made investment in Canadian-incorporated private companies less attractive, even through a LLC is not itself taxed under U.S. tax law, and even if an individual member of the LLC resident in the U.S. may qualify for favourable tax treatment under the treaty. Problems could also arise if a U.S. investor is structured as a limited liability partnership. Depending on the attributes of the partnership and the legislation under which the partnership was formed, the CRA could take the view that the limited liability partnership should be treated as a corporation for tax purposes. In these circumstances, problems similar to those discussed above with respect to LLCs could arise, as the gain (or loss) resulting from the sale of shares of a Canadian company help by a limited liability partnership would be attributed to the partnership itself, not to its limited partners. Moreover, a partnership is generally not considered a resident for Treaty purposes, and therefore the U.S. limited liability partnership may not qualify for the benefits that are typically available to U.S. residents under the Treaty. Pursuant to the recent amendments, if a U.S. resident derives an amount of income, profit or gain from an entity (other than an entity resident in Canada), and the tax treatment of the amount is the same as if the amount were derived directly by the investor10, that amount is considered to be derived by the U.S. resident. Since U.S. residents are typically afforded favourable tax treatment for Canadian tax purposes, the amendments in effect eliminate many of the undesirable Canadian tax consequences mentioned earlier of investing in a Canadian-incorporated private company through a U.S. LLC. The favourable changes also extend to a limited partnership. As long as U.S. tax law looks past the limited partnership and requires individual partners to include in income amounts derived therefrom, the CRA will look through the limited partnership, notwithstanding its lack of residence for Treaty purposes, and assess Canadian taxes based to the limited partners U.S. residence. Another change to the foreign investment landscape revolves around the disposition of shares of a Canadian-incorporated company which are not publicly traded. Under the Income Tax Act (Canada), a disposition of taxable Canadian property by a non-Canadian vendor obliges the purchaser to withhold 25% of the gross purchase price, which is remitted within 30 days of the end of the month in which the acquisition occurs. The amount withheld is intended to cover the potential tax liability of the non-resident seller. To avoid the withholding, the seller may apply for a certificate of compliance (popularly known as a Section 116 certificate), which is usually granted upon demonstration of an applicable exemption from Canadian tax under a treaty, by paying 25% of the capital gain on the property, or by furnishing acceptable security in respect thereof. Where the non-resident seller is exempt from paying capital gains tax in Canada pursuant to the CanadaU.S. Tax Treaty, the granting of the treaty exemption for a Section 116 certificate is discretionary and may, in some circumstances, be difficult to obtain if qualification for the exemption cannot easily be proven. Considering that there can be significant delays before requests for a Section 116 certificate are

10 The requirement that the amount of Canadian-source income, profit or gain receive the same tax treatment in the U.S. is met if the timing of the recognition of the amount, character of the amount and quantum of the amount are the same. Typically, a LLC which is treated as a partnership for U.S. tax purposes is in a position to satisfy this requirement, as is, by definition, a limited liability partnership.

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processed11, and the risks posed by volatile markets in the interim, the perception of some U.S. investors was that investing in a Canadian incorporated company was a non-starter notwithstanding tax and other advantages of doing so. Amendments to the Income Tax Act (Canada) passed effective March 4, 2010 change the definition of taxable Canadian property to the benefit of non-resident investors. Formerly, shares of corporations resident in Canada which were not publicly traded were included in the definition of taxable Canadian property, which triggered the need for sellers to apply for Section 116 certificates to recover the amount withheld by the purchaser that they were entitled to as U.S. residents under the treaty. The new definition narrows the scope of taxable Canadian property by excluding shares of corporations that do not, at any time during the 60-month period prior to the time of determination, derive more that 50% of their value from real or immovable property in Canada, Canadian resource property, timber resource property, or options or interests in respect of the foregoing. The effect of this change is that purchasers no longer need to withhold 25% of the purchase price upon acquisition of shares of most privately-held Canadian companies from sellers resident in the U.S., and it obviates the need for sellers to apply for a Section 116 certificate before the full purchase price may be received. Finally, while U.S. tax law is outside the scope of this publication, it is our understanding that shares of a Canadian company cannot be qualified small business stock (QSBS) so as to qualify for special treatment under U.S. tax laws. Gains on QSBS held for the requisite period of time may be taxed at lower rates, or even rolled-over on a tax-free basis into new qualifying investments. Investment in QSBS is a tax-effective vehicle for U.S. venture capital funds structured as limited partnerships or LLCs but is only available in respect of portfolio companies incorporated under U.S. law.

Corporate Considerations
From a company perspective (but not necessarily from a minority shareholder perspective), there are certain inherent advantages to incorporating in the State of Delaware. The Delaware General Corporation Law is generally more permissive and less protective of minority shareholder rights compared to the CBCA and provincial corporations statutes. For example, Canadian corporations must conduct shareholder business either by unanimous written resolution (i.e., a resolution signed by each and every shareholder permitted to vote) or by an annual or special meeting of the shareholders. For Delaware corporations, shareholder approvals can be obtained by the written consent of the majority of shareholders. At first blush this may seem like a relatively minor difference. However, financing transactions which generally require some form of shareholder approval are much easier to co-ordinate if management does not have to track down each and every shareholder to sign written resolutions (which can be difficult or impossible to obtain if, for example, there are disgruntled and departed founders who continue to hold shares), or hold a shareholders meeting which may entail delivering a notice, preparing information circulars and the like. A further consideration if a company will have U.S. investors represented on the board is director residency requirements under the CBCA and provincial corporations statutes. Recent amendments to the CBCA have

11 Some CRA tax services offices may respond more quickly than others. It is advisable to submit a request for a Section 116 certificate at least 30 days before a non-resident actually disposes of the shares so that the CRA has sufficient time to review the transaction and consider whether a treaty exemption applies.

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liberalized residency requirements such that only 25% of directors (or at least one director, in companies having fewer than four directors) must be resident Canadians. It should be noted, however, that corporate legislation of some Canadian provinces, such as New Brunswick and Nova Scotia, do not have director residency requirements.

Weighing the Options


Based on the discussion above, the interests of Canadian founders and U.S. investors can be in direct opposition when it comes to deciding whether to incorporate in Canada or the United States. On balance, for businesses intended to operate primarily in Canada, we tend to support Canadian incorporation when one or more of the following factors are in play: The company will be majority-owned by Canadians so as to qualify as a CCPC. This consideration is paramount if most of the founders and key employees are Canadian residents, or if the company wishes to rely on refundable SR&ED tax credits to fund its startup operations. The company anticipates that it can fund its operations and execute its business plan without having to seek significant amounts of venture capital from U.S. sources. A labour-sponsored venture capital corporation or the Business Development Bank of Canada has stepped up to be a lead investor at an early stage. The company is a smaller, more speculative venture that cannot afford the extra expense of U.S. incorporation. Nevertheless, U.S. incorporation may be advantageous under the following circumstances: The founder group and prospective investors are primarily non-residents, such that the company would not otherwise qualify as a CCPC. A principal lead investor is a U.S. limited liability company or limited partnership. The anticipated exit for the company is acquisition by a U.S. entity. As it matures, the company anticipates shifting the bulk of its operations south of the border. As AIM is not a prescribed stock exchange for the purposes of the Income Tax Act (Canada), non-resident shareholders of a Canadian-incorporated corporation that does an AIM-only public offering will be required to obtain a clearance certificate from CRA prior to disposing of shares. In most cases, it is relatively easy to make an informed decision regarding jurisdiction of incorporation. Conflicts can arise, however, where a company would otherwise be a CCPC, but the initial investor group includes U.S. investors who understand the risks of, and are opposed to, investing in a Canadianincorporated entity. In this situation, the incorporation decision will be a factor of the relative bargaining strength of the Canadian founder group and U.S. investors. If the stakeholders ultimately decide on U.S. incorporation, and the company would otherwise be a CCPC, (i.e. not controlled, directly or indirectly, by one or more non-residents of Canada or public corporations) it may be possible to establish a cloned Canadian company, the ownership of which mirrors the shareholder group of the U.S. company. The Canadian company will then be a CCPC, and will be eligible for refundable SR&ED tax credits at the enhanced rate for SR&ED activities it carries on and lower taxes on the first

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$500,000 of active business income.12 If the parent is U.S.-incorporated, however, there is no practical way to recapture the $750,000 capital gains exemption and the stock option treatment that would ordinarily be applicable to CCPCs. A further consideration is the extra accounting and legal costs entailed in issuing equity to the shareholder group at both the U.S. parent and the Canadian subsidiary levels, although in our experience these costs are more than offset by the tax benefits.

Exporting a Canadian Company to the U.S.


If a corporation is incorporated in Canada and it is later decided to move to the United States, it is possible to export a Canadian company to Delaware or another U.S. jurisdiction. Generally, an export (or continuance) will not result in shareholders being deemed to have disposed of their shares, resulting in a capital gain. The corporation will have a deemed taxation year immediately before the emigration and will be deemed to have disposed of its property for proceeds equal to the fair market value, and liable to pay tax equal to 25% of the excess of the fair market value of its assets over the total of the paid-up capital13 of its shares and any outstanding debts, at the time it ceases its Canadian residency. This can be avoided if the corporation adopts an exchangeable share structure. Implementing an exchangeable share structure, however, will typically be more expensive.

Capital Structure
At the time of incorporation, the corporation will be established with one or more classes of shares. Under both the Canada Business Corporations Act and the Business Corporations Act (Ontario), where a corporation has only one class of shares, the rights of the holders of such shares must include the right to vote the right to receive any dividend declared by the corporation and the right to receive the remaining property of the corporation upon its dissolution. Where more than one class of shares is created, each of the above listed rights must be attached to at least one class of shares, but all of the rights are not required to be attached to any one class. More than one class of shares will be created, either at the time of incorporation, or at a later date by the filing of Articles of Amendment, when a disparity in the rights of various groups of shareholders is desired. For example, in order to attract investment to the corporation, the corporation may create a class of shares to be issued to investors that give the investors the right to receive fixed dividends on a periodic basis and/ or the right to receive dividends and a return on investment before holders of another class of shares. These classes of shares are commonly referred to as preference or preferred shares.14 Special tax rules may apply to the holders and, in some cases, to the issuing corporation in respect of dividends and deemed dividends received on such shares. In a typical case, preferred shares will not be created until immediately prior to the closing of a financing transaction. As a result, most technology startups will be established with one class of shares (i.e. common shares). An exception to this general rule applies when assets are to be transferred into the newly formed corporation. In such cases, a simple class of preferred shares is typically issued to the transferor,
12 See note 8. 13 The starting point for computing the paid-up capital in respect of a class of shares of a corporation for Canadian tax purposes is the stated capital of the class as determined under the applicable corporate statute. 14 For further discussion regarding preferred shares see Chapter 7 Financing the Business.

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so that the transfer of assets can occur on a tax deferred or roll- over basis and the value of the shares received for the assets transferred is frozen. Future growth of the company is therefore reflected in the common shares. While the number of shares issued upon incorporation is usually not as important as the percentage of ownership they represent, founders should be mindful of the fact that as the company grows and new investors acquire holdings in the company, the founders will generally lose control over future issuance of shares and stock splits. In addition, as the company matures, the purchase price of its shares will typically increase. As a result, it is a good idea for founders to purchase all of the shares they intend to have at the time of founding the company, with the understanding that their percentage of ownership in the company will be diluted over time.

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Issuing Shares To Founders


Dividing the Ownership Pie
In most technology startups, the initial shareholders are the individuals who originally conceived the idea for the business, and often the first individuals recruited to help get the business off the ground. This initial group of individuals is commonly referred to as the founders. In most cases, as an incentive to join the new business, the founders will be given the right to subscribe for shares in the corporation. It is at this point that the founders must make one of their first important decisions: how many shares should each founder be entitled to purchase? The tendency is for each founder to regard himself or herself as equally important to the success of the business and thus deserving of equal treatment. While this may be accurate in some cases, it is often true that a startup corporation will have one or two individuals who are the driving force behind the business, with a few other individuals who play a supporting role, or, in less fortunate circumstances are merely hangers on. As a result, it is important to objectively assess the expected contribution from each individual participating in the business, and take this into account when determining each individuals ownership stake in the company.

Valuing Founders Shares


At the time of its founding, the corporation will typically have no operating history, very few assets, and thus little value. As a result, founders shares are usually issued at a nominal price, such as $0.0001 per share, paid in cash.

Income Splitting
A key tax-planning strategy for many founders is income-splitting with family members. Income-splitting refers to the division of income that would otherwise be received by one person who is in a high income tax bracket (such as the founder) to another person who is in a lower income tax bracket. In general, when income otherwise receivable by one family member is split among several family members, some of whom may be subject to a lower rate of income tax, the total tax liability of the family will be lower and the amount of after-tax income remaining to fund the familys expenses will be greater. In the case of a startup company, income-splitting may be achieved by having some or all of the shares that have been allocated to the founder issued instead to (a) a low-income spouse, adult children, or other family member of the founder; (b) a trust for the benefit of these family members; or (c) a holding company owned by these family members. In many cases, subject to specific rules in the Income Tax Act (Canada) which may be attribute the income back to the higher income earner, taxable capital gains realized by the family members (or in certain cases, dividends) on any sale of the shares can then be taxed in the hands of the family members at a lower rate than if they had been received by the founder personally (unfortunately, this is not the case for dividends paid by a startup company to a child under the age of 18, which are generally taxed at the highest marginal rate).15 In addition, if the shares of the startup company qualify at the time of a sale for the $500,000 capital gains exemption16, each family member who realizes a capital gain

15 This is commonly referred to as the kiddie tax and is designed to discourage the redirection of income to a minor child. 16 See Chapter 3, Section 3.6 for an explanation of the $500,000 capital gains exemption.

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in respect of the sale of qualifying shares may be able to claim the exemption. For example, if the founder, his spouse, and their three children all hold shares, up to $2,500,000 of capital gains may be realized by the family tax-free.

Shares Held Directly by Family Members


In the case of a financially responsible spouse or adult child (age 18 and older) of the founder, direct share ownership may be the simplest way to document the share issuances and the most likely to avoid unforeseen tax consequences in the future. However, unless a shareholder agreement provides otherwise, each family member may act independently in matters such as electing directors and determining whether to accept an offer to purchase his or her shares. This fragmentation of ownership may be unacceptable to the founder, as it will potentially dilute his influence over the affairs of the corporation. In addition, the other founders of, and investors in, the corporation may not want to become partners with persons who they do not know and who may not have the same level of involvement in, and commitment to, the business. Finally, it may be inconsistent with the founders personal estate plan to give up absolute ownership of a potentially valuable asset at a time when the founder cannot anticipate his future circumstances and those of his or her family. Direct share ownership is also not appropriate where the family members of the founder include young children, mentally or physically disabled people, or financially unsophisticated or imprudent family members who might pledge or otherwise mismanage the shares. Some of these issues, however, can be addressed through the use of a voting trust agreement in favour of the founder.

Shares Held By a Family Trust


One alternative to direct ownership of shares by a founders family members is to issue shares to a family trust. The beneficiaries of the trust may include the founder himself or herself, along with the founders spouse, children, or other persons as desired. Unlike with direct ownership, the beneficiaries of the trust will not have any direct access to the shares. Instead, the trustees of the trust, who may in certain circumstances include the founder, are registered as a shareholder of the startup corporation and have all the rights and responsibilities (such as voting rights) of any other shareholder in respect of the shares held by the trust. The trustees typically have complete discretion as to whether to invest the assets of the trust (including any dividends paid out on shares held by the trust and taxable capital gains realized on a sale of shares by the trust), or to distribute them to or on behalf of any one or more beneficiaries, depending on their respective needs and tax circumstances. Capital gains and dividends received by the trust and then paid out to a beneficiary retain their character in the hands of the beneficiary, and so are still subject to favourable tax treatment (including the $500,000 capital gains exemption, if the beneficiary has not already used it in respect of a previous investment). Because of the control and flexibility afforded by a family trust, it is probably the most common vehicle for income-splitting in a business context. However, there are also disadvantages to a trust in comparison to direct ownership. The founder will incur costs on the initial creation of the trust (the drafting of the trust agreement) and likely also on its annual maintenance (the preparation of tax returns, the updating of a statement of all transactions made by the trustees, and the payment of trustees fees). Any income retained in the trust (rather than distributed) will be taxed at the highest marginal rate. Unless the assets of the trust are distributed beforehand or a potentially costly reorganization is implemented, all accrued capital gains on the

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trust property will be taxed on the 21st anniversary of the creation of the trust, whether realized or not. The trust agreement must be very carefully drafted to avoid other negative tax consequences. Finally, the trustees of the trust have certain responsibilities to the beneficiaries which may result in financial liability.

Shares Held by a Holding Company


A second alternative to direct ownership of shares by a founders family members is to issue shares to a holding company controlled by the founder or family members of the founder. A holding company has the same advantages over direct ownership as a family trust in terms of concentrated ownership of the startup company and retention of control over the startup company by the founder. However, the costs of setting up and maintaining a holding company would generally be equal to or greater than those associated with creating and maintaining a family trust, and, depending on the make-up of the board of directors of the holding company, the founder may have less control over, and flexibility in respect of, distributions to his or her family members. Most importantly, the $500,000 capital gains exemption would not be available to the holding company on the sale of shares of the startup corporation. To access this exemption, the family members would have to sell the shares of the holding company, assuming such shares meet the requirements of the Income Tax Act (Canada). Regardless of which structure is chosen, it is critical that the family member, trust or holding company that is to hold the shares of the startup company subscribes for them directly, and pays the subscription price out of his, her or its own funds. If the founder directly or indirectly funds the subscription price, or if the founder transfers shares to the family member, trust or holding company after the shares have increased in value (other than on a sale to the family member for proceeds equal to the fair market value of such shares), then the founder will generally be taxed on the dividends and may be taxed on the capital gains derived from the shares, even if those dividends and capital gains are received by the founders family members.17

Tax Planning and Valuation


While founders wish to purchase shares of the company at a nominal price, the company will want to generate working capital by selling its shares to investors at a higher valuation. If, however, the company sells shares of the same class at or about the same time to different individuals at different prices, the party purchasing shares at the lower price may have to treat the difference in price as taxable income. Ways in which to avoid such a scenario include: issuing shares to founders early on so that time passes before shares are issued to investors; creating value in the company prior to issuing shares to investors (value may be created in a variety of ways, including the writing of a business plan, recruiting key management personnel, developing a prototype, or entering into an agreement with potential customer or partner); and, issuing a different class of shares to investors. Another aspect of business formation with tax consequences for founders is the transfer of property to the corporation. Often, a founder will want to transfer certain property such as equipment or intellectual

17 Under the Income Tax Act (Canada), if the founder funds the subscription price or transfers shares to a spouse or common law partner, both income (such as dividends) and any capital gain on the disposition of the shares will be taxed in the hands of the founder: where the funding or transfer is to a related minor, only the capital gains and not the dividends will be attributed to the founder, however, as described above, the dividends paid by a startup company to a child under 18, will generally be taxed at the highest marginal rate.

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property to the corporation. In general, the transfer will be deemed to be a sale of transferred property for proceeds equal to the fair market value of the transferred property. To the extent the fair market value of the transferred property exceeds the transferors cost of such property, the transferor will have to pay tax on the excess amount, or capital gain. To avoid this consequence, the transferor and the corporation should consider making a joint election in the prescribed form under section 85 of the Income Tax Act (Canada) which permits certain transfers of property to a corporation to be made on a tax-deferred basis. The transferor must receive at least one share of capital stock of the corporation as consideration. This will defer the tax payable on any accrued but unrealized gain in respect of the property until the corporation disposes of the property or the transferor disposes of his or her shares in the corporation.

Vesting and Buy-back Rights


There are few things that create more resentment than the departure of a founder after only a short time with the corporation, who retains all of his or her shares and thus gets a free-ride on the efforts of those who stay behind. For this reason, startups often institute a vesting schedule that requires founders to earn their shares. These provisions are typically embodied in a Restricted Stock Purchase Agreement or Founder Restriction Agreement. A typical vesting arrangement allows the corporation to buy back all or a portion of a founders unvested shares at the time the founders involvement with the corporation ceases (e.g. through termination or resignation) at the lower of the price at which they were initially purchased by the shareholder and fair market value (or sometimes the higher of the two if termination is without cause). The vesting period is typically between three and five years, with a variety of formulas being employed to determine when shares will vest. For example, a commonly used vesting schedule features a one-year cliff (i.e., no shares vest during the first year of employment), with 25% of the shares vesting at the end of that year. Thereafter, an equal pro-rata portion of the remaining shares vest at the end of each month over the next four years. Whatever time period is selected, the goal is to set a vesting period which reflects the period during which the founder will have legitimately earned his shares. While some founders may be reluctant to self-impose a vesting schedule, where there is more than one founder, vesting conditions are in the groups best interest. In addition, sophisticated investors will often require that a vesting schedule or repurchase agreement be put in place as a condition of their investment. Taking the initiative to design and adopt a vesting plan will not only add to the founders credibility in the eyes of potential investors, but may also allow the founding group to escape a harsher plan imposed by investors. It may also avoid the problems that may be encountered when a founder refuses to co-operate with a proposed financing or acquisition.

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Shareholder Agreements
General
There is no legal requirement for shareholders to enter into a shareholder agreement, and it is possible for a corporation to be governed only by the applicable corporation statute, together with its articles of incorporation and by-laws. However, most shareholders find that this default scenario is not satisfactory. For example, minority shareholders may not be willing to subject themselves entirely to the will of the majority when important corporate decisions are made. On the other hand, majority shareholders may wish to have the right to compel minority shareholders to sell their shares to a third party who wishes to acquire all of the corporations outstanding shares. In general, a shareholder agreement can be used to ensure that each shareholders investment in the corporation will be dealt with fairly and in accordance with the rules set out and agreed to by the parties. In the case of a technology startup that intends to seek external investment, it is often debated whether founders should enter into a shareholder agreement prior to receiving outside investment. As the outside investor will typically require significant changes to an existing shareholder agreement, some argue that negotiating and entering into a shareholder agreement before external investment is received is an unnecessary expenditure of time and money. Nevertheless, many founders find that a basic form of shareholder agreement is desirable even before outside investment is obtained. Care should be taken, however, to avoid provisions that require unanimous consent for actions such as the amendment of the corporations articles or the shareholder agreement itself, as a difficult shareholder can use these provisions to block an investment or a potential exit.

Key Provisions of a Shareholder Agreement


There is no such thing as a one-size-fits-all shareholder agreement. A typical shareholder agreement will deal with a number of complex issues, each of which must be tailored to the circumstances and the parties involved. For example, the founding shareholders of a corporation that has no plans to issue additional shares will have a different perspective on what should be included in a shareholder agreement than an investor who has invested significant funds in a corporation, but whose shareholdings do not give it control over the direction of the corporations business. The remainder of this chapter describes some of the key provisions that are typically found in a shareholder agreement for a startup technology company that has received funding from venture capital investors. The applicability of these provisions to a particular group of shareholders will depend on the circumstances of the shareholders and it is strongly recommended that the assistance of experienced legal counsel be sought to ensure that the interests and intentions of all of the shareholders are properly considered.

Unanimous Shareholder Agreement


Where a startup company has a small group of shareholders, it is common to require all of the shareholders to be become parties to the shareholder agreement (commonly referred to as a unanimous shareholder agreement). A unanimous shareholder agreement has special status under the CBCA and the OBCA in that it can be used to restrict the powers of the directors (under the common law, directors cannot rely on a non-unanimous shareholders agreement to fetter their discretion).

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When the shareholder group becomes larger and more disparate, however, a unanimous shareholder agreement can be unwieldy. If a non-unanimous shareholder agreement is used, minority shareholders who are not a party to the principal shareholder agreement should be required to enter into a separate agreement with the corporation (often referred to as a share restriction agreement). Share restriction agreements typically contain restrictions on transfer, a right of first refusal in favour of the company, a drag-along and confidentiality provisions, and sometimes provide for a company repurchase right.18

Management of the Corporation


One of the key issues to be addressed in a shareholder agreement is the management of the corporation. In particular, the following items should be considered: Board of Directors Where investors are to receive representation on the corporations board of directors, the shareholder agreement should set out the size of the board and the manner in which board members will be elected. One common method of selecting members for the board is to permit particular shareholders, or groups of shareholders, to nominate persons to serve as directors. For example, where the board is to consist of five directors, the shareholder agreement could provide that two directors be nominated by the investors (either by a majority vote or some other threshold), one director be nominated by the founders, and two directors be independent nominees agreed to by the investors and founders. In order to ensure that each of the respective partys nominees is elected to the board, the shareholder agreement should provide that each shareholder shall vote its shares to elect the directors nominated in accordance with the agreement. When nominating directors, it is important to consider the Canadian residency requirements for directors under the applicable corporation statute as well as any effect that the board composition may have on the corporations status as a Canadian-controlled private corporation (if applicable).19 Observer Rights Investors who are not represented on the board of directors may seek to have observer rights. An observer is entitled to be present at board meetings and to receive materials and information provided to board members, but is not entitled to vote on matters before the board. Observer rights are usually only granted to investors who have made a significant investment in the corporation. As observers tend to be added through subsequent rounds of financing, it is often a good idea to provide for a mechanism to remove an observer when the appointing shareholders shareholdings in the corporation fall below a designated threshold. Some shareholder agreements include provisions permitting the board of directors to exclude observers from discussions of a highly sensitive nature.

18 See Chapter 4, Section 4.5 for further discussion of repurchase rights. 19 See Chapter 3, Section 3.6(b)(i) for a definition of a Canadian-controlled private company.

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Procedural Matters A shareholder agreement will often include provisions dealing with the frequency of board meetings, the manner in which a meeting may be called, what constitutes a quorum for a board meeting, and other related matters. In drafting these provisions, the corporations by-laws should be reviewed to ensure there are no inconsistencies between the by-laws and the shareholder agreement.

Covenants of the Corporation


Investors will often require the corporation to agree to certain obligations with respect to the information provided to investors and the operation of the corporation. For example, the shareholder agreement might provide that the corporation must prepare and deliver to the investors unaudited quarterly and audited annual financial statements within prescribed time- frames. The shareholder agreement may also include obligations regarding the acquisition and maintenance of directors and officers liability insurance.

Dealing with Shares


A shareholder agreement should clearly set out any restrictions or obligations related to the shares of the corporation. The following are some examples of such restrictions and obligations: Restriction on Transfer of Shares A shareholder agreement will typically include a general prohibition on transferring shares, or any rights or obligations under the shareholder agreement, except as specifically permitted in the shareholder agreement or as consented to by the shareholders (or a defined group of shareholders, e.g., holders of x% of the preferred shares). Permitted Transfers Despite the general restriction on transfers, the shareholder agreement should provide for sufficient flexibility so that shareholders can deal with the shares in an efficient manner for tax planning purposes. For example, for shareholders that are investment funds, the shareholder agreement may provide that such investors can, upon notice to the corporation, transfer all or any part of their shareholdings to an affiliate of the investor, a fund under common management or control with the investor, as part of a distribution of assets to the shareholders, limited partners, the investors own investors or members, or in the sale of all or substantially all of the assets of the investor. Where the shareholder is an individual (e.g., a founder), such shareholder should ensure that the shareholder agreement permits him to transfer his shares to a corporation wholly-owned by the shareholder or his family members, a custodian, trustee (including RRSP, RIF, IRA or similar retirement or investment fund) or other fiduciary for the shareholder and/or his family members, or any other person if such transfer is effected pursuant to the shareholders will or, where there is no will, applicable laws dealing with the succession of property upon death. In case of a permitted transfer, the shareholder agreement should state that any transfer is conditional upon the transferee agreeing to be bound by and becoming a party to the shareholder agreement. Right to Repurchase In addition to the general restrictions on transfer, it may be desirable to include a right for the corporation to repurchase shares owned by a founder on the death, disability or insolvency of the founder, or on the involvement of the founder in a division of net family property as a result of marital breakdown. Such a repurchase right may instead be included in a separate founder share repurchase agreement.

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Pre-emptive Rights In order to prevent their ownership interest from being diluted by future issuances of shares, investors will typically require that they be given the right to participate in any subsequent offering of shares, options, warrants or other securities. In granting such rights, one should consider the following: if the right extends to a founder/employee, extinguishing the right if the founder leaves employment of the company; including a minimum ownership threshold, below which the shareholder loses its pre-emptive right (e.g. 5%); whether shareholders will have the right to subscribe for more than their pro rata share of securities if not all of the shareholders elect to exercise their pre-emptive rights (i.e., oversubscription may adversely impact the ability to bring in new investors); and issuances of securities that should not trigger pre-emptive rights (e.g., (a) up to X number of common shares issued under the corporations stock option plan, (b) common shares issued on conversion of, or as a dividend or distribution on preferred shares, or (c) common shares issued on the exercise or conversion of any other disclosed security or right existing as of the date of the shareholder agreement). Right of First Refusal A right of first refusal affords shareholders the opportunity to purchase the shares of another shareholder who wishes to sell his shares to a third party. Prior to selling his shares, a shareholder who is subject to a right of first refusal must first offer his shares to those shareholders who hold a right of refusal. In addition to determining whether the obligation of a right of first refusal applies to all shareholders or a subset of all shareholders (e.g., founders), one of the most important considerations in negotiating a right of first refusal provision is whether the selling shareholder must first obtain a bona fide offer from a third party before offering the other shareholders the first right of refusal (often referred to as a hard right of refusal). The alternative is that the shareholder who wishes to sell his shares makes an offer to the other shareholders and, if such offer is not accepted, may make the same offer to a third party within a prescribed time-frame (often referred to as a soft right or a right of first offer). Requiring the selling shareholder to first obtain a bone fide third party offer gives the remaining shareholders some comfort regarding the market value of the shares. It also allows the remaining shareholders to see all terms of the proposed transaction. Such a requirement, however, is usually regarded as being disadvantageous to the selling shareholder as the selling shareholder must expend time and money to negotiate the transaction with the third party. In addition, knowing that the other shareholders have a right of first refusal, a prospective buyer may be reluctant to enter into negotiations, especially if it does not receive assurances that it will be reimbursed for its amounts expended on professional and other fees during the negotiation process. Another important consideration is whether the non-selling shareholders must agree to purchase all of the shares being offered by the selling shareholder in order to exercise their right or whether they can purchase just a portion of the shares being offered. Selling shareholders will prefer the former, since it can be difficult to complete a sale to a third party for a fewer number of shares than was included in the original third party offer.

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Co-sale or Piggy-back Rights A co-sale right entitles the applicable shareholder(s), on a prorata basis, to participate in any third party offer made to purchase the shares held by one or more shareholders. Drag-along Rights Drag-along rights permit the holders of such rights to compel the other shareholders to sell their shares (or approve other transactions related to a sale of the business, such as a sale of assets) to a third party who has made such an offer. In order to trigger a drag-along, the approval of the holders of a specified percentage of shares (or class of shares) is typically required. In addition, a drag-along right should include conditions to the drag-along, such as a limitation on the type of representations and warranties that the shareholders who are forced to sell their shares must give to the buyer, a minimum purchase price, and restrictions on the type of consideration that may be used to acquire the shares (e.g., illiquid securities). The above list is not an exhaustive list of key items to be considered when negotiating a shareholder agreement. Rather, it is intended to illustrate the complex issues and interests that must be addressed when documenting the rights and obligations of shareholders. As most of these items will be raised during the term sheet stage of negotiations, it is important to involve legal counsel early in the process.

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Board Of Directors, Officers And Advisors


While a corporation has the capacity, rights, powers and privileges of a natural person, a corporation cannot act on its own. In order to conduct business, it requires directors, officers and shareholders. Under both the federal and Ontario business corporation statutes, directors are responsible for the management, or supervision of the management, of the business and affairs of the corporation. In many small, seed or early stage corporations, the board of directors will consist of one or more of the founders of the corporation. As the corporation matures, and especially where it brings in outside investors, the composition of the board will typically change, and the influence of outside directors will increase. Corporate statutes also provide a degree of flexibility and allow the directors to delegate certain powers to officers of the corporation. This added flexibility recognizes that directors often do not personally manage the day-to-day affairs of the corporation, but delegate this task to executives who are intimately familiar with the nuts and bolts of the business. Finally, the powers of the directors, and their ability to delegate to officers, may be restricted by a unanimous shareholders agreement. In this case, all or a portion of the directors powers will instead be exercised by those shareholders (or a third party) who assumes those powers under the unanimous shareholders agreement. In addition to having the powers of directors, however, such shareholders will also have the corresponding liabilities of the directors.

Qualifications of Directors
Both the federal and Ontario business corporations statutes impose minimum qualifications for any person who wishes to become a director of a corporation. A director: must be eighteen years of age or older; must not be a person who has been found incapable of managing property under the Substitute Decisions Act, 1992 or the Mental Health Act, or has otherwise been found so incapable by a court in Canada or elsewhere; must be an individual (e.g. a corporation cannot be a director); and must not be bankrupt. In addition to the requirements set forth above, both the federal and Ontario business corporations statutes impose residency requirements on boards of directors. Where a corporation is incorporated under the Canada Business Corporations Act or the Business Corporations Act (Ontario), at least 25% of its directors must be resident Canadians (provided that if there are less than four directors, at least one must be a resident Canadian).

Directors and Officers Liability


Individuals may be subject to personal liability as a consequence of acting as a director and/or officer. The application of personal liability is intended to ensure that directors are accountable to the corporation they serve, and are responsible for the failure of the corporation to meet certain of its legal obligations.

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General Duties Under Common Law and Corporate Statutes


The common law and corporate statutes each impose several duties on directors that may result in personal liability. Fiduciary Duty Directors are considered fiduciaries of the corporations they serve. This principle requires directors to act honestly and in good faith with a view to the best interests of the corporation, to put the corporations interests ahead of their own, and to avoid conflicts of interest. Conflicts typically arise where a director holds a personal interest in a material contract with the corporation or gains an opportunity because of information obtained in his position as a director. Directors are required to disclose all such conflicts and refrain from voting on any related resolution. Failure to disclose a conflict may make a director liable for any gain earned from the conflicting interest. Directors are also generally prohibited from taking advantage of a business opportunity that the corporation either had or was seeking. Taking advantage of such corporate opportunity may attract personal liability even where a director resigns prior to engaging in the opportunity, and the corporation suffers no demonstrable loss from the breach of fiduciary duty. Minimum Standard of Care Directors are required to provide a minimum standard of care in carrying out their responsibilities. This minimum standard is generally described in the corporate statutes as exercising the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. Courts generally apply the business judgment rule in evaluating whether the minimum standard has been applied, which is a focus on the procedure applied in coming to a decision, rather than the results of such a decision. Inside directors and individuals who hold other positions within management may also be held to a higher standard of care than outside or independent directors, since they are generally better informed about the corporations affairs. Delegation and Reliance While directors may delegate authority and responsibility to management, independent advisors and special committees, all work is performed under the general supervision of the directors. Directors are entitled to rely on the information provided by officers and other employees, provided that the directors have verified that the source is qualified and makes the proper inquiries when the work product is presented to them. Directors should keep in mind that they are liable for any acts or omissions of the board of directors carried out in their absence, since they are deemed to have consented unless they register their dissent according to the procedures set out in the governing corporate statute.

Specific Statutory Liabilities


Various provincial and federal statutes impose personal liability on directors. Some of these liabilities may arise even without the wrongful or negligent conduct of the director. For directors of early stage technology companies, some of the most commonly encountered statutory liabilities include the following:

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Actions in Contravention of the Business Corporations Statutes Under both the federal and Ontario business corporations statutes, directors who vote for or consent to a resolution authorizing any of the following actions are jointly and severally liable to restore to the corporation any amounts distributed or paid (that are not otherwise recoverable by the corporation) as a result of: a purchase, redemption or other acquisition of shares contrary to the relevant legislation; a payment of commission contrary to the relevant legislation; a payment of a dividend contrary to the relevant legislation; a payment of an indemnity contrary to the relevant legislation; a payment to a shareholder contrary to the relevant legislation; and the issuance of shares for inadequate consideration.

Employee-related Liabilities Directors are personally liable to employees of the corporation for up to six months of unpaid wages payable for services rendered while the directors served the corporation. In Ontario, directors are also personally liable for up to twelve months of vacation pay that accrued while they were acting as directors to the corporation. Directors can also be held liable for a corporations failure to remit source deductions such as Canada Pension Plan and Employment Insurance on behalf of its employees, and for a corporations failure to comply with provincial occupational health and safety legislation requirements. Tax Legislation Personal liability arises for directors as a result of a variety of offences under federal and provincial tax statues, including a corporations failure to remit any prescribed amounts under the federal Income Tax Act and Excise Tax Act (covering the Goods and Services Tax).

Advisors
In most new and early stage private corporations, the board of directors will be relatively small and made up almost exclusively of the founders and representatives of investors in the corporation. For many corporations, however, the requirements for outside assistance extend beyond the capabilities of the board of directors. As a result, the establishment of advisory boards has become increasingly popular. An advisory board provides advice and guidance to the corporation, but does not have any decision-making power or management duties. Advisory boards are therefore attractive vehicles for businesses that wish to obtain advice from, and develop closer ties with, potential future board members, customers, industry contacts and other valuable advisors, without ceding any control over the corporations affairs. An advisory board not only offers the corporations management and board of directors a different perspective but, depending on the advisors stature and reputation, can also add credibility to the business. In addition, the absence of decision-making power and management duties makes advisory boards attractive to individuals who wish to play a role in a corporation but are reticent to take on personal liabilities associated with acting in the role of a director or officer of the corporation. This is especially true in the case of new and early-stage corporations that are unable to obtain directors and officers liability insurance (or for which the cost may be prohibitive). Care must be taken, however, to ensure that the advisory board does not overstep its bounds and take an active role in the management of the corporation. While statutory liabilities apply only to

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the directors and officers, non-statutory liability could be imposed on members of the advisory board who are seen to be exercising decision-making powers and actively guiding the corporations business. The mandate of an advisory board can be tailored to the specific circumstances and needs of the corporation. For example, a corporation may establish a general advisory board consisting of individuals of varying backgrounds, including persons with financial, technical and marketing expertise. Alternatively, a corporation may wish to establish one or more advisory boards with a narrower focus, such as marketing or research and development. It is important to consider the time required to recruit and maintain a constructive working relationship with the advisory board members. Directors and management must be committed to listening to the advisory board and must also provide members with the information necessary to giving meaningful advice. While having an influential group of individuals on the corporations advisory board can add prestige and value to the corporation, failure to consistently consult and inform the advisory board can harm the credibility of the corporation and its management team in the eyes of its advisory board members and those whom they influence. Compensation for advisory board members can come in many different forms. The most obvious form of compensation is cash. For many new and early stage corporations, however, cash is in short supply. The expectation of payment is also not the motivating factor for many individuals who join advisory boards. Instead, many prospective advisors are motivated by interest in the business, networking opportunities, or the chance to obtain professional engagements with the corporation in the future. Where an expectation of compensation is present, the corporation may consider issuing stock or stock options rather than paying cash.

Corporate Governance
While a full discussion of corporate governance is beyond the scope of this publication, it is important for technology startups to be mindful of corporate governance best practices. While some may consider corporate governance as an issue for public companies only, for a company that hopes to be acquired or go public in the future, it will be necessary, at the appropriate stage(s) in its development, to develop a more formal corporate governance structure and practices, including the creation of compensation and audit committees and the inclusion of independent board members. Observing proper corporate governance practices also helps establish credibility when seeking third party financing, even at the earliest stages of a companys development.

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Financing The Business


One of the biggest challenges faced by technology startups is raising enough money to fund their working capital, research and development, and marketing requirements. As the founders of most startups have a limited supply of capital, outside sources of capital must often be courted. Many founders underestimate how difficult and time consuming this process can be and are often unprepared when they first embark on fundraising efforts. In order to increase the businesss chance of attracting investment, an understanding of the following components of the fundraising process is important.

Is Your Company Ready to Raise Money?


Before starting a fundraising campaign, you should first be sure that your corporations immediate needs are financial and that your business is ready for investment. Sometimes businesses have more pressing concerns than money, such as the need for stronger leadership, better product or service ideas, or broader market validation. Your ability to raise capital will be seriously hindered by issues like these, as potential investors will regard them as reasons for not investing. For this reason, it is important that you identify and resolve these types of obstacles before you use up valuable time knocking on the doors of prospective investors. There are many programs available for technology startups designed to assist entrepreneurs and companies to prepare themselves to meet with investors and raise money, such as the MaRS Discovery District (MaRS), Ontario Centres of Excellence (OCE) and the Ottawa Centre for Research and Innovation (OCRI).

Stages of Funding
For many companies, fundraising is an ongoing (and seemingly never-ending) process. While the term startup is sometimes used to describe companies at any stage of development short of an initial public offering (or being acquired), most technology startups will have different funding requirements depending on their stage of development and other needs. Understanding the different stages of funding will help the founders and other company executives better anticipate the companys needs and the different sources of investment the company will need to seek. While the demarcation points between the stages described below are somewhat arbitrary, they serve as illustrations of how a companys needs and sources of financing will generally evolve. The earliest stage of financing is often referred to as seed capital. Seed capital refers to the first injection of capital into the company. This usually occurs at the idea stage, before a product or service has been developed, and is used to help fund some of the initial research and development expenditures. Seed capital is usually provided by the founders, either from the direct investment of money or through sweat equity20 (or both). Where the founders do not have sufficient capital to seed a company, investment from friends

20 Sweat Equity refers to the provision of an individuals time and services with no, or little, expectation of receiving payment. In some cases, individuals will agree to forgo payment, while in other cases they will agree to defer the receipt of payment. Corporations must be aware, however, that an employee cannot agree to contract out of the mandated minimum standards under applicable provincial employment standards legislation (e.g. minimum wage) and deferred payments remain a liability for the corporation and its directors. Therefore, a disgruntled employee may, despite his prior agreement, initiate a complaint against the company for its failure to provide the employee with his or her entitlements. For further discussion, see Chapter 8, Section 8.1(f).

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and family and angel investors may be sought. Certain government programs may also be available to assist with the research and development of new products and services as well as funding commercialization efforts such as OCEs market readiness program and MaRS business project funding. The next stage of financing is sometimes referred to as the A round. At the A round stage, a company will typically have made significant progress in its product or service development and is beginning to engage customers in discussions regarding the testing or purchase of its products and services. At this stage, expenditures typically still far exceed revenues generated, and profitability may still be several years away. A round financing for startups is usually provided by angel investors, some venture capitalists, and in some cases, strategic partners, customers and government agencies such as the Business Development Bank of Canada (BDC), Export Development Canada (EDC) or the Investment Accelerator Fund (IAF). If, after receiving A round financing, the company is not able to generate sufficient revenue to fund its operations, the company will be required to seek additional rounds of financing. In many cases, the funds raised at the next round of financing will continue to be used primarily for research and development purposes, but as the company matures and its products are brought to market, more of its funding will be devoted to the sale and marketing of its products. Venture capital funds and government agencies that focus on early stage investment opportunities and strategic partners (particularly larger distribution partners) are the typical sources of capital at this stage. Banks and other traditional lenders are usually wary of lending money to companies at this stage (or earlier stages), as they have not developed a dependable revenue stream. The final stage of funding is expansion capital. At this stage, the company has a history of sales growth and, if not yet profitable, is on a course to sustainable profitability. If profitable, all of the companys profits are being reinvested into the company, but additional capital is required to expand the business into new markets or new product lines. Sources of expansion capital include venture capitalists, banks and other commercial lenders, strategic partners, and the public markets through a public offering of shares.

Types of Financing
Generally speaking, a company will seek to obtain money in one of three ways: issuing shares (equity), borrowing money (debt) or issuing a hybrid instrument such as a loan that is convertible into shares. All three are discussed below, but the most common for technology startups are the equity and hybrid investments.

Debt Financing
While debt financings can take a variety of forms, the source of such financing for most businesses includes banks and other institutional lenders. To a lesser extent, debt financing is also sourced from other shareholders or related persons and even from trade creditors, who frequently offer their products and services on customary trade or payment terms. Debt Financing by Banks and Other Financial Institutions Although a loan may either be secured or unsecured, in most instances, security for borrowings will be required and, in certain cases, guarantees of the shareholders or other related parties will also be requested.

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The form of security required will depend upon a number of factors, including whether the loan is payable on demand, in installments over a specified term, or at a specified maturity date. Operating loans are usually payable on a demand basis, whereas term loans are usually paid in installments over time subject to the lenders right to accelerate the entire loan balance upon the occurrence of one or more certain specified events of default. Most credit facilities are secured by more than one form of security notwithstanding that there may be overlapping security. In Canada, the tendency for banks is to take and hold a number of different forms of security, even though one form of security may legally suffice. For many companies, borrowing money from a bank or other commercial lender will not be possible during its early stages. This is due to the lack of revenues necessary to make payments on the debt and the absence of tangible liquid assets to secure the debt obligation (i.e. with regard to technology companies, banks will not secure a debt solely against the companys intangible intellectual property). Debt Financing by Shareholders and Other Individuals Generally speaking, when making loans to a company, shareholders, or other individuals advancing loans, should obtain security for any and all such advances to the company. Where security is taken, the shareholders and other individuals who advance the loans will have priority over the claims of unsecured creditors (including most trade creditors). It should be noted, however, that banks and other institutional lenders normally require that shareholders agree to postpone and subordinate their security in favour of the security held by the bank or institutional lender. In addition, future equity investors such as venture capitalists and government funding agencies will typically require that the money they invest go towards the operations of the company, and not to the repayment of debt owed to the shareholders or related persons.

Equity Financing
An alternative to debt financing is equity financing. Equity financing refers to the raising of capital through the sale of a corporations shares and/or other securities. In the case of a technology startup, the class of shares offered to investors will typically be created as part of the financing and will be given attributes that are specifically tailored to the requirements of the investor(s). Equity investment is usually considered to be a riskier form of investment, as there is no guarantee that the value of the shares purchased will increase, or that a buyer will step forward to purchase the shares when the investor wishes to sell his shares. This is particularly so when the investment is in a private company as opposed to a public company whose shares are listed on a stock exchange and traded freely by the public. As a result, equity investments in private companies will generally be made only by persons connected with the business or operations of the corporation, or by certain investors who are less risk-averse and who have been established to provide merchant banking, mezzanine financing or venture capital investments for startup and early stage corporate ventures. Regardless of the stage of funding, when issuing shares, a corporation must comply with applicable securities laws. Non-compliance can result in fines and penal sanctions, and give purchasers of shares a rescission right that can compel the corporation to refund money received from the sale of its shares. For new corporations, one of the most important factors is to ensure that any issuance of its shares will be exempt from the costly process of filing a prospectus.

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Compliance with applicable securities laws is not necessarily a costly endeavor, provided that counsel from a lawyer who is experienced in the area is obtained before shares are offered to investors. For further discussion regarding securities law compliance, please see Section 7.5 of this chapter.

Hybrid
In addition to straight debt and equity financings, some financing vehicles include elements of both. For example, an investor may offer to lend money on the condition that it may be converted into equity upon the occurrence of certain defined events, such as a significant or qualified financing that exceeds a defined threshold amount. A convertible loan gives the investor the security associated with a traditional debt financing, while allowing for participation in the corporations growth through the conversion to equity. The instrument most typically used is a convertible debenture or promissory note that has many of the features of a loan agreement such as positive and negative covenants and defined events of default, but also includes a mechanism by which the loan may be converted to equity either automatically in certain circumstances or at the option of the investor.

Sources of Financing
As discussed above, the primary method of obtaining financing for a technology startup will be equity financing or convertible debt. Understanding the different sources of financing and the expectations of each type of investor is crucial to planning a successful fund raising campaign.

Founders
An early infusion of capital into a company will typically come from the founders. Not only is this an obvious first source of capital, financing from founders is an important signal to future investors of the founders commitment to the business.

Friends and Family


Many founders will next turn to friends and family as a potential source of capital. When approaching friends and family for investment, an understanding of their expectations is crucial, as misunderstandings and unrealistic expectations can seriously harm even the closest relationships. For example, you should fully understand whether the investment is being made as love money, with no or low expectation of return, or whether the family member or friend expects to see a significant return on their investment in several years. In either case, you should ensure that the risks associated with the investment are clearly explained to your family and friends.

Angel Investors
Angel investors are usually successful business people who have sufficient cash available to invest in startup businesses and take the high risks that investing in technology startups entails. Most angel investors are motivated not only by the opportunity for a significant return on their investment, but by the desire to be involved in an exciting new venture. In many cases, their investment decisions rely less on formal due diligence and more on their confidence in the capabilities of the founders and, to some extent, their own knowledge and experience of the sector in which the startup company will operate.

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In general, angel investors tend to invest in areas they know (often related to their past business or employment experience) and in close proximity to their home base. Although the environment for angel investor financings has been a difficult one over the past few years, with fewer acquisitions and initial public offerings providing returns to angel investors resulting in fewer angels willing to invest in early stage technology companies, angel investment remains an important source of financing at the seed or startup stage.

Venture Capital
A venture capitalist is a professional investor who manages an investment fund made up of capital invested by corporations, pension funds and/or wealthy individuals who are seeking higher returns than can be gained in the public markets. In seeking higher returns, venture capitalists typically provide capital for startup or expansion businesses where the potential for profit is high. As these types of investment are often very speculative, with a considerable risk of loss, venture capital is also sometimes referred to as risk capital. Most venture capitalists see their funds investments as long-term investments of typically four to seven years in duration. While in the days of the stock market bubble many technology-focused venture capital funds accepted common shares in exchange for their investment, todays venture capital investments usually involve the issuance of preferred shares that are convertible into common shares and provide the investor with a preference in the event the company is sold. As a venture capital funds investment is typically locked in for a long period of time with no interim repayment, a venture capital investor will typically demand certain information and approval rights as well as some level of participation in the management of the corporation. Typical terms of a venture capital financing are described below in Section 7.5(b)(ii).

Government Investment and Assistance


In recent years, with the decline in venture capital available to technology startups in Canada, federal, provincial and municipal governments have enhanced the programs available to invest in and to assist with the development of technology businesses. These programs come in a wide variety of forms and can play a critical role in determining whether, when, where, and how to establish or expand a business. No financial or business development plan for a Canadian business should be regarded as complete unless the opportunity to obtain funding and/or investment from available government sources has been explored. For example, MaRS has published a compendium of funding programs (both public and private) that includes over 250 sources of funding opportunities including direct and indirect investment, tax incentives and credits, grants, awards and prizes. While the programs are many, so is the competition for government investment and assistance. Most programs are over-subscribed and even though your company may meet all of the eligibility requirements, your application may be rejected because most programs are discretionary. Generally speaking, companies need to demonstrate how the funding will assist the business to generate significant revenues, create jobs and provide increased economic and social benefits well beyond the company itself. Government programs are typically focused on particular industry sectors with a view to assisting a business to achieve a certain milestone such as starting the company, developing a proof-of-concept, commercialization or international expansion. A business plan that is developed with the programs eligibility requirements and assessment criteria in mind has a greater chance of success.

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As mentioned above, there are many federal and provincial programs that invest in or grant support to technology startup businesses. In terms of investing, at the federal level, BDC and EDC are both active investors who typically invest alongside venture capitalists, and at the provincial level in Ontario, the IAF and the Ontario Emerging Technologies Fund (the OETF) invest in technology startups. The federal and provincial governments also provide funding assistance in the form of grants. For example, the National Research Councils Industrial Research Assistance Program has been providing funding to Canadian technology companies for many years. In Ontario, the Ontario Centres of Excellence Centre for Commercialization of Research has a number of matching and grant programs.

Strategic Investor
A strategic investor is an investor that makes investments as part of a larger business strategy. For example, a large technology company may invest in one or more startup companies that are developing technologies that are complementary to its business. In addition to participating in the growth of the startup, the strategic investor may also become a customer of the startup and will often regard the startup as a possible target for acquisition. While receiving funding from a high profile strategic investor may appear attractive to a startup company, some strategic investor funding comes with strings attached. A strategic investor may require as a condition of the financing that it be given special treatment with respect to the purchase of the startups product (e.g., time-limited exclusivity and/or most favoured customer pricing). Similarly, a strategic investor may require that it be given a first right of refusal with respect to the sale of the company. While conditions such as these may appear to be reasonable trade-offs for receiving funding, they highlight the potential for conflict between the investors financial interests in the investment and its other business interests. Such a conflict can lead to undesirable complications when the startup is attempting to commercialize its products or negotiating an acquisition by someone other than the strategic investor.

Anatomy of a Financing
Approaching an Investor
In most cases, fundraising is a very time-consuming process. In order to best allocate limited resources, research on potential investors should be conducted before they are approached for investment. While the Internet is a wonderful tool for finding information on some types of investors, friends, family and other entrepreneurs should also be approached for referrals. Professional advisors such as lawyers, bankers and accountants are also a good source for discovering sources of financing in the community. Through such investigations, answers to the following questions should be obtained: Who are the investors who may be interested in investing in my business?; What type of investments have the investors made in the past?; Are they actively looking to make new investments?; Are they knowledgeable about the industry in which my business operates?; Are they close enough to me to be able to provide advice and assistance in addition to money (if such advice and assistance is desired)?; and, In addition to money, what other value can the investor bring to the business (e.g, industry contacts) . When first approaching an investor, it is generally preferable to obtain an introduction from someone who is known to and trusted by the investor, such as legal counsel or accountants known to the investor.

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As most investors receive large volumes of proposals, a personal introduction from a trusted advisor and/or respected contact can help your proposal receive greater attention. Where a personal introduction is not possible, the investors preferred method of being contacted should be determined. In addition, attending local industry events where investors will be present (such as venture capital fairs) is a good way to introduce the business to potential investors or those who may be able to make useful introductions. While preferences vary on what and how much information investors wish to review when first considering an investment opportunity, almost all interested investors (except perhaps for family and friends) will want, at some point in time, to see a detailed business plan for the business. While the form of business plans varies, most business plans will include a short executive summary followed by a detailed plan covering the following topics: Overview of the company; Product and/or services to be offered; Size and growth rate of market; Competition and competitive analysis; Management team; Financial summaries; and Amount of financing being sought and proposed structure of financing.

It is important to remember that the executive summary and/or business plan will often be the first introduction to the business for investors. If it is not well thought out, researched, and presented, the business will likely not receive a second look. Care must also be taken to ensure that the executive summary and/or business plan does not qualify as an offering memorandum, or if it does, that it complies with applicable securities law regulations. 21

Structuring the Deal


It is difficult to describe a typical financing transaction, as each transaction will have its own unique idiosyncrasies. That being said, it is possible to highlight some of the common elements found in two types of financing transactions. Seed Financing In the case of most seed financings, its too early to determine a valuation of the business. Nevertheless, investors may agree to advance funds to the corporation in exchange for a convertible debenture that is secured against the assets of the corporation and/or the founders. The expectation is that the corporation will then seek further financing (e.g. within the next year), at which time a value for the corporation will be agreed to with the future investors (who may include the initial seed investors). At such time, the outstanding debenture (including interest) will be converted into the class of shares offered to the new investors at a price equal (or at a discount) to the price of, and on the same terms and conditions as, the shares that are offered to the new investors. If the subsequent financing is not concluded before the debentures maturity date, the debenture must be repaid.

21 See Section 7.6(d) for more information regarding offering memoranda.

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Series A Financing The term Series A financing or Series A round is usually used to describe a venture capital financing that represents a corporations first major investment from outside investors, typically venture capitalists. A Series A financing will usually commence with the negotiation and execution of a term sheet which sets out the major terms and conditions of the proposed financing. The term sheet will typically not be binding upon the investors and will be subject to the investors being satisfied with their further due diligence and the negotiation of binding agreements which incorporate the terms set out in the term sheet. While each financing varies to some degree, terms that will be considered by the parties in negotiating a typical Series A term sheet include the following:

Issuer
The issuer is the corporation in which the investors will be investing their funds. For reasons outlined in Chapter 3, the jurisdiction of incorporation and residency of shareholders will have significant tax consequences for both the corporation and its shareholders (including the potential investors). These consequences should be considered early in the negotiations and any arrangements designed to deal with them should be clearly set out in the term sheet.

Valuation
As part of the financing, the issuer and the investor must agree upon the value of the corporation. This valuation is usually referred to as the pre-money valuation of the corporation, as it represents the value of the corporation prior to the infusion of funding from the investment. While there are a number of methods which may be employed in calculating the value of a company, the usefulness of such methods in calculating the value of a startup technology company (i.e., with no revenue and few assets) is questionable. What is likely a more accurate description of the valuation process is that the investor(s) will estimate how much money will be required to fund the companys operations up to a specific milestone (e.g., initial product completion or first market trial) and then equate that amount to a percentage of the company that the investor(s) expect to receive (e.g. 30%-40%). The amount of money to be invested and the corresponding percentage of ownership that will be acquired by the investors will depend upon the stage of development of the company and the amount of capital that the corporation is expected to require before it becomes self-sufficient.

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The following tables illustrate the valuation of a hypothetical company from its inception to its Series A financing:

INCORPORATION
HOLDER Founder 1 Founder 2 COMMON SHARE 1,000,000 1,000,000 2,000,000 Pre-money Valuation: Price per share: Proceeds: Nil $0.000001 $20.00 TOTAL ISSUED 1,000,000 1,000,000 2,000,000 % TOTAL ISSUED 50% 50% 100%

SEED ROUND
HOLDER Founder 1 Founder 2 Seed Investors COMMON SHARE 1,000,000 1,000,000 1,000,000 3,000,000 Pre-money Valuation: Price per share: Proceeds: Post-money Valuation: $1,000,000 $0.50 $500,000 $1,500,000 TOTAL ISSUED 1,000,000 1,000,000 1,000,000 3,000,000 % TOTAL ISSUED 33.33% 33.33% 33.33% 100%

*Numbers have been rounded.

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SERIES A ROUND
Holder Founder 1 Founder 2 Seed Investors A Round Investors ESOP24 3,000,000 Pre-money Valuation: Price per share: Proceeds: Post-money Valuation: 3,000,000 $3,350,00022 $0.6723 $2,000,000 $5,350,00024 6,000,000 100% Common Shares 1,000,000 1,000,000 1,000,000 Series A Preferred Total Issued 1,000,000 1,000,000 1,000,000 % Total Issued 16.66% 16.66% 16.66% Options Total Fully Diluted 1,000,000 1,000,000 1,000,000 % Fully Diluted 12.5% 12.5% 12.5%

3,000,000

3,000,000

50%

3,000,000

37.5%

2,000,000 2,000,000

2,000,000 8,000,000

25% 100%

While existing shareholders will always want to see as high a pre-money valuation as possible, care should be taken not to fixate on the valuation attributed to the company in lieu of considering the other important elements of the investor term sheet. A high pre-money valuation can become much less attractive if the remainder of the term sheet contains onerous terms and conditions. Likewise, a valuation that might appear at first glance to be disappointing, may be more attractive if more favourable terms are contained elsewhere in the term sheet.

Funding and Milestones


Funding is often staged in tranches, with the corporation being required to meet performance milestones in order to trigger the payment of each tranche. 25 Milestones may include items such as the completion of customer trials, reaching certain revenue or financial goals, or the completion of a designated stage of product development. While the adoption of milestones is intended to help manage the investors risk, the corporation should be mindful that a milestone which seemed appropriate at the time it was agreed upon may become less relevant over time. As a result, management may find itself pursuing a milestone only to secure funding, and not because reaching the milestone will otherwise further the corporations objectives.

22 Pre-money valuation will almost always take into account all issued options, warrants and other securities that are convertible into shares of the corporation, as well as any options authorized but not yet issued as part of the corporations stock option plan. 23 Share price is determined by dividing the pre-money value of the corporation ($3,350,000) by the number of issued and outstanding securities (5,000,000), including the number of authorized but not yet issued options. 24 The size of an employee stock option plan will vary from company to company. Based on our experience, the typical size of a technology startup option plan is between 10% and 20% of the companys issued and outstanding share capital. 25 The use of funding milestones is particularly popular in the biotech sector.

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In addition, if the achievement of a milestone cannot be objectively measured, the corporation may end up in a dispute with its investors. For this reason, special care should be taken in negotiating milestones so that they are both meaningful and measurable.

Use of Proceeds
The term sheet will typically set out the purpose for which the funds are to be used. In a typical technology startup the funds will be used for working capital and research and development expenses. If the funds are to be used for some other purpose (e.g. the repayment of a debt), this should be expressly stated in the term sheet.

Securities Offered
While venture capital investments can include the use of debt instruments (such as convertible debentures discussed above), a typical venture capital investment will consist of convertible preferred shares. Like common shares, preferred shares represent an ownership interest in the corporation. The rights attaching to preferred shares, however, will differ from those attaching to the common shares and will typically provide the preferred shareholders with greater upside potential and downside protections for their investment. The preferred shares usually include a mechanism to permit conversion into common shares. The basic types of additional rights or preferences are discussed below. Typical attributes of a series of convertible preferred shares are as follows:

Board Composition
Investors will almost always seek representation on the companys board of directors. The exact ratio of investor representatives to the total number of directors will often depend on the proportion of ownership that the investors will hold following the financing. Where a substantial amount of money is being raised, it is not unusual to have a majority of the board of directors consisting of investor representatives. In keeping with current corporate governance guidelines, it is also increasingly common, especially for those companies that envision a potential public offering, to find boards of directors that include, and sometimes consist of a majority of, independent directors. Given the increased scrutiny and potential liability for company directors, however, it is becoming increasingly difficult to find individuals willing to serve as independent board members. 26

Dividend Preference
Particularly where preferred shareholders are limited to a one times liquidation preference (see below Liquidation Preference), investors will often want to receive a guaranteed rate of return prior to the payment of any proceeds to the holders of common shares. This is typically accomplished by giving preferred shareholders some sort of dividend preference or entitlement. For example, investors may negotiate that the corporation may not declare a dividend on the common shares until a specified dividend is paid on the preferred shares. In a venture capital financing, however, it is more common that the preferred shares will bear a set cumulative dividend (usually in the range of 6%-8% per annum) paid on the occurrence of a defined liquidation event, such as the sale of the company.

26 See Chapter 5, Section 5.2(b)(i) and (ii) for further discussion regarding board composition and observer rights.

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Voting Rights
Holders of preferred shares will typically be permitted to vote with the holders of common shares on an as if converted into common shares basis. The holders of preferred shares may also be entitled to nominate individuals to hold one or more seats on the board of directors, with all shareholders being required to vote for such nominees (pursuant to the terms of a shareholders agreement). The Canadian and Ontario business corporation statutes also give preferred shares the right to vote as a separate class of shares regarding certain fundamental changes, such as the creation of a senior class of shares.

Liquidation Preference
A liquidation preference describes the order in which funds are paid out to shareholders of the corporation on liquidation or certain other events. A typical liquidation preference will provide that, upon the occurrence of a liquidation, dissolution, winding-up, sale or merger, the holders of the preferred shares will be entitled to receive a fixed amount prior to the distribution of any amounts to the holders of the common shares. The fixed amount may be equal to the amount originally invested (often referred to as a one times liquidation preference) plus any accrued but unpaid dividends, or may be equal to a greater amount, such as two or three times the original investment. With a non-participating liquidation preference, investors will usually be allowed to choose between receiving the guaranteed fixed amount, or receiving the amount they would receive if they had converted their preferred shares to common shares and participated on a pro rata basis with the holders of common shares. With a participating liquidation preference, the investors will be entitled to receive the fixed amount in preference to the holders of common shares, and then will also be entitled to participate on a pro rata basis with the holders of common shares on an as if converted to common shares basis.

Redemption Right
A redemption right provides that the investors may require the corporation to purchase the shares held by the investors for a fixed amount. This right is included in order to permit investors to receive a return of their investment plus, in many cases, a redemption premium. Redemption rights are typically not exercisable by the investors until the lapse of a specified period of time. In the case of a Canadian corporation, redemption earlier than five years plus a day after the date of issue may result in adverse tax consequences for the corporation and the investors.

Conversion Rights
Preferred shares will almost always be convertible into common shares at the option of the preferred shareholder. The ratio used in determining the number of common shares into which preferred shares will be converted is usually calculated by dividing the original purchase price by the conversion price. The conversion price is usually calculated by taking the original purchase price and adjusting it to take into account stock splits, consolidations, stock dividends recapitalizations and anti-dilution protections (discussed below). In addition to the option to convert preferred shares, the provisions of most preferred shares will usually provide that such shares will automatically be converted into common shares on a qualified initial public offering by the corporation and upon the agreement of the holders of specified percentage of shares (or class of shares). The share provisions will include a definition of qualified initial public offering that
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sets out specific criteria regarding the minimum price per share, the minimum size of the offering, and in many cases the stock exchange on which the shares must be listed. Automatic conversion will sometimes also occur upon merger of the corporation with another corporation or by vote of a specified percentage of shareholders (or holders of specified class(es) of shares). Some preferred share provisions will also include a pay to play provision that requires current investors to purchase their pro rata share of a future share offering in order to keep some or all of their preferences. In one type of pay to play scenario, if the investor does not participate in the future offering, its preferred shares will be automatically converted to common shares. In another type of pay to play scenario, the investors preferred shares will be converted to another class of preferred shares that includes the same preferences as the original preferred shares, but without anti-dilution protection. Such pay to play provisions are intended to encourage investors to support the corporation when it is forced to raise additional funds.

Anti-dilution Protection
Preferred shares will almost invariably contain protection from dilution in the event of stock splits, recapitalizations and the like. In venture capital financings, preferred shares will often also contain protections against dilution caused by future offerings of shares at prices that are lower than the price paid by the current preferred shareholders. There are two basic types of price protection anti-dilution provisions. The first (and more company-friendly) is a weighted average adjustment. The weighted average adjustment adjusts the conversion ratio for the preferred shares lower based upon a calculation that weights the adjustment based on the number of shares sold in the new offering relative to the then current number of outstanding shares. A full ratchet adjustment, on the other hand, lowers the conversion price for the preferred shares to the price of the current offering, regardless of how many shares are sold. The full ratchet adjustment has the potential to be extremely dilutive to holders of shares without similar protections (e.g. common shareholders) and should, if possible, be avoided by such shareholders. In the current market, weighted average adjustments are the norm, whereas during the relatively tougher markets of the early 2000s, full ratchet adjustments were more common. Where anti-dilution protection of any type is negotiated, the founders should ensure that certain issuances, such as common shares issued pursuant to the corporations stock option plan or upon conversion of preferred shares, do not trigger an adjustment.

Protective Provisions
In addition to the voting rights described above, many investors wish to secure additional voting rights regarding matters not covered by the applicable corporate statute. While the corporation will want to limit the number of items for which separate preferred shareholder approval is required, investors will want to have control or veto rights over actions they consider to be important to protect their investment. While the list will differ from transaction to transaction, some of the matters that might require the approval of a specified percentage of shareholders (or the holders of a particular class or classes of shares) include the following: (a) a sale of all or substantially all of the assets of the corporation; (b) a merger, consolidation, sale of shares or other transaction in which holders of the corporations voting securities prior to such transaction will hold, after such transaction, less than 50% of the combined voting power of the continuing

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or surviving entity; (c) the liquidation, dissolution or winding-up of the corporation; (d) the repurchase or redemption of securities of the corporation (other than pursuant to a founder stock restriction agreement, the corporations stock option or other equity-based compensation plan, or the mandatory redemption right held by the preferred shareholders); (e) amendment to the corporations articles or by-laws, including the authorization of additional classes or series of shares; (f) the issuance of additional securities of the corporation (other than for a limited list of permitted issuances, such as the granting of stock options or the issuance of shares pursuant to the exercise of such options). These protective provisions are commonly incorporated into the shareholder agreement to be entered into by the investors and the current shareholders as part of the financing transaction. If, however, the shareholder agreement will not be a unanimous shareholder agreement and the corporate statute governing the corporation contains a prohibition on fettering the discretion of the corporations board of directors (unless by way of a unanimous shareholder agreement), the protective provisions can be included in the corporations articles of incorporation.

Pre-emptive Rights
Pre-emptive rights entitle investors to participate in any subsequent offering of securities, enabling them to maintain their percentage of ownership in the corporation. The corporation should ensure that the preemptive rights do not apply to certain types of issuances, such as the issuance of common shares pursuant to the corporations stock option plan. 27

Right of First Refusal


Investors will typically wish to have a right of first refusal on the sale of any of the shares owned by the founders (and, in some cases, the other investors). 28

Co-sale or Piggy-back Rights


A co-sale right entitles the investors to participate, on a pro rata basis, in any offer made to a founder (or other shareholders) to sell his shares.

Drag-along Rights
Drag-along rights entitle the investors (or a specified percentage of the investors) to require the other shareholders to sell their shares or vote in favour of a sale of all or substantially all of the assets of the company.

Registration Rights
Once a suitable (if not significant) return on investment is achieved or achievable, investors want to exit their investment in the company. One means of exiting their investment is to sell shares in a public market. Before shares can be sold to the public, however, they must be qualified by the filing of a prospectus in Canada, and/or registered by the filing of a registration statement in the United States. Registration rights set out the circumstances under which the investors can require the corporation to qualify and/or register the shares for sale to the public. Because the qualification/registration process is expensive and
27 See Chapter 5, Section 5.2(d)(iv) for further discussion. 28 See Chapter 5, Section 5.2(d)(v) for further discussion.

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time- consuming, the corporation will want to limit the circumstances in which it will be required to qualify/ register shares held by the investors.

Repurchase Option on Founder Stock


As discussed in Chapter 4, Section 4.5, it is common for investors to require that the corporation be given an option to purchase shares owned by a founder when and if the founder leaves the company.

Employment Agreements
If the founders and other employees of the corporation have not entered into satisfactory employment agreements with the corporation, many investors will require that founders enter into new employment agreements (often including non-competition and/or non-solicitation covenants) prior to the closing of the financing.

Employee Stock Option Plan


If it has not already done so, the corporation will usually be required to establish a stock option plan (or other equity-based compensation plan) prior to closing. The number of shares to be reserved for issuance under the plan is usually in the range of 10%-20% of the post-closing share capitalization. This pool of option shares will usually be counted in determining the pre-closing share capitalization of the corporation, so as not to dilute the percentage of ownership of the corporation that the investors will receive upon closing. In such cases, the founders will be paying for the plan, so it is not in their best interest to have a large number of shares authorized for issuance under the plan.

Expenses and Legal Fees


It is customary for the corporation to pay the legal fees and reasonable out-of-pocket expenses of the investors, whether or not the transaction contemplated by the term sheet is concluded. The term sheet, however, should include a cap on fees and expenses of legal counsel.

Exclusivity
Most investors will require that the corporation deal exclusively with them for a period of time after the signing of the term sheet and refrain from soliciting investment from third parties. This is usually a reasonable request from investors, as they do not want to invest time and effort only to discover that the corporation is holding parallel discussions with other potential investors. The corporation, however, should try to limit the length of the exclusivity period, so that it is not prevented from seeking alternative offers if the current financing offer appears to be going off the rails.

Closing the Deal


The execution of a term sheet does not result in a binding agreement to finance the corporation. From the term sheet, two processes will usually commence in parallel; documenting the deal and completing due diligence. A binding agreement will only result after the investors have completed their business and legal due diligence on the corporation and the financing documents have been negotiated and finalized. The time from receiving a term sheet to receiving a cheque from investors can take weeks or months. This window should be taken into consideration in the corporations business plan and financial projections.

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Typical Documentation A typical Series A equity financing will include a subscription agreement, shareholder agreement, and articles of amendment which establish one or more new classes of shares to be issued to the investors. Other ancillary documentation such as a registration rights agreement, founder stock restriction agreements29, new employment agreements for key employees, a stock option plan and a management rights agreement may also be part of the financing transaction. For a financing lead by a U.S. investor, the provisions normally contained in a shareholder agreement may instead be contained in two separate agreements, one commonly called a stockholders agreement, and the other a voting agreement. Typical Due Diligence The type of due diligence performed by investors can be generally grouped into four categories: (a) founder and employee due diligence; (b) technology/market due diligence; (c) financial due diligence (if the company has an operating history); and (d) legal due diligence. In a typical scenario, the first three areas of due diligence will be significantly underway, if not completed, by the time a term sheet is issued by the investors. It is by evaluating the team, the technology, the market and the financials that the investors will reach a decision to invest and at what price. The legal due diligence typically does not start in earnest until a term sheet has been executed by the parties. As a result, many founders underestimate the importance of legal due diligence and regard it as a mere formality. The truth, however, is that the legal due diligence can have a dramatic effect on the outcome of a financing transaction, including the ultimate valuation placed on the corporation, the risk of liability that must be accepted by the founders, the timing of the closing of the transaction, and, in some cases, whether the deal is consummated. While the areas of most interest to investors will vary depending upon the corporation that is being investigated, a typical due diligence process will include, but not be limited to, a review of the following: the corporations (and any subsidiaries) basic corporate documents, such as the articles of incorporation, by-laws, minutes of meetings of directors and shareholders, existing shareholder agreement(s), shareholder registers, business plans and financial projections provided to the board of directors, previous share or asset acquisition agreements, and any other significant agreements entered into by the corporation, such as partnership agreements or joint venture agreements; the corporations capital structure, including a list of all shareholders and holders of any other form of security such as options, warrants or convertible debt, and any agreements affecting the shares of the corporation; documents and agreements relating to the corporations finances, including any documents or agreements evidencing secured or unsecured borrowing and any guarantees by the corporation; documents and agreements relating to the corporations customers, distributors, resellers and key suppliers;

29 See Chapter 4, Section 4.5.

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intellectual property owned, licensed by or otherwise used by the corporation in its business. Of particular importance, the investors will wish to confirm that the corporation has taken reasonable steps to retain and protect key intellectual property developed or conceived by its founders, employees and contractors30; personnel matters, including employee and contractor agreements, benefit plans and regulatory compliance issues; any settled, outstanding or prospective litigation or disputes; and property leases and owned real property. By conducting a review of the matters listed above, investors are aiming to identify risks or skeletons that might affect the future prospects of the corporation and, as a result, the value of the corporation. Due to the significance of legal due diligence, it is strongly advised that corporations seeking outside investment have their house in order prior to soliciting investment. Identifying and, where possible, dealing with issues that may be of concern to investors will help make the investment process proceed smoothly and reassure investors that their decision to invest is a sound one.

Securities Law Compliance


Application of Securities Laws
In issuing shares or other forms of securities in exchange for money, corporations must ensure that they are acting in compliance with applicable laws and regulations. The trading of securities is governed by separate legislation in each of the provinces and territories. As a result, when considering a securities offering, a corporation may have to comply with the laws of more than one jurisdiction. For example, a corporation wishing to sell securities to investors in Ontario, Quebec and British Columbia will have to comply with the securities legislation of each of the three provinces. In Ontario, trades in securities are primarily governed by the Ontario Securities Act (OSA). The term trade is defined by the OSA as including any sale or disposition of a security for valuable consideration. The term security is defined to include sixteen non-exhaustive categories. The definition includes shares of all classes, partnership interests, limited partner interests, mortgages, promissory notes, debentures, other evidence of indebtedness, options warrants, any profit sharing and any agreement providing that money received will be repaid or treated as a subscription to shares, stock, units or interests at the option of the recipient or of any person or company. Given the broad definition of security, most commonly used methods of raising capital fall within the scope of the OSA. Therefore, it is imperative that a corporation first determine whether its fund raising activities are captured by the OSA (and/or similar legislation of other provinces or territories) and, if so, comply with the requirements of the legislation.

30 See Chapter 4, Section 4.5.

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General Requirements
The OSA requires that any person trading in a security (a company issuing securities falls within this category) must be registered as a dealer or salesperson. The OSA also requires that no distribution of securities (e.g., a trade in securities of an issuer that have not been previously issued) may be conducted unless a preliminary prospectus and a prospectus have been filed and receipts for same have been received. The purpose of the prospectus is to provide full, true and plain disclosure of all material facts relating to the securities issued or proposed to be distributed, and is intended to protect the interests of investors and potential investors. The process for completing a prospectus, however, is time-consuming and expensive. In the context of an early stage technology company, the amount of capital being raised rarely justifies the expenditure of such time and money. Fortunately, the securities regulators recognize that there are circumstances in which registration as a dealer and the filing of prospectus are not necessary by creating exemptions from these requirements.

Registration and Distribution Exemptions


In attempting to strike a balance between protecting investors and enabling companies to efficiently raise capital, securities regulators have created a scheme of prospectus and registration exemptions. The exemptions most commonly used by early stage technology companies are: (i) the private issuer exemption; (ii) the founder, control person and family exemption; (iii) the $150,000 exemption; (iv) the accredited investor exemption; and (v) the exemption for trades to employees, senior officers, directors and consultants. Private Issuer Exemption The private issuer exemption is expected to operate as the primary private placement exemption for startup, family-run and other closely-held businesses. The chief advantage of the private issuer exemption is ease of use; for example, this exemption does not require any fee payment or form filing obligations. There is no limit on the amount of money that a business may raise in reliance upon the private issuer exemption. The principal requirements for the private issuer exemption are: Securities (other than non-convertible debt securities) must be subject to restrictions on transfer contained in the issuers constating documents (i.e. articles of incorporation) or security holders agreements. While it is possible to amend a companys articles of incorporation to either add or remove restrictions on transfer of securities, these changes require separate class votes under federal and Ontario corporations statutes and will trigger shareholder dissent rights. As such, the decision to include restrictions on transfer of securities in a corporations articles from inception in order to rely on the private issuer exemption should be weighed against these risks if the company anticipates that it will later wish to establish a public market for its shares. On a related point, the constating documents of most foreign-incorporated issuers will not include the necessary restrictions on transfer to rely on the private issuer exemption, since similar restrictions will generally not apply where these companies are domiciled. Securities (other than non-convertible debt securities) must be beneficially owned, directly or indirectly, by not more than 50 persons, not including employees or former employees of the issuer or its affiliates, and subject to certain special rules with respect to ownership of securities by entities created or used solely to purchase or hold securities of the issuer.
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The issuer is only permitted to issue securities to certain categories of purchasers, including: directors, executive officers, employees, founders or control persons of the issuer, certain family members, close personal friends and close business associates of the issuers management and principal shareholders, and accredited investors. The otherwise closed list also includes one catch-all, namely, persons who are not the public. If securities are issued to persons who are not included in this list (even under another exemption), the issuer will no longer qualify as a private issuer. While the determination of who is a member of the public is always contextual and fact-specific, historically, two related tests have been applied: a. A person will generally not be considered to be a member of the public if he or she has common bonds of interest and association with an officer, director or shareholder of the company who is in a position to provide the information that would otherwise be disclosed in a prospectus. b. A person will not be considered to be a member of the public if he or she has no need to receive a prospectus, since he or she already has or has access to the information that would otherwise be contained in a prospectus. The onus is on the issuer to establish that the person is not a member of the public. Except for a trade to an accredited investor, no commission or finders fee may be paid to any director, officer, founder or control person in connection with a trade under this exemption. This exemption applies in all Canadian jurisdictions. Founder, Control Person and Family Exemption The new founder, control person and family exemption will permit Ontario businesses to issue securities on an exempt basis to: founders of the issuer and their affiliates; a spouse, parent, brother, sister, grandparent or child of an executive officer, director or founder of the issuer; or a control person of the issuer. A founder is defined as a person who, acting alone or with one or more other persons, directly or indirectly, takes the initiative in founding, organizing or substantially reorganizing the business of the issuer, and, at the time of the trade is actively involved in the business of the issuer. A control person includes a person who holds either a sufficient number of securities of an issuer so as to affect materially the control of the issuer, or more than 20% of the outstanding voting securities of an issuer (except where there is evidence showing that the holding of those securities does not affect materially the control of the issuer). This exemption applies only in Ontario. A similar, but more expansive, exemption applies in all other Canadian provinces.

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$150,000 Exemption The issuance of securities of an issuer with a minimum acquisition cost of $150,000 (Canadian dollars) will be exempt from prospectus and registration requirements. If this exemption is relied upon, it will be necessary to file a notice of trade with the Ontario Securities Commission within 10 days after the distribution. This exemption applies in all Canadian jurisdictions. Accredited Investor Exception The accredited investor exception allows issuers to raise any amount of equity financing, at any time, from any person or company that fits the definition of accredited investor, which includes, but is not limited to, the following: a bank listed in Schedule I or II of the Bank Act (Canada), or an authorized foreign bank listed in Schedule III of that Act; the Business Development Bank incorporated under the Business Development Bank Act (Canada); a person or company registered under the OSA or securities legislation in another jurisdiction as an adviser or dealer, other than a limited market dealer; an individual who beneficially owns, or who together with a spouse beneficially own, financial assets having an aggregate realizable value that, before taxes but net of any related liabilities, exceeds $1,000,000; an individual whose net income before taxes exceeds $200,000 in each of the two most recent years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of those years and who, in either case, has a reasonable expectation of exceeding the same net income level in the current year; an individual, who, either alone or with a spouse, has net assets of at least $5,000,000; a promoter of the issuer or an affiliated entity of a promoter of the issuer; a spouse, parent, grandparent or child of an officer, director or promoter of the issuer; and a company, limited partnership, limited liability partnership, trust or estate, other than a mutual fund or non-redeemable investment fund, that had net assets of $5,000,000 as reflected in its most recently prepared financial statements. The rationale behind this exemption is that the types of institutions and categories of persons and companies which fall within the definition of accredited investor meet specific net worth criteria or have other relationships or qualifications (including the ability to withstand the financial loss and sufficient experience or access to expertise to permit a proper evaluation of the investment opportunity) so as not to require the protection afforded by prospectus disclosure. There are no limits as to the number of times the accredited investor exemption may be utilized. Accredited investors can invest in securities of any issuer without a prospectus and with no minimum purchase price. There is no requirement under the accredited investor exemption to deliver a disclosure document to prospective purchasers. Trades made in reliance on the accredited investor exemption (subject to certain exceptions), must be reported to the OSC within 10 days of the date of the trade. The report must be accompanied by the applicable filing fee. This exemption applies in all Canadian jurisdictions.
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Trades to Employees, Senior Officers, Directors, and Consultants Most trades by an issuer of its securities to its employees, senior officers, directors and consultants will be exempt from prospectus and registration requirements. A condition of the exemption is that participation in the trade must be voluntary, that is, the trade cannot be induced by the expectation of future or continued employment, appointment or engagement by the corporation. In other words, it is not permissible to offer employment to an individual on the condition that he purchase securities of the company. Not surprisingly, this exemption is most often used when issuing stock options, restricted stock or some other form of equity compensation to employees and other individuals who fall within the exemption. When relying on this exemption to issue securities to consultants, it is important that the intended recipient properly falls within the definition of consultant. A consultant, for this purpose, must be working under a written contract and spend or will spend a significant amount of time and attention on the affairs and business of corporation. This exemption applies in all Canadian jurisdictions.

Offering Memoranda
None of the above referenced exemptions requires the issuer to deliver a disclosure document to prospective purchasers. It is not unusual, however, for an issuer to want to provide information about the company to prospective purchasers in order to assist them in making their investment decision. In doing so, however, the issuer runs the risk that such disclosure document will be classified as an offering memorandum under applicable securities laws. An offering memorandum is defined as a document purporting to describe the business and affairs of an issuer that has been prepared primarily for delivery to and review by a prospective purchaser, so as to assist the prospective purchaser to make an investment decision. Where an issuer voluntarily provides an offering memorandum, the issuer will be required to provide a statutory right of action, allowing purchasers to assert a right of rescission or a claim for damages for any misrepresentation contained in the offering memorandum. For this reason, most technology startups will try to avoid using an offering memorandum when seeking financing.

SR&ED Tax Incentives


As noted previously, government assistance can play a vital role in the financing of a startup corporation. One program of particular importance to technology companies is the Scientific Research and Experimental Development Program (also known as SR&ED). SR&ED is a tax incentive program designed by the Canadian government to encourage research and development activities in Canada. It is administered by the Canada Revenue Agency (CRA) and is the largest single source of federal government support for industrial research and development.

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Program Incentives
The two main program incentives are the deduction of current and capital SR&ED expenditures to reduce income for tax purposes, and investment tax credits (ITCs) that can also be used to reduce tax liability or, in some cases, can result in a cash refund. Qualified SR&ED expenditures are immediately deductible. There is no requirement for the claimant to repay the money, provide guarantees or other security, or surrender any intellectual property rights to the Canadian government. Deduction of Current and Capital Expenditures The claimant can deduct current and capital SR&ED expenditures in computing income for tax purposes to reduce tax liability in the current year, or carry expenditures forward indefinitely to reduce income for tax purposes and thus tax liability in future years. Investment tax credit refunds The claimant can receive investment tax credits on qualifying expenditures through a cash refund, a reduction of taxes payable, or both. Unused investment tax credits can be carried back 3 years or forward 20 years31. The amount of the ITC will depend on whether or not the claimant is a qualifying Canadiancontrolled private corporation (CCPC). A CCPC with $500,00032 or less of taxable income can generally receive an ITC for 35% up to the first $3 million33 of qualified SR&ED expenditures carried out in Canada and 20% of any excess amount. ITCs must first be applied against taxes payable in the year of the claim, after which cash refunds can be received in two ways: (1) a full cash refund on tax credits calculated on qualified current SR&ED expenditures or (2) a 40% cash refund on tax credits calculated on qualified capital SR&ED expenditures. A Non-CCPC can receive an ITC of 20% for both current and capital qualified SR&ED expenditures. These credits are non-refundable and may be carried back three years, or carried forward 10 years to reduce tax liability. Proprietorships, partnerships, and certain trusts can earn ITCs at the rate of 20% of the qualified current and capital SR&ED expenditures. After applying ITCs against payable taxes, cash refunds can be received on 40% of the balance.

Qualifying SR&ED Expenditures


General Expenditures Expenditures include: the salaries and wages of employees performing SR&ED work; materials that are consumed or transformed;

31 If the investment tax credits were earned prior to 1997, they may be carried forward 10 years. 32 If the CCPC was associated for Canadian tax purposes with any other corporation(s) during the year, the taxable income of those corporation(s) will be included in determining whether the CCPC is below the $500,000 threshold. 33 The expenditure limit must be shared by all CCPCs that are associated for Canadian tax purposes. The expenditure limit is reduced where the CCPCs taxable income (together with the taxable incomes of all corporations with which it was associated during the year) is between $500,000 and $800,000 and is eliminated if taxable income exceeds $800,000.

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machinery and equipment that is rented or purchased; some overhead expenses; and certain third-party payments and other SR&ED contracts. All or substantially all (i.e. 90% of greater) of such expenses must have been incurred for SR&ED purposes. In addition, repayments of government or non-government assistance can also increase the pool of deductible SR&ED expenditures. Recent Developments: Stock Options In Alcatel Canada Inc. v. The Queen, a decision rendered by the Tax Court of Canada (TCC) on February 24, 2005, stock options given to employees engaged in SR&ED activities were also considered expenditures incurred for SR&ED purposes. The court found that [t]he expenditure consists of the consideration which [the company] foregoes when it issues its shares for less than market value, and that the cost of the stock option program was an ordinary current expense. In other words, although there was no cash disbursement, the stock option program was part of an employee incentive plan and was, thus, an expense incurred for the salary or wages of an employee rather than a means of raising capital. Prior to the January 2006 federal election, draft legislation (section 143.3 of the Income Tax Act (Canada)) was introduced as a direct response to the Alcatel decision. The proposed legislation, if enacted, would make it clear that stock options granted or issued on or after November 17, 2005, would not be considered expenditures incurred for purposes of the SR&ED tax incentive program. Parliament dissolved before the legislation was passed. Similar draft legislation was reintroduced in 2007, but again failed to pass before Parliament was dissolved. The July 16, 2010 Draft Legislation re-introduces section 143.3, effective November 17, 2005.

Eligibility
What projects qualify as SR&ED? In order to qualify for the SR&ED incentive program the project must be carried out in Canada. In some cases, a Canadian corporation may execute only one phase or stage of a larger project directed by a global network of corporations. In either case, the contribution of the Canadian corporation must meet the three following criteria to be eligible for SR&ED benefits: Scientific or technological advancement The project must generate information that advances the understanding of scientific relations or technologies. Routine engineering development will not be eligible. Scientific or technological uncertainty Whether the desired result or objective can be achieved, or how to achieve it, must be unknown or undetermined based on commonly available sources of scientific or technological knowledge or experience before the project begins. Scientific and technical content There must be evidence that qualified personnel with relevant experience are responsible for directing or performing a systematic investigation of the project hypothesis through experiments or analysis.

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What work qualifies as SR&ED work? Not all work done by a corporation carrying out a SR&ED project will be considered a qualified SR&ED expenditure. The legislative definition of SR&ED includes the following four types of work: Experimental Development work done to achieve technological advancement to create, or improve, new materials, devices, products or processes, including incremental improvements thereto. Applied Research work done to advance scientific knowledge with a specific practical application in view. Basic Research work done to advance scientific knowledge without a specific practical application in view. Support work work that directly supports and is commensurate with the above three, that is undertaken in Canada by, or on behalf of, the taxpayer (the corporation). This includes only the following 8 types of work: engineering, design, operations research, mathematical analyses, computer programming, data collection, testing, and psychological research. Eligible work may be done by the corporation itself, or on behalf of the corporation. However, only SR&ED carried on in Canada qualifies. When work is carried on both inside and outside Canada, only expenditures for work done in Canada will be eligible for the incentive program. Ineligible work includes: research in social sciences or humanities; commercial production of new or improved material, device, or product, or the commercial use of a new or improved process; style changes; market research or sales promotion; quality control or routine testing of materials, devices, products, or processes; routine data collection; and prospecting, exploring, or drilling for or producing minerals, petroleum, or natural gas.

Applying
Applicants must complete the Form T661, Scientific Research and Experimental Development Expenditures (SR&ED) Claim, and either Form T2 SCH 31, Investment Tax Credit Corporations or Form T2038 (IND), Investment Tax Credit (Individuals). Generally, corporations have a total of 18 months from the end of the taxation year in which to file the forms. 34 When filing, claimants must include a comprehensive technical description of the SR&ED work being performed. This description must include details regarding worker qualifications, project planning, project process, and project progress. Essentially, claimants need to convince CRA that the project and associated expenditures meet the requirements described above.

34 To be eligible for the SR&ED tax incentives, the forms must be filed no later than 12 months after the filing-due date for the tax return in respect of the taxation year in which the expenditures were made.

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Processing Targets CRA has various targets for completion of the review process, depending on the type of claim: Refundable claims the review should be complete within 120 days of receiving the claim; Non-refundable claims the review should be complete within 365 days of receiving the claim; Refundable claims related to adjustments for previously filed income tax returns the review should be complete within 240 days of receiving the claim; and Non-refundable claims related to adjustments for previously filed income tax returns the review should be complete within 365 days of receiving the claim. In order to ensure that the above deadlines are met, the claims must be complete; sufficient technical and financial information must be provided to CRA; and requests for additional information should be answered in a timely manner. CRA Claimant Services CRA provides several services to facilitate SR&ED claims. These include the First Time Claimant Service, the Preclaim Project Review Service, and the Account Executive Service. For more information on these and other CRA services, visit the SR&ED web site at www.cra-arc.gc.ca/txcrdt/sred-rsde/menu-eng.html.

Maximizing Benefits
There are several ways for a US company (USco) to structure its Canadian operations in order to maximize SR&ED benefits: a US parent company can undertake SR&ED activities in a Canadian subsidiary; SR&ED can be contracted out to a Canadian company (Canco), that will factor the tax benefits, such as refundable ITCs, into the contract price; the USco could become a minority shareholder in a CCPC. Typically, other shareholders would include venture capital companies, Canadian researchers, hospitals, and universities. In this case, the USco cannot control, or have future rights to control, the company in order to maintain CCPC status; and the USco could enter into a joint venture with a Canco. Generally, a Canco is established to perform the Canadian research and development. The USco then contracts with the Canco for the Canco to perform the SR&ED activities on its behalf. Ownership of any resulting intellectual property will depend on the negotiated contractual relationship. For example, it is possible for the following relationships to be established: the USco enters into an R&D agreement with the Canco, by which the Canco will perform qualifying R&D activities for the USco. Any resulting intellectual property will accrue to the USco, with the exception of those Canadian rights that are necessary for the Canco to be eligible for the SR&ED program; the Canco will licence any existing intellectual property to the USco that is necessary for the USco to have the beneficial interest in the new intellectual property; and the Canadian rights that remain with the Canco for SR&ED purposes will be licensed to the USco for a royalty payment.

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Provincial Incentives
The various provinces in Canada offer additional tax incentives. For example, in Ontario, small-to-mediumsized corporations may be eligible for a 10% refundable credit (Ontario Innovation Tax Credit) on SR&ED expenditures, for which the corporation is eligible for a federal SR&ED ITC, provided the SR&ED is carried on in Ontario. Provincial and territorial R&D assistance should be accounted for when applying for federal tax incentives, as they may result in a reduction of the pool of deductible SR&ED expenditures.

Employees And Contractors


As legal advisors to technology businesses, we have observed that many corporations (particularly at the startup or early stage) are not necessarily aware of their legal obligations as employers. As a result, corporations may be unnecessarily exposing themselves (and their directors and officers) to potentially significant liabilities and penalties by failing to fully comply with various employment law statutes and/or the common law. Such liabilities and penalties are not only problematic in their own right, but may also unexpectedly affect the valuation of the corporation in a sale or financing transaction. This chapter identifies common pitfalls that corporations face when dealing with employees and contractors and suggests strategies to address them.

The Hiring Process


Corporations readily declare that their employees are among their greatest assets. Unfortunately, if the employment relationship is not properly documented from the outset, employees can also become one of a corporations greatest liabilities. Corporations often hire employees without proper letters of hire or employment agreements. This does not mean that there is no agreement between the corporation and the employee. What it does mean is that, at the end of the day, a court may end up defining the agreement for the parties. A proper letter of hire or employment agreement can avoid uncertainty and unexpected liability in the terms of employment. When drafting a letter of hire or employment agreement, matters to be considered include the following: job description and responsibilities; term of employment; specifics of any benefits; limitation of entitlements upon termination of employment; limitations on the employees ability to compete with the employers business once the employee leaves protection of the employers intellectual property, client lists and other confidential information; ownership of the employees work product; and dispute resolution.

Examples of issues that are often inadequately addressed in drafting letters of hire and employment agreements include the following:

Termination Clause
Some employers are uncomfortable addressing the employees entitlements on termination at the beginning of the employment relationship. These same employers often regret this initial discomfort when a decision is made later to terminate the employee. A signed employment contract (whether a letter of hire accepted by an employee or a more formal employment agreement) can limit the amount of notice, or pay in lieu of notice, that an employee will be entitled to receive in the event of a without cause termination. In Ontario, this contractual notice can be limited to the statutory minimum under the Employment Standards Act, 2000 (Ontario) (the ESA), which is generally one week per year of employment up to eight weeks plus statutory severance (if applicable), or any other amount, provided that it meets or exceeds the minimum statutory requirements under the ESA.

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In the absence of such a clause, an employee will be entitled on termination to notice or pay in lieu of notice calculated under common law principles, which may considerably exceed the minimum standards under the ESA. Unlike the ESAs notice provisions, the common law does not provide a fixed measure of what constitutes reasonable notice. At the upper levels, case law has awarded two years or even more to certain senior-level, long-term employees. Even at the lower levels, employees with common law entitlements often receive 3 or 4 times the amount of notice that they would have received if they were subject to the minimum standards of the ESA. These types of potential liabilities, when disclosed as part of a due diligence process, can surprise and concern investors or acquirers. In particular, it is not uncommon for a startup in the midst of acquisition discussions to be told that the purchase price will have to be reduced or, in extreme situations, that the deal is off, because the potential employee termination liability is too large. Rather than having an acquiring company reduce the purchase price to make up for the liability that it is taking on or having the selling company terminate and pay out its employees prior to the acquisition, it is far easier to quantify termination liabilities up front with an employment agreement. A written agreement on notice or pay in lieu of notice, even if it is greater than the ESA minimums35, will not only help to quantify termination obligations but will also help to avoid costly and time-consuming wrongful dismissal claims based on common law entitlements.

U.S. Contracts
Some corporations make the mistake of using forms of employment contracts that were originally drafted for use in other jurisdictions. One such example is a U.S. corporation establishing Canadian operations and simply using their U.S. form of agreement as their employment contract. U.S. concepts like employment at will are not recognized in Canada and will not be enforceable. Furthermore, the use of such language may render the entire employment agreement invalid and unenforceable in Ontario, including provisions relating to intellectual property. When that happens, the courts rely on common law as the default. Therefore, while company templates originating in the U.S. can be used as a base document, these forms should be revised in order to ensure compliance with Ontario employment law.

Restrictive Covenants
An important function of the employment contract is to restrict harmful or unfair conduct by a departing employee. This can be achieved through the use of restrictive covenants such as non-competition and/or non-solicitation clauses. It is crucial to craft such provisions with an eye to their enforceability. Sweeping, unreasonable prohibitions will generally not be enforceable in Ontario. In particular, while non-solicitation and confidentiality clauses will be honoured if properly drafted, non-competition clauses are very difficult to enforce under most circumstances. In fact, Ontario courts will often strike down all restrictive covenants if a non-competition clause was included in an agreement where a simpler non-solicitation clause would have sufficed. Therefore it is important, through proper drafting, that the issue of the enforceability of a non-competition provision not affect the validity and enforceability of other important provisions.

35 Proposed entitlements should be discussed with legal counsel or human resource professionals to determine whether they are greater than the norm. Overly generous entitlements can raise concerns for prospective investors. In addition, care must be had to ensure that the termination clause is properly drafted and the agreement has been properly entered into, as employers can otherwise find the courts setting aside the employment agreement and imposing common law in any event.

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Confidentiality and Intellectual Property Provisions


It is not uncommon to see employment agreements that do not address the employees obligation to protect the corporations confidential information from unauthorized disclosure or include an assignment of the employees rights and interest in any inventions, discoveries or work product conceived of or created by them during the course of their employment. While some of these issues are addressed by common law or statute, the protection of a corporations confidential information and intellectual property assets requires properly drafted provisions within the body of the employment agreement or in a separate intellectual property/confidentiality agreement signed at the time the employee enters into employment. As previously mentioned, care must be exercised when using forms of agreement that were created for use in other jurisdictions. For example, in Canada, the author of a copyrightable work holds moral rights to such work. A properly drafted employment agreement will require the employee to waive his or her moral rights in such works created during the course of their employment. The concept of moral rights is much narrower in the United States and as a result is generally not addressed in U.S.-style agreements.

Vacation Entitlements
Employment contracts should address an employees vacation entitlements. Given that directors and officers have personal liability for certain amounts of unpaid vacation under the ESA, employment agreements must be carefully worded to avoid any uncertainty. Companies should also note their statutory obligation under the ESA to ensure that employees take a minimum of two weeks vacation per year, following the first year of employment. This obligation to insist on vacation time being taken cannot be avoided simply by paying out vacation pay. Lastly, it is advisable to limit the employees ability to carry forward unused excess nonstatutory vacation time entitlements from one year to the next so that this potential liability can be managed.

Salary
It is not unusual for technology startups to hire individuals before they have sufficient funds to pay them a competitive salary. Instead of recognizing this fact in the employment agreement, however, many companies include the salary that it expects to pay the employee once it receives financing and then have the employee forego or defer payment of the salary until such time. In doing so, the company has created unnecessary potential liability for itself, and its directors, if the deferred payments are not made. Problems can also arise under the ESA, as employees have a legal entitlement to receive monetary remuneration. A preferable manner in which to deal with such circumstances is to set out the initial salary as being the minimum wage prescribed by the ESA, with a higher salary to become payable once a defined milestone event (e.g. the company receiving $X in funding) is reached. Another option is to hire individuals as contractors and later convert them to employees. However, this option has other risks, as set out in Section 8.2 below, and should never be undertaken without legal advice.

Contract Implementation
Failure to have the employee execute a letter of hire or employment agreement prior to commencing work can result in the letter of hire or employment agreement being found to be invalid and unenforceable. This is due to the fact that an employment agreement is a contract, and the employee must receive consideration in order for the contract to the enforceable. The consideration which an employee usually receives is the

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job itself; in other words, in exchange for the promise of the job, a contract is signed. However, if the job is started before the contract is signed, there will be no consideration for any new terms or conditions that are contained in the written contract. In this instance, the court will look to the common law in determining the employees contractual entitlements. For example, a provision purporting to limit to ESA minimums the amount of notice, or pay in lieu of notice, that the employee will receive in the event of a without cause termination will likely be unenforceable and the amount of notice, or pay in lieu of notice, will be as calculated under the common law. For this reason, it is important that prospective employees be presented with the form of letter of hire or employment agreement that they are expected to sign well before they commence work, and that they be given adequate time to review the document and, if necessary, consult with their legal advisor. In the event that this is not possible or in the event that a new contract is to be entered into in the course of employment, some fresh consideration should be offered to the employee, which is most often in the form of a signing bonus, a salary increase or a new stock option grant. It should also be remembered that the consideration must have value, meaning that a new option grant may not be effective is the employee is terminated prior to vesting or if the options are under water at the relevant time.

Engagement of Contractors
The engagement of contractors can be problematic for a number of reasons and therefore great care must be taken in this area. The following are a few of the issues that regularly arise:

Is it an Employment Relationship?
Courts and administrative bodies will generally examine the entire relationship between the parties in order to determine whether an individual is a true contractor or in substance an employee. Although the existence of an independent contractor agreement will be taken into consideration, it will certainly not be determinative on its own. Other factors that will be taken into account include, but are not limited to the following: the contractors degree of control over his working arrangements, whether the company withholds employee statutory deductions on the contractors pay, whether the company monitors hours of work, whether the contractor is assuming his own risk of profit or loss, whether the contractor provides his own tools and workspace and whether the contractor is integrated into the workplace and enjoys benefits given to employees. Despite entering into so called independent contractor agreements, a company may face significant liabilities under various statutes and/or the common law for not meeting its obligations as an employer if it is determined that a contractor is in reality an employee. Some of the risks following a determination that a contractor is in reality an employee are as follows: payment to the Canada Revenue Agency for outstanding Employment Insurance and Canada Pension Plan contributions, with or without a fine pursuant to the Income Tax Act (Canada); fines pursuant to the Income Tax Act (Canada) for not withholding income tax at source; payment to the Ontario Workplace Safety and Insurance Board of premiums, together with interest and/or fines levied against the company and/or directors, which can reach $100,000 and $25,000 respectively, pursuant to the Workplace Safety and Insurance Act (Ontario);

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payment of wages owing such as overtime pay, vacation pay, statutory notice and statutory severance upon termination and/or fines levied against the company and/or directors, which can reach $500,000 and $50,000 respectively, per offence, pursuant to the ESA; and pay in lieu of notice upon a contractors termination of employment, if he or she is found to be an employee under the common law.

Intellectual Property Rights


Unlike an employment situation, any intellectual property developed by the contractor will typically be owned by the contractor unless the agreement specifically provides that such intellectual property is to be owned by the company. Therefore, it is essential to have a written agreement with the contractor in which the contractors intellectual property rights are assigned to the corporation. Where the contractor is a corporation and/or will be using other personnel to perform the development services, proper diligence and/or contractual provisions should be utilized to ensure that any intellectual property rights that such personnel may possess in the work product or inventions developed as a result of the development services are properly assigned to the corporation (either directly or indirectly through the contractor).

Changes to the Employment Relationship


Employers have some latitude to make changes to an employees terms and conditions of employment for business-related reasons. However, the following are examples of issues that may arise in the implementation of such amendments:

Unilateral Modifications
Employers should be cautious of unilaterally modifying an employees terms and conditions of employment, as they may find themselves defending a constructive dismissal claim once those modifications become apparent to the employee. Such a claim may be alleged where, in the absence of reasonable notice, a fundamental term or condition of employment is unilaterally altered by the employer in any manner detrimental to the affected employee. Actions of an employer that could amount to grounds for a constructive dismissal claim include any substantial change in remuneration, benefits, position, responsibilities, reporting duties or location of work. It is still possible, however, for an employer to make unilateral changes, even if they are substantial, without triggering a constructive dismissal claim, provided the changes are announced and implemented in the proper manner.

Enforceability of New Terms


Any amendment to the terms of an existing written employment agreement should be in writing, preferably with the employees consent or at least with the employees knowledge. Furthermore, the employer should offer fresh consideration over and above the performance of existing contractual obligations in order to ensure future enforceability of the new terms of employment. Fresh consideration may consist of simply offering an employee a modest bonus or a one-time perquisite in exchange for agreement to the amendments. It is also effective to implement amendments as part of a promotion or a discretionary increase in compensation, including the granting of a bonus or options. Ordinarily, mere continuation of employment will not

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constitute adequate consideration. Moreover, it is clear that both parties to the employment contract must have full knowledge of the scope and nature of the change and must voluntarily assent to it without duress or coercion in order for the modification to be legally binding.

Termination of Employment
Proper termination practices and policies are imperative as every employment relationship will inevitably terminate and the legal consequences can be serious, especially for terminations that are unilaterally implemented by the employer. Despite the serious potential liabilities, we have observed that many technology companies are not fully aware of the ESAs minimum requirements upon termination of employment, including but not limited to those governing the following entitlements: pay in lieu of notice of termination; severance pay; mass termination pay; unpaid overtime and/or vacation; and employee benefits during the statutory notice period.

Specific issues that often arise include the following:

Mass Termination
It is possible to inadvertently trigger the strict mass termination obligations under the ESA. These provisions will come into play in the event that 50 or more employees are terminated in any period of 4 weeks or less. For example, the mass termination provisions could be triggered if a company terminates the employment of 35 employees and constructively dismisses 15 more employees by unilaterally modifying a fundamental term of their employment, all in a period of 4 weeks. We have seen companies work hard to keep their number under 50, then inadvertently exceed the limit because of a couple of terminations in management ranks that they forgot to include. Mass termination requirements include, but are not limited to, a substantially increased statutory notice period for each employee involved, and the filing of a report with the Ministry of Labour.

Insurance Benefit Coverage


Employees are entitled to receive their entire group insurance benefit coverage for the duration of their statutory notice period pursuant to the ESA. In the event an employer does not provide benefits continuance to the extent required by the ESA (due to the insurers refusal or the employers unilateral termination of the coverage), it may be found to be in violation of the ESA. Furthermore, in the event the employee dies or becomes disabled during the statutory notice period, the employer may become responsible for the proceeds of the life insurance policy or the disability benefits that would normally be in place, and payable, but for the termination of the coverage. As such, employers are advised to contact their insurance provider prior to the termination of employment, in order to obtain confirmation of benefits continuance and conversion possibilities (if any), in writing. Employers should also inform employees, in a termination letter, of the scope of the benefit continuance, the termination date of these benefits and the time limits for any conversion possibilities. This termination letter should also recommend that the employee pursue alternate coverage.

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Cause
On occasion, an employer will attempt to terminate an employee for cause. One of the employer benefits of a termination for cause is that the dismissed employee is not entitled to any notice period or pay in lieu of notice. Except in cases of extreme misconduct, however, it will difficult for an employer in Ontario to substantiate an allegation of dismissal for cause unless the employer has implemented a well-documented and properly administered process for record keeping and the issuance of warnings. An investigation and due process to the employee is usually also necessary before cause is alleged. In the case of a termination without notice where the employer alleges cause, but has failed to keep proper records and provide warnings in an appropriate manner, the dismissed employee will likely succeed in an action for wrongful dismissal. Even where proper records have been kept and warnings given, the courts are unlikely to uphold terminations for cause in all but the most extreme circumstances. For this reason, it is important to speak with legal counsel experienced in this area of law well before any termination for cause is attempted.

Equity Compensation
For most technology and emerging growth companies, equity incentives (including stock options, restricted stock and stock purchase plans) are an essential tool to attract, motivate and retain key employees. However, equity compensation plans are lengthy and complex, and we often encounter tax, securities, corporate or accounting concerns when examining these plans. The most frequently seen problems include the following:

Vesting after Termination of Employment


Management and investors often assume that if an employee is terminated, the employees options or restricted stock grants will cease to vest on the date of notice of termination or notice of resignation. This expectation, however, does not reflect the current state of the law in Ontario. Ontario courts have taken the position that, unless a plan or option agreement provides very clear wording to the contrary, in the event of the termination of employment of an option holder, vesting will continue through the employees notice period. As described above, if a terminated employee is entitled to common law notice, this can result in unintended lengthy periods of additional vesting after the employee has ceased to work for the company. It is possible to limit vesting to the period of actual service if a plan or option agreement contains a properly worded provision which provides that vesting ceases on notice of termination or on the last date of active employment. However, the wording that is necessary to effect this result is constantly subject to challenge in Ontario courts, so it is important to ensure that your plan reflects the most up-to-date state of the law. Similar issues arise with post-service exercise periods -that is, to the extent an option is exercisable after termination of employment, the clock on the exercisability period should start ticking on the last day the employee works for the company, not at the end of his notice period.

Corporate Law Restrictions


Holders of equity incentives are not just employees, they are also current or potential minority stockholders, and should be treated as such. From an investor standpoint, it is important that shares acquired under an equity compensation plan are subject to appropriate contractual restrictions. These include a right of first

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refusal, a drag-along, a buy-back of vested and/or unvested shares on termination of employment, and a post-IPO market stand-off agreement. In some situations, we have seen a number of companies attempt to take a short-cut to some of these restrictions by imposing a voting trust that purports to transfer voting power over the shares to an officer of the company. In our experience, even if these voting trusts are enforceable, they can put management in a conflict of interest position, and should not be relied upon as completely effective replacements for traditional drag-alongs, powers of attorney, share escrows and other restrictions.

Securities Law Compliance


A company must comply with the securities laws of each jurisdiction in which it has executives, employees or consultants who receive securities under an equity compensation plan. Securities regulators have recently liberalized requirements for equity compensation schemes for companies that are not reporting issuers36. There is, however, a continuing requirement that an employees participation in a trade must be voluntary, that is, an employee cannot be induced to purchase securities by expectation of employment or continued employment. For this reason, among others, serious securities law (and employment law) concerns apply to schemes in which startup companies purport to compensate employees with shares in lieu of salary. The consequences of failing to comply with securities laws can be severe. Ontario has administrative penalties for non-compliance with securities laws of up to $5 million and/or imprisonment for up to 5 years per infraction, which can potentially apply not only to companies but to directors and officers who authorize, permit or acquiesce to the non-compliance. Other additional penalties may also be levied depending on the offence.

Regulatory Compliance
A due diligence review will include an assessment of the companys regulatory compliance. In addition to the other issues referred to above, we have noticed that a number of technology companies have faced the following regulatory problems:

Workplace Safety and Insurance Act Compliance


The Workplace Safety and Insurance Act (Ontario) (WSIA) establishes a comprehensive regime regarding the compensation of workers injured at the workplace. One of the basic requirements of this system is that mandatory coverage employers are required to register with the Workplace Safety and Insurance Board within 10 days after becoming such an employer. A company failing to register may be charged the outstanding amount due in applicable premiums, plus interest charged at the Bank of Canada rate plus 6%. Furthermore, the company may be found guilty of a provincial offence and fines may be levied against the company and/or directors, which can reach $100,000 and $25,000, respectively. As a result, it is particularly important for all new employers to come to an early understanding as to whether or not they are required to Comply with WSIA registration requirements.

Joint Health and Safety Committee


Joint health and safety committees are required at any workplace that regularly employs 20 or more workers pursuant to the Occupational Health and Safety Act (Ontario). Failure to comply with this requirement is

36 See Chapter 7, Section 7.5.

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an offence under this legislation and, as a result, fines may be levied against the company and/or directors, which can reach $500,000 and $25,000, respectively. New to the Occupational Health and Safety Act (Ontario) as of June 15, 2010 is the requirement that most Ontario employers with more than 5 employees are required to prepare and implement a workplace harassment policy and a workplace violence policy.

Human Rights Compliance


Employers must ensure that their human resources practices and procedures are in compliance with the Human Rights Code (Ontario). In the event of non-compliance, employers may leave themselves open to human rights complaints in the courts or at the Ontario Human Rights Tribunal. A successful complaint can result in an employer being liable for damages for any losses that an employee has suffered (such as loss of earnings or job opportunities) and damages for mental anguish. A successful complaint can also lead to mandatory reinstatement of the employee and things like mandatory employer training.

Privacy Legislation Compliance


Employers need to be aware of the requirements under the federal Personal Information Protection and Electronic Documents Act (PIPEDA) and any applicable provincial legislation, as they may have a substantial impact on the workplace and the manner in which employee and other personal information is collected and stored. Although PIPEDA does not generally apply to employee personal information in Ontario, it can apply where that personal information is being collected, used or disclosed for commercial purposes (eg. in the course of a financing, merger, acquisition or IPO). In the circumstances, it is best for employers to maintain compliance with privacy legislation right from the beginning.

Confidentiality
Under common law, employees are generally required to maintain confidentiality over company confidential information. However that common law obligation does not extend to contractors and in addition, it can often be a matter of dispute between employer and employee as to what constitutes confidential information or trade secrets. Accordingly, it is of particular importance for technology startups that written confidentiality agreements are entered into at the beginning of the employment relationship, in exchange for proper consideration as discussed above. A properly drafted confidentiality agreement will also provide for the return of all confidential information at the end of the employment relationship.

Employee Policies
In addition to employment agreements and Confidentiality and Intellectual Property Agreements, it is recommended that all employers create employee manuals to deal with the various policies which are required for the smooth operation of the company as well as to keep employer liabilities to a minimum. At a minimum, employee manuals typically deal with the following items: overtime; vacation and statutory holidays; workplace harassment; workplace violence; ethical code of conduct; work-related travel; statutory leaves of absence; sick leave and other non-statutory absences; performance reviews; discipline; benefits; human rights; and computer use.

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With respect to items such as computer use, it is possible for an employer to set out acceptable workplace internet and other computer use and to monitor employee use of computers and the internet. In fact it is incumbent on employers to do so in order to maintain security and to ensure that the network is not being used for illegal, discriminatory or other purposes. However in order to ensure that a dispute does not arise in relation to whether or not a particular computer use was for personal purposes, a computer use policy should be drafted which clearly sets out the employers expectation that the entire computer system is company property and that there can be no expectation of employee privacy.

Protection Of Intellectual Property


The Importance of Intellectual Property
Founders of a technology startup usually envision an innovative and hopefully transformative product or service that the company will offer for sale to the public. In most cases, the product or service will be unique, or at least in some way different, from anything else on the market. This competitive advantage will quickly disappear, however, if it can be easily duplicated. For this reason, the protection of intellectual property is imperative for technology companies. Only by properly protecting its intellectual property assets will a corporation be able to fully realize the value of its ideas and creations.

Understanding Intellectual Property Rights


While most people involved in the technology industry have some knowledge of intellectual property rights, the extent of this knowledge varies widely. Some will have heard of patents, copyrights and trade-marks, but have difficulty articulating the differences between them. Others may have a better understanding of the different types of intellectual property rights, but be uncertain as to how they are identified, protected and exploited. While technology company executives do not have to be experts in the field, they should have a sufficient understanding of intellectual property to be able to guide their company in realizing the full economic value of its intellectual property and use these rights as a strategic business tool. This chapter focuses on the most common forms of intellectual property rights: trade secrets, patents, copyright and trade-marks. Other types of intellectual property rights may also be available to a company and should be considered in consultation with legal counsel in developing a companys intellectual property strategy.

Trade Secrets/Confidential Information


What is a Trade Secret?
Generally speaking, a trade secret is information that derives its economic value from not being generally known, not being readily ascertainable by others, and being the subject of reasonable efforts to maintain its secrecy. For a typical technology company, trade secrets will include some of its most valuable information, including some of the following: ideas, designs, methodologies, processes, financial matters, pricing policies, marketing plans, methods of business operation, employee salaries and other forms of compensation. It is not always possible, however, to realize the full value of a trade secret without disclosing it to others. Employees, independent contractors, strategic partners, customers, venture capitalists, bankers and other advisors are some of the people to whom trade secrets may have to be disclosed. Notwithstanding the need for such disclosures, the value of a trade secret can be preserved by taking steps to control the dissemination and use of such information.

The Duty of Confidence


Although often grouped under the heading of intellectual property rights, a trade secret is not a form of property. While some trade secrets may also qualify for the protection afforded to intellectual property (such as patents), the protection of a trade secret arises from a duty of confidence that is recognized by the common law. (The term confidential information will be used hereafter to differentiate information protected by this duty of confidence from the U.S. statute-based concept of trade secrets.)

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The duty of confidence arises when confidential information is disclosed in circumstances where the person receiving the information has notice, or has agreed, that the information is confidential. Such circumstances may include the disclosure of confidential information to partners in a joint venture, manufacturers and designers, distributors, consultants and independent contractors, licensees and employees. Relying only on this duty of confidence, however, raises evidentiary concerns and can result in lack of certainty. How, for example, do you prove that the recipient knew that the information was confidential or agreed to treat the information as confidential? In addition, relying exclusively on the duty of confidence may be considered evidence of a lack of adequate security measures and result in a loss of confidential status for the applicable information. For these reasons, it is advisable to have all recipients of confidential information enter into a non-disclosure agreement prior to the disclosure of any confidential information.

Non-disclosure Agreements
A non-disclosure agreement (also commonly referred to as a confidentiality agreement) is a written agreement pursuant to which one party agrees to disclose confidential information to the other party on the condition that the use and further disclosure of such information is limited in a manner that is intended to preserve the confidential nature of the information disclosed. Unfortunately, many corporations do not use adequate care in the drafting and implementation of nondisclosure agreements. As a result, much of the protection that the corporation thought it was receiving by having a non-disclosure agreement in place is lost. Perhaps the most important rule regarding the use of non-disclosure agreements is that there is no such thing as a standard non-disclosure agreement. It is all too common that a corporation will continually reuse a form of non-disclosure agreement regardless of differing circumstances. While it is beyond the scope of this guide to address all the issues that should be considered when drafting a non-disclosure agreement, some of the important elements to be considered include the following: Have the discloser and recipient of confidential information been properly identified in the agreement (including subsidiaries who may disclose or require access to confidential information)? Has the term Confidential Information (and other applicable defined terms) been accurately defined? Are the customary exceptions to the definition of confidential information included in the agreement? Does the agreement require that confidential information be identified as such by the discloser at the time of disclosure? Must orally or visually disclosed confidential information be summarized in written form? Is the definition overly broad? Where applicable, has the recipient expressly identified information that it does not want to receive? Are there concerns that the receipt of certain information may contaminate or cast doubt on the recipients current or future independent research and development and/or business activities? Does the agreement set out the purpose for which the confidential information may be used by the recipient? Does the agreement expressly state that the recipient has a duty to protect the confidential information that it receives? Does the agreement describe the standard of care the recipient must use in protecting the confidential information from unauthorized disclosure?

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Does the agreement permit the disclosure of confidential information to those individuals and entities who will require access to such information in order to achieve the purpose for which the information was disclosed? Does the agreement include time limitations on the recipients obligations? Are such time limitations reasonable? Should the duties of confidentiality apply for a longer period of time with respect to certain elements of the confidential information? Does the disclosing party have the right to disclose the information it intends to disclose?

Implementation of a Non-Disclosure Agreement


While non-disclosure agreements are excellent tools for protecting confidential information, many corporations operate under the misconception that a non-disclosure agreement is all that is required in order to protect the corporations confidential information. The execution of a non-disclosure agreement, however, is only one part of a proper information protection program. Without such a program in place, it may be difficult to establish that the corporations sensitive information properly qualifies as confidential information. While an information protection program will vary depending on each companys particular circumstances, a typical program will, at a minimum, include the following: proper identification and marking of confidential information; controlled and, where possible, documented access to confidential information; sound documentation destruction practices; monitored and restricted access to premises by visitors, including sign-in and display of visitor identification badges; a process to review all marketing materials, speeches and other public disclosures for inadvertent disclosure of confidential information; the creation of a company policy and the education of employees and contractors regarding the protection of confidential information; and appropriate confidentiality agreements with employees, consultants, contractors, licensees and other third parties.

Venture Capitalists and Non-Disclosure Agreements


When seeking investors, corporations will discover that most venture capital firms refuse to enter into non-disclosure agreements. The typical reason given for such refusal is that the venture capitalist sees so many business plans and speaks with so many businesses that it cannoy possibly keep track of all the information it receives, and as a result, does not want to inadvertently breach the terms of a non-disclosure agreement. Regardless of the merits of such an argument, most entrepreneurs and corporations will find themselves in a situation where they must disclose confidential information to a potential investor without having a non-disclosure agreement in place. A corporation disclosing information to a venture capitalist without the benefit of a non-disclosure agreement, however, is not completely without protection. First, the disclosing company should consider the reputation of the venture capitalist with whom it is dealing. If the venture capitalist has

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been operating for a while and is generally well regarded, chances are that the venture capitalist will not willfully disclose the corporations confidential information to others and thereby risk ruining its reputation. Second, by clearly marking all written material containing confidential information as confidential, as well as, identifying any confidential information disclosed orally, the disclosing party may still be able to rely upon the common law duty of confidence. Third, by holding back on the disclosure of the businesss crown jewels until the interest level of the venture capitalist can be ascertained, the disclosing corporation can regulate the type of information disclosed and to whom. Finally, by researching the venture capital firm and the companies in its portfolio, the disclosing corporation can determine if the firm has invested in a competitor to whom the disclosure of the corporations confidential information would be particularly harmful. Where such investments have been made, the disclosing corporation can first inquire whether the venture capital firm would even consider an investment in a competing business. If not, there is no need to disclose any further information.

Patents
What are Patents?
As discussed above, confidential information (or a trade secret) gains much of its value from being kept secret. It was recognized long ago, however, that society would benefit if some types of confidential information were disclosed to, and could be used by, the general public. To mandate such disclosure, however, would rob inventors of a principal incentive for innovation. It was for the purpose of encouraging disclosure of inventions that the patent system was created. A patent is an exclusive right to prevent others from making (or having made), using, offering for sale or selling a patented invention in the jurisdiction that grants the patent. In Canada, this right is granted pursuant to the provisions of the Patent Act (Canada) (the Act) and has a life of 20 years from the date that the patent application is filed. In other words, if a particular invention qualifies for patent protection, the state will give the inventor the right to control the use of such invention for a limited period of time. After such time period, the invention may be used by anyone. An inventor or an assignee of the inventor may apply for a patent. It is the first person to file an application (not the first person to invent, as is the case in the United States) in respect of an invention who is entitled, subject to certain qualifications, to the grant of a patent.

Essential Attributes of a Patentable Invention


Invention is defined as any new and useful art, process, machine, manufacture or composition of matter or any new and useful improvement thereof. To be patentable, the invention must be novel and not have been obvious to a person skilled in the art or the science to which the invention relates. It must also have some utility or real world value (i.e. more than just an idea or concept). Finally, the invention must not have been disclosed to the public in Canada, or anywhere else in the world, before the application is filed. Notwithstanding this bar on public disclosure, both Canada and the United States provide for a grace period where an inventor can still file a patent application within one year of public disclosure. Such disclosure, however, will prevent patentability in most other countries.

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Reasons for Seeking Patent Protection


There are a variety of reasons for seeking patent protection for an invention. They include: to protect a corporations ability to manufacture and/or sell a core product or service; to inhibit competition; to create alternative sources of revenue (e.g. licensing); as insurance against infringement claims (i.e. cross-licensing); and to add value to the corporation when seeking financing or negotiating the sale of the corporation.

What Should be Patented?


The process of patenting an invention is often time-consuming and expensive. For these reasons, it is important that a corporation create and implement a strategy for evaluating whether patent protection should be sought for a particular invention. Such a strategy should consider, among other things, how to identify patentable inventions before they are disclosed to the public, as well as how a patent for such invention would be used by, and add value to, the corporation. The corporations strategy should also consider what other forms of protection are available for the invention (such as non-disclosure) and whether such other forms would be equally effective. If it is determined that patent protection is desirable for the corporations inventions, thought should also be given to how best to use patents to protect such technology. A few of the common approaches employed by corporations include: The Sniper Strategy Under the Sniper strategy, a corporation relies on a few patents to cover the corporations core technology, but does not seek to protect modifications or improvements to the technology. This strategy is typically used by corporations with limited resources. The main risk of such an approach is that competitors may anticipate improvements to the core patents, patent such improvements and then lock the corporation out of the market or attempt to extract licensee fees from the corporation if it wishes to use the improvements. The Shotgun Strategy A second strategy is to try to obtain as many patents as possible in a particular area. The goal of this strategy is to make it difficult for others to operate in the same area. The obvious drawback of such an approach is that it can become quite expensive. The Family Tree Strategy Another strategy is to first seek patents to protect the corporations core technology. As the core technology evolves, it will often branch out into various related fields (hence the family tree analogy). Each branch is then evaluated in order to determine if additional protection is required.

When to File a Patent Application


In deciding when to file a patent application, there are a number of options. The first option is to file a patent application as soon as possible in order to secure the priority date (i.e. most countries, other than the United States, have a first-to-file system) and in order to have the patent issued as soon as possible. A second option is to keep the invention a secret and to treat it as confidential information until the commercial viability

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of the invention is better known. One of the risks with this option is that a competitor could independently conceive of the same invention and file a patent application before your application is filed. A third option is to file a partial patent application.

Partial Patent Application


Where time and/or money is in scarce supply, a corporation may consider making a partial patent application. A partial patent application (also known in the United States as a provisional patent application) is a less costly, interim step in the patent application process. The application requires only a description of the invention without the need for claims or other formalities. Once filed, the applicant will obtain an application number and a filing date which can eventually be used as a priority date. The regular or complete application must be drafted and filed within twelve months from the filing date of the informal application in order to benefit from the earlier filing date. The use of partial patent applications, however, is not without risk. For example, applicants will generally only be able to obtain a patent for claims that are covered by the general description contained in the partial application. As a result, innovations that are developed after filing of the partial application and that are not contained in the invention description, will not benefit from the early priority date. In addition, if such innovations are disclosed to the public, and a new application regarding such innovations is not made within the applicable time period, the ability to obtain patent protection for the latest innovations will be lost.

Where to File
The rights granted to patent holders are limited to the country in which the patent is issued. For this reason, inventors must determine in which countries protection is most desirable. For Canadian technology companies, the most obvious countries in which to seek protection are Canada and the United States. Other territories commonly considered include the United Kingdom, Europe and Asia. As it is often difficult to determine in which countries a corporation will have success in marketing a particular invention, many corporations will file their patent applications pursuant to the Patent Cooperation Treaty (PCT). Pursuant to such treaty, a national or resident of a contracting State may file an international application which sets out those contracting states in which it wishes the application to have effect. The effect of the international application in each designated State is the same as if a national patent application had been filed with the national patent office of that State. This results in the applicant having approximately eight to eighteen additional months in which to reflect upon the decision of whether to file an application in a contracting State.

Copyright
What is Copyright?
Copyright is a form of protection that is granted to authors of original literary, dramatic, musical and artistic works to whom the Copyright Act (Canada) applies. This protection consists of separate and independent rights such as the sole right to produce, reproduce or perform the work or any substantial portion of the work in Canada. Of note to technology companies, the Copyright Act (Canada) expressly includes computer programs as part of the definition of literary works.

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In explaining the difference between copyright and other forms of intellectual property, such as patents, it is often stated that copyright does not protect the idea, but rather the expression of the idea. For example, the idea of creating a software program that allows end users to perform a specific task is not protected by copyright, but the copyrightable portions of the program (e.g. elements of the look and feel, user interface, and source code) will be. Copyright generally subsists for the life of the author and for 50 years after the calendar year of his or her death and arises upon the creation of the work. Registration is not required to obtain the protections of copyright.

Rights Conferred by Registration


Although registration is not a prerequisite to protection, it is deemed to give a potential infringer reasonable grounds for suspecting that copyright subsists in the material. This is important to a copyright owner because if it can be shown that an infringer was not aware (or did not have reasonable grounds for suspecting the subsistence) of the copyright, the owner can only obtain an injunction and damages are not recoverable. An owner of copyright can bring an action for infringement against any person who, without the consent of the owner, does anything that only the owner of the copyright has the statutory right to do. In general, infringement involves copying the whole or a substantial part of a copyrighted work. Copyright is also infringed by any person who sells, leases, distributes, exhibits by way of trade or imports for sale or hire into Canada any work that to his knowledge infringes copyright or would infringe copyright if it had been made in Canada. Remedies to which the owner of a copyright may be entitled for infringement of the copyright include an injunction, an order for the detention of imported infringing copies, damages, accounting for profits, recovery of infringing copies, and costs. Although marking is not required in Canada, it is advisable to mark a protected work with the symbol or the word copyright followed by year of first publication and the name of the copyright owner.

Trade-marks
General
The Trade-marks Act (Canada) (the Act) defines a trade-mark as a mark that is used for the purpose of distinguishing wares or services manufactured, sold, leased, hired or performed by the owner of the trademark from the wares or services of others. A trade-mark may take the form of a word or phrase, a picture or label, numbers, the shape of a product or its packaging, and take on aspects of get-up and colour, or anything which is capable of distinguishing wares and services from the wares and services of others, so long as it is used as a trade-mark. A trade-mark need not be registered but an unregistered trade-mark can only be enforced by an action for passing off. It is often difficult to establish all of the conditions required to prove a claim for passing off; it is, therefore, advantageous to register the mark, if it is registrable.

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Registration
An applicant is entitled to the registration of a (registrable) trade-mark if the applicant: has used or made known the trade-mark in Canada; has duly registered the trade-mark in his country of origin (includes WTO countries), which must be a member of the Paris Convention for the Protection of Industrial Property (the Convention), and has used the trade-mark; or intends to use the trade-mark in Canada and actually uses it after allowance of his application but before registration. Generally, a trade-mark is registrable if it is not: primarily merely the name or surname of an individual; clearly descriptive or deceptively misdescriptive of the character, quality or the place of origin of the related wares or services or of the conditions of or the persons employed in the production of such wares or services; the name in any language of the related wares or services; confusing with a registered trade-mark; or one of the marks specifically prohibited by the Act. Where the applicant does not reside in Canada, an appointment of a representative for service in Canada must be included in the application.

Rights Conferred by Registration


Valid registration of a trade-mark in Canada gives the owner the right to exclusive use of such trade-mark throughout Canada for 15 years in respect of the wares and services for which it was registered. Registration may be renewed indefinitely for further periods of 15 years. The owner of a registered trade-mark can bring an action for infringement and/or passing off against a person who, without authorization, sells, distributes or advertises wares or services in association with a confusing trade-mark or trade-name. The remedies available for infringement of a registered trade-mark or for passing off include an injunction, damages or an accounting for profits, destruction of infringing materials and costs. Anyone who reproduces or removes a trade-mark without consent also may be subject to criminal prosecution.

Licensing of Trade-marks
A third party may be licensed to use a trade-mark by or with the authority of the trade-mark owner, provided that the owner retains under licence the direct or indirect control of the character or quality of the wares or services associated with the trade-mark. Such control will be presumed where public notice is given of (i) the fact that use of the trade-mark is a licensed use and (ii) the identity of the owner. Subject to any agreement to the contrary, the licensee may call on the owner to take proceedings for infringement of the trade-mark. If within two months of being called on by the licensee, the owner refuses or neglects to take action, the licensee may institute proceedings for infringement in its own name as if the licensee were

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the owner. The owner must be made a defendant to proceedings commenced by the licensee and the owner may be liable for costs.

Industrial Design
General
Under the Industrial Design Act, an original design of an article (features of shape, configuration, pattern or ornament and any combination of those features that, in a finished article, appeal to and are judged solely by the eye) may be registered as an industrial design. Registration does not extend to methods or principles of construction or to the mere configuration of the article; there must be some form of ornamentation to which the protection of this statute may apply.

Registration
In order for an industrial design to be protected, the design must be applied for within one year from the date of first publication in Canada. Offering or making the design available to the public constitutes publication.

Rights Conferred by Registration


Registration gives the proprietor the exclusive right to apply an industrial design to an article for purposes of sale. The duration of an exclusive right for an industrial design is 10 years from the date of registration, subject to the payment of such periodic maintenance fees as may be prescribed (presently, at the fifth anniversary). If any person without authorization applies or imitates any design for the purpose of sale, an action for damages may be maintained by the registered proprietor. A Court may also award an injunction, recovery of infringing material and an accounting for profits. In addition to civil actions, fines may be imposed for criminal offences under the Industrial Design Act.

Marking
In the event that a design is applied or imitated by a third party without the consent of the proprietor, the proprietors remedy will be limited to an injunction (in other words, no damages will be recoverable), unless all or substantially all of the proprietors articles to which the industrial design registration pertains or the packaging or labels for such articles were marked with the capital letter D in a circle and the name or the usual abbreviated name of the proprietor.

Integrated Circuit Topography Law


In May, 1993, specialized legislation for the protection of integrated circuit topographies came into force providing for the registration of the original design of a topography. The three-dimensional configuration of electronic circuits (contained in an integrated circuit product) is known as a topography. An integrated circuit product is a device that performs certain complex electronic functions. The protection under the legislation extends only to the topography (or physical layout) of the integrated electronic circuits and does not extend to the functions (or logic) performed by the integrated circuit.

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Maintaining Ownership of Intellectual Property


Intellectual property is a technology companys most important asset. It is our experience, however, that many companies do not take adequate steps to secure their ownership of technology that is at the core of their business. For a typical technology company, the conception and development of technology will involve some, if not all, of the following actors: (i) founders (including work performed prior to the creation of the corporation); (ii) employees; (iii) contractors; (iv) educational institutions; (v) government agencies and/or funding; (vi) third party licensors of technology and intellectual property rights; and (vii) customers. Many technology startups mistakenly assume that any work performed on their behalf by these actors will be owned by them. Others refer to the ownership of intellectual property rights in their written agreements with the developers of the technology, but do so in a manner that is not sufficient for their needs. In doing so, issues such as moral rights, retention of rights to background technology, government funding restrictions, and the scope of the licences granted are often ignored or poorly dealt with. The use of properly drafted contracts with developers is fundamental to the success of any technology company. It is strongly suggested that proper legal advice is obtained prior to entering into any contract which deals with the development and/or ownership of technology and intellectual property rights.

The Problem of Joint Ownership


It is extremely rare to find a technology company that is able to develop in-house all of the technology required for its business. This is particularly true of startup companies. As a result, technology and intellectual property rights are often acquired or licensed from other companies and individuals. In many cases, where required technology does not already exist, companies will engage others to develop it for them. In such cases, it is always a matter of negotiation as to who will own the intellectual property rights in the newly developed technology. In the majority of the cases, the company paying for the development will require that it own the intellectual property rights to the development work. Alternatively, where the developer, in creating the new work, uses intellectual property that is key to its ongoing business (e.g. an integrated circuit design services company), the developer might insist that it retain ownership to the work (or at least the pre-existing intellectual property used in the development of the work) and grant a licence to use the work to the company paying for such development. In other cases, the parties might not be able to agree on who should own the product of such development work and decide that they shall jointly own the intellectual property rights in the newly developed technology. While agreeing to jointly own the newly developed technology might seem like a reasonable compromise, such an arrangement is fraught with difficulties and, when put into practice, often has results that are undesirable. By way of example, in Canada, a joint owner of a patent may assign the whole of its interest without the need to obtain the consent of the other joint owner(s). A joint owner, however, may not licence the patent without the consent of all other joint owners. Depending on the particular situation, neither of these results may be desirable and the joint owners may be at the mercy of each other.

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The issue of joint ownership becomes even more complicated when the same jointly owned asset is protected in multiple jurisdictions (e.g., a Canadian patent and a U.S. patent have been issued for the same invention). Because different countries often have different default rules governing joint ownership, the joint owners may not be fully aware of the implications of joint ownership in a particular jurisdiction. In addition to issues relating to the exploitation of jointly owned intellectual property, joint ownership raises complex issues regarding the registration, or application for, maintenance and enforcement of jointly owned intellectual property rights. For example, what happens if one party wishes to apply for a patent in a jurisdiction where the other joint owner does not see the value of obtaining patent protection? Or what if a joint owner wants to sue a third party (who happens to be the other joint owners best customer) for infringement, but the rules of the jurisdiction where the action is to be brought require all joint owners to join as parties to the infringement claim? If the joint owners are aware of all of the implications of joint ownership, they can include provisions in their agreement setting forth the rights and obligations of each joint owner. However, as it is difficult to anticipate all of the circumstances which my arise from joint ownership, it is recommended that, if possible, joint ownership be avoided entirely. Rather, in most cases, a model of ownership and licensing can be tailored to the particular situation so that each partys needs are adequately addressed.

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