Articles of Incorporation Basics
 
Background
If you have the opportunity to start your business off on the right foot, why not capitalize on it? Having an effective and well thought out legal structure is not only conducive for business growth, but it can also save a lot of headaches and future problems down the road. Articles of Incorporation is going as far back, legally, as possible. Understanding what these documents are is critical to understanding how the law can directly impact your business.
 
Articles of Incorporation are part of a legal document that is submitted to either the provincial, territorial, or federal government which registers a business as a corporation within Canada. For the purposes of this blog post, we will be examining two jurisdictions. The first is Alberta-based corporations which is governed by the Business Corporations Act (Alberta).[1] The second is federally incorporated companies which are governed by the Canada Business Corporations Act.[2]
 
As a refresher, operating under a corporate entity separates the business from its owners. The liability attributed to the corporation is only in regard to the corporation’s assets, not the assets of the owners of the corporation. This is important if the business is being subject to any legal action or debt recovery; it limits shareholder and director liability.
 
What is included in the Articles?
Articles of Incorporation include specific information for all corporations. Requirements of the Articles are found in S.6(1) of the ABCA and CBCA. The legislation mandates the inclusion of the name of the corporation, the corporation’s share structure, the number of directors of the corporation, and restrictions. Found on the legal Articles document is the corporation’s address and date of filing.
 
Business Name
A business name is always included in the Articles. Often, you will see companies named ###### Alberta Inc., or ###### Canada Inc. This would be the legal name of the business, but the Articles allow you to have a named corporation as well like ABC Company Inc. To make sure there are no other companies with your business’ chosen name, you will have to do a NUANS report to confirm that no duplicates exists.
 
Directors and Officers
All directors’ names and their addresses must be included in the Articles. Federally, if there are only one or two directors in the company, at least one of them must be a Canadian resident.[3] In Alberta, there is a similar rule, but the Alberta corporation only mandates that one in four directors must be resident.[4] Non-Canadian residents can also be directors of the corporation, however, and in most instances, provinces will still require the company to have an attorney for service or someone in the province to be able to receive mail and more, on behalf of the corporation. When this is not the case, most provinces will require an attorney for service or someone in the province to be listed. Residential addresses for all directors are required to confirm residency status.
 
Although officers are not legally mandated in corporations, in a small owner-operated business, it is common for the shareholder(s), director(s), and officer(s) to be all the same. For example, if Bryce is the CEO of 123456 Canada Inc, Bryce can also be listed as a director and a shareholder on the Articles. However, officers manage the operations of the business and therefore, the decision to select them should not be taken lightly.
 
Head Office
The Articles must include the corporation’s head office address. The head office of the corporation needs to be located in the province or territory in which the business is being registered.
 
Restrictions
Any restrictions that apply to the business must be included in the Articles. Restrictions generally relate to the company’s share structure and share transfers. Restrictions on share transfers allow shareholders to control who can become a shareholder in the corporation. Having this embedded in the Articles makes sure that changes cannot be made without updating the Articles with the government. In order to update the Articles, shareholders must vote to pass the amendments with a two-thirds vote.

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[1] Business Corporations Act, RSA 2000 c B-9 (ABCA).
[2] Canada Business Corporations Act, c C-44 (CBCA).
[3] Ibid at s 105(3.3).
[4] ABCA, supra note 1 at s 105(3).

Incorporating a Business – A Tax Perspective
As the business grows, entrepreneurs at some point may need to consider, or at least have heard of, the idea of incorporating their business. This is a complex decision that involves several legal, financial and tax implications. This blog will provide a brief overview some of the important consequences of incorporation from a tax perspective.
An informative summary of the legal considerations can be found on the Business Venture Blog here.
​
Why Incorporate?
A corporation is one of three basic types of business organization, with the other two being sole proprietorships and partnerships. There are two basic differences between corporations from the other forms: [i]

1)Corporations have a separate legal existence. The corporation, rather than the owner, operates the business and bears all the rights and obligations that come with that business.
2)The owners and managers of the corporation become separate and have distinct rights and obligations.

This has an important consequence – the income earned by the corporation running the business and the income earned by the shareholders of the corporation are separately taxable. Because there are two levels of taxation, the differences in the way they are taxed create advantages and disadvantages for the business owner. Some advantages include the ability to reduce taxes by claiming tax credits only available to corporations, controlling the timing of income, or splitting income (to a limited degree). Some disadvantages include the restriction against deducting business losses against personal income, the additional costs of maintaining a corporation such as registration and accounting fees, and the complexity of winding down the corporation when the business ends.[ii]

Taxable Income – Corporations vs Unincorporated Businesses
There are some differences between the tax treatment of business income earned through a corporation and business income from a sole proprietorship or partnership. For a more thorough overview of the tax treatment of business income, see our blog posting here.
In short, the amount of taxes owed from a business is based on Taxable Income, which is calculated as:

1)Net income (or “profit”) based on accounting rules,[iii] then
2)Adjustments are made to calculate Net Income for Tax Purposes,[iv] then
3)Additional deductions are made to arrive at Taxable Income.[v]

This calculation applies to both corporations and individuals with unincorporated businesses. However, there are different kinds of deductions available to each type of business, or the deductions may be treated differently. Deductions available to individuals but not corporations include:[vi]

• Employee stock option deductions[vii]
• Deduction for payments such as social assistance and workers’ compensation benefits
• Lump sum payments
• Lifetime capital gains deduction
• Northern residents deductions

Deductions that are treated differently include:[viii]

• Charitable donations – charitable donations are used to create a tax credit (directly reduces taxes payable) by individuals and a tax deduction (reduces income subject to tax) for corporations.

 

• Dividends – dividends received by individuals are grossed up when included in income, but also receive a tax credit. There are no gross-up or tax credits procedures for dividends received by corporations. Dividends received from other Canadian corporations are deducted from income. Dividends paid by a corporation are also deducted as an expense.

Tax Incentives Specific to Corporations
Several tax incentives available to support incorporated businesses include:

1)Small business deduction – ITA s 125(1)
 
The federal small business deduction allows Canadian-controlled private corporations (“CCPC”) reduce their taxes payable based on a limited amount of active business income earned in Canada. The business must be a CCPC, which is a private Canadian corporation that is not controlled by one or more non-resident persons or corporations whose shares are publicly traded or listed on a stock exchange.[ix]
 
Income from an “active business” includes most kinds of business income except for income from a “specified investment business” or “personal services business”.[x] These terms have complicated meanings, but it essentially means that active business income excludes passive income earned merely by owning property (for example, stocks and bonds), and income earned by providing what could be reasonably seen as an employee service.
 
The deduction is calculated as 19% of active business income (for the 2020 tax year) earned during the year up to $500,000.[xi] This amount would then be deducted from your federal tax payable.
 
2)Investment tax credits – ITA s 127(5) through s 127.1(4)
 
Canada offers specific tax credits to support corporations investing into their business. These include credits for scientific research and experimental development (“SR&ED”), employing an eligible apprentice, and purchasing property to run a business in Atlantic Canada.[xii]
 
3)Foreign tax deduction – ITA s 126
 
Both individuals and corporations may claim a tax credit to offset foreign taxes paid on business and non-business income earned outside of Canada. The main difference is that, for foreign non-business income, the amount of credit an individual can claim is limited to the lesser of:
 
a)15% of foreign non-business income, and
b)Another limit based on a formula.
There is no 15% limit for corporations – they may instead claim up to the total foreign taxes paid on foreign non-business income or the formula limit, whichever is lower.[xiii]

4)Manufacturing and processing (“M&P”) profits deduction – ITA s 125.1
 
The federal government offers a tax reduction based on 13% of profits earned (for 2020) from “manufacturing and processing” activities in Canada. There is no precise definition of manufacturing and processing, but the tax rules exclude activities such as logging; construction; extracting minerals; and producing industrial minerals, natural gas, and heavy crude among many other exceptions.[xiv]
 
Note that there may not be any actual tax benefits from claiming the M&P profits deduction as any income not included in that deduction is eligible for the general rate reduction, which creates another deduction using same percentage and applies to all other income. However, Ontario, Quebec, and Saskatchewan offer their own tax credits based on M&P activities.[xv]
 
5)Provincial small business deductions and tax credits
 
All provinces provide small business deductions to CCPCs like the federal deduction above. Each province also provides tax credits for corporations performing specific activities. For example, Alberta offers the Innovation Employment Grant (beginning January 1, 2021) and tax credits for scientific research and development, foreign taxes paid, capital expenditures, and production and labour costs for film and television productions.[xvi]

Salary vs Dividends
In the case of an owner-managed business corporation, owners have the option to pay themselves a salary, dividends, or a combination of both. This decision depends greatly on the individual circumstances of the owner and their business. Some important considerations are listed below:[xvii]

1)Provincial tax rates and credits

While all Canadian corporations are subject to the same federal tax rates, different provincial tax rates and credits could weigh in favour of salaries or dividends depending on where the business is incorporated. Generally, individuals taxed at higher rates would likely prefer dividends as their tax effects are offset by dividend tax credits. Salaries of course receive no such credit.
 
2)Types of dividends received

Corporations can pay either eligible or non-eligible dividends, each of which have their own tax treatment. Eligible dividends typically receive (are “eligible” for) more generous tax credits than non-eligible dividends. However, whether a dividend is eligible or not depends on the tax treatment of the corporate income from which the dividends were paid, and the tax credit is intended to offset that difference. Given that and the differences in the provincial tax treatment of dividends, there is no clear answer to whether salaries or dividends should be preferred.

3)CPP and EI contributions
 
Being paid a salary allows an owner to continue making contributions to the Canada Pension Plan (“CPP”) and Employment Insurance (“EI”), whereas dividends do not. Being paid in dividends will have the effect of lowering the amounts the owner is eligible for under either plan.
 
4)RRSP contributions
 
Salary payments are used to determine how much an owner can contribute to their Registered Retirement Savings Plan (“RRSP”). RRSP contributions enable individuals to defer taxes by allowing them to deduct their contributions from income. Dividends received are not factored in and so would not increase their total contribution room.
 
5)Childcare expense deductions
 
Salary is also used to determine how much an individual can deduct in childcare expenses.[xviii] Dividends do not count towards this limit and so could reduce the amount an owner may claim for this deduction.

GST Obligations
A goods and services tax (“GST”) is charged on most goods and services in Canada and is paid by consumers. With some exceptions, the suppliers of these items (including business corporations) are responsible for collecting and remitting GST to the Canada Revenue Agency. For an overview of a business’s GST obligations, please see our blog post here.

Transferring Business Assets to a Corporation
It is often the case that business owners will have worked at and grown their business long before they consider incorporation. If they do decide to incorporate, owners may transfer their business assets to the corporation. However, under normal tax rules this transfer could result in the owner paying additional taxes (through capital gains and CCA recapture).[xix]
Section 85 of the Income Tax Act[xx] provides a solution to this. The owner must notify CRA that he or she intends to transfer their assets to the corporation and elect to have Section 85 apply by filing certain forms. There are many detailed rules around how to properly perform the transfer, including what kinds of assets are eligible for transfer, what the owner should receive in return for the transfer (for example, shares in the corporation), and how the assets should be valued. In essence, this election may prevent owners from facing needless tax liabilities in growing their business.

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[i] J Anthony VanDuzer, The Law of Partnerships and Corporations, 4th ed (Toronto, Ontario: Irwin Law Inc, 2018) at 13-16.
[ii] Clarence Byrd, Ida Chen & Gary Donell, Byrd & Chen’s Canadian Tax Principles: 2020-2021 Edition, Volume 2 (North York, Ontario: Pearson Canada Inc) [Byrd and Chen] at 725-727.
[iii] For an explanation of “profit”, see “Basic Tax Implications for Canadian Entrepreneurs”, (30 December 2020), online (blog): Business Venture Blog http://www.businessventureclinic.ca/blog/december-30th-2020.  
[iv] Income Tax Act, RSC 1985, c 1 (5th Supp) [ITA], s 9(1).
[v] ITA, supra note iv at s 110(1).
[vi] Byrd and Chen, supra note ii at 585.
[vii] In 2019, the Government of Canada proposed changes to the current treatment of employee stock options, where there will be a $200,000 limit on stock options that qualify for the stock option deduction. Employees with options over this limit would not receive the deduction on those options and include the entire excess benefit in income when the options are exercised. Instead, the employer will be able to deduct the amount that would have been eligible for the deduction. CCPCs and non-CCPC corporations with annual gross revenues of $500 million or less would not be subject to the new rules. The Government’s goal was to “ensure that start-ups and emerging Canadian businesses that are creating jobs can continue to grow and expand and attract key talent, while limiting the benefit of the employee stock option deduction for high-income Canadians who work in mature companies.” The new rules are expected to apply to options granted on or after July 1, 2021. See Department of Finance Canada, “Supporting Canadians and Fighting COVID-19: Fall Economic Statement 2020“ (2020) at 113-114, online (pdf): Her Majesty the Queen in Right of Canada https://www.budget.gc.ca/fes-eea/2020/report-rapport/FES-EEA-eng.pdf
[viii] Byrd and Chen, supra note ii at 585-586.
[ix] ITA, supra note iv at s 125(7).
[x] ITA, supra note iv at s 125(7).
[xi] ITA, supra note iv at s 125(1.1)(c) and 125(2).
[xii] See Canada Revenue Agency, “Line 41200 – Investment tax credit” (date modified: 18 January 2021), online: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/deductions-credits-expenses/line-41200-investment-tax-credit.html
[xiii] Byrd and Chen, supra note ii at 615.
[xiv] See ITA, supra note iv at s 125.1(3) for definition. See also Canada Revenue Agency, “Income Tax Folio S4-F15-C1, Manufacturing and Processing” (last modified: 15 February 2017), online: https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax/income-tax-folios-index/series-4-businesses/series-4-businesses-folio-15-manufacturing-research-development/income-tax-folio.html#N101DD
[xv] Byrd and Chen, supra note ii at 609.
[xvi] See Government of Alberta, “Corporate income tax” (date accessed: 30 January 2021), online: https://www.alberta.ca/corporate-income-tax.aspx#deduction
[xvii] Byrd and Chen, supra note ii at 753-758.
[xviii] ITA, supra note iv at s 63(1)(e)(i).
[xix] Byrd and Chen, supra note ii at 775.
[xx] ITA, supra note iv at s 85(1).

 Agency Costs
The “agency problem” arises whenever one person (the “Principal”) entrusts another person (the “Agent”) with the power to make decisions that affect the Principal. This could involve entrusting property to the Agent to deal with on behalf of the Principal, or it could involve delegating decision-making power to the Agent that affects the legal rights of the Principal. The core of the agency problem is that the Agent has the authority to act on behalf of the Principal and yet the interests of the Agent may diverge from the interests of the Principal.[1] For example, the Agent may not negotiate as hard as the Principal would on the price of the Principal’s goods unless there is something in it for him. This is a prime example of an “agency cost”.

In Canadian common-law, the essence of an agency relationship is that the Agent can affect the legal rights and obligations of the Principal with the outside world.[2] For example, the Agent can negotiate, enter into contracts, or dispose of the Principal’s property. The list of agency relationships is not closed, but trustee-beneficiary, employee-employer, solicitor-client, and business partners all give rise to certain agency problems. In a corporation, an agency relationship exists between the corporation's shareholders (Principals) and its management (Agents).

The common-law’s solution to the agency problem is the fiduciary duty. The fiduciary duty holds the Agent to a strict standard of conduct.[3] It requires the Agent to exercise reasonable care and diligence (duty of care), and to exercise his authority in the best interests of the Principal, not to obtain a benefit for himself to the detriment of the Principal (duty of loyalty).[4] Courts are reluctant to impose fiduciary duties, particularly in commercial contexts because it is thought to be a “blunt tool” in that it imposes serious legal duties upon one party without much regard for circumstances. To find a fiduciary duty at least three elements must exist (although the presence of all of them or the lack of one of them is not determinative):

(1)  The fiduciary has scope for the exercise of some discretion or power.
(2)  The fiduciary can unilaterally exercise that power or discretion so as to affect the beneficiary's legal or practical interests.
(3)  The beneficiary is peculiarly vulnerable to or at the mercy of the fiduciary holding the discretion or power.[5]

In a corporation, it is the directors and officers who make decisions about the corporation’s business, and it is the shareholders whose property is at stake. As a result, both the common-law and legislation impose fiduciary duties on directors and officers to act in the best interests of the corporation. This public-law solution is good, but as mentioned above, it is “blunt” and not very proactive. There are several other ways that shareholders can protect themselves contractually i.e., structuring the enterprise in a way that aligns the interests of management, with the interests of owners.

In a corporation, agency costs are the costs incurred by the shareholders (Principal) to supervise and control management (Agent).[6] Traditionally, economists point to three ways to effectively control and oversee management:
​

• Independence – management, and directors should be independent of one another
• Equity – management should have a stake in the company’s ownership
• Market for Corporate Control – where management acts in self-interest by taking opportunities for themselves, operating inefficiently, or shirking responsibilities, it devalues the company and creates an opportunity for better management teams to step-in and acquire the company at a discount.[7]

The market for corporate control, like the fiduciary duty, is criticized as being “blunt” and only really applies when management has seriously failed.[8] It does not proactively prevent mismanagement. The market correction also relies heavily on an efficient market where these kinds of inefficiencies can be addressed immediately. But, transaction costs, market regulations, asymmetric information, and the fact that other firms are not always in a position to acquire make the market for corporate control less efficient.
Similarly, empirical research has shown that board independence is not actually very effective at reducing agency costs or improving firm performance.[9] Boards of directors are rarely truly independent, and even if they are, they are often influenced by management and are less effective at disciplining management and representing the interests of shareholders than one might think. Regardless, in a start-up company, it is unlikely that an independent board of directors is possible.

In very early-stage companies the founder often holds 100% of the company’s capital and manages 100% of the affairs of the business. When the company needs to grow, it needs to attract some form of venture capital. The moment that outside capital is involved, there are going to be agency problems. What you end up with is a company with shareholders who are particularly vulnerable to the control of a single founder or group of founders, and founders who are particularly vulnerable to shareholders who want their money back.[10] Not to mention that both the founders and the shareholders are particularly vulnerable to going out of business. So naturally, agency costs are significant in start-up companies. This partially explains why start-up companies and investors make use of relatively complex investment instruments and shareholder agreements.

Capital structure, shareholder agreements, bylaws, and employment agreements all play a significant role in controlling agency costs in a start-up company. The table below provides a few examples of the legal tools corporations can use to address agency problems. This table is not authoritative and the boundaries between independence, equity, and corporate control are not clear-cut, but hopefully, it gives the reader a sense of the motivation behind certain contractual provisions and rules. 

 
   

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[1] Dalton et al, “The Fundamnetal Agency Problem and Its Mitigation: Independence, Equity, and the Market for Corporate Control” in James P Walsh & Arthur P Brief, The Academy of Management Annals: Volume 1, New York: Taylor & Francis Group, 2008) 1 [Dalton].  
[2] Trophy Foods Inc v Scott, 1995 NSCA 74 [Trophy Foods].
[3] Guerin v The Queen, 1984 CanLII 25 (SCC).
[4] Trophy Foods, supra note 2.
[5] Lac Minerals Ltd v International Corona Resources Ltd, 1989 CanLII 34 (SCC).
[6] Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (Canada: LexisNexis Canada, 2018) [Tingle] at 328.
[7] Dalton, supra note 1 at 3.
[8] Dalton, supra note 1 at 27.
[9] Dalton, supra note 1 at 10.
[10] Tingle at 329.

Choosing the Right Investment Structure for Financing a Start-Up:
Equity Investments, Convertible Debt, and SAFEs
 
Choosing the right financing option for a company in its early stages will depend on the unique needs of both the start-up and its investors. The most common investment structures used for financing early-stage companies include: equity investments, convertible debt instruments, and SAFEs. Advantages and disadvantages of these different investment instruments are outlined below and should be weighted carefully so as to select the financing option that best meets both company founder and investor needs.  
 
 EQUITY INVESTMENTS
An equity financing involves investors directly purchasing a certain percentage of capital stock from the company based on the company’s current valuation. This could be in the form of purchasing either common or preferred shares in the company.
 
Advantages:

• A start-up company may prefer an equity investment over debt because investors cannot “call” the equity investment the way they can “call” debt to be repaid upon maturity. Many start-ups don’t want to worry about having enough cash on hand to pay out debts at inconvenient times in its early lifecycle.
• Equity looks better than debt on the balance sheet of a start-up company in its early stages, which makes the company more attractive to later investors.

 
Disadvantages:

• Depending on the complexity of the investment, equity agreements often require higher legal fees to negotiate a wide range of terms.
• Equity investments lock in a company’s valuation at an early stage in a growth company’s life cycle, which means less flexibility for negotiating the valuation of the company with subsequent investors.

 
 CONVERTIBLE DEBT/CONVERTIBLE NOTES
Convertible debt, or “convertible notes”, can sometimes be a good alternative to early-stage equity investments. Convertible debt essentially allows investors to loan money to the company in exchange for a future right to have their debt converted into shares of the company’s stock. The percentage and amount of shares the debt will convert into is determined by the terms of the agreement and is usually converted in line with the valuation given to the company in its next equity financing.
 
Advantages:

• Convertible debt involves fewer negotiation terms and less paperwork, which drives down both legal costs and deal timelines, allowing the company to put that money into the business instead of into lawyers.
• Start-ups might prefer convertible debt financing in its early stages because it delays the valuation of the business until later in the company’s lifecycle. This provides the company with more flexibility in negotiating their later-stage financing rounds.
• For investors, the convertible debt note offers a fixed interest rate of return and some priority to be paid out before common shareholders if the start-up fails.

 
Disadvantages:

• The main disadvantage of convertible debt financing resides in the nature of debt itself; that is, the investors have the right to call the debt upon its maturity date. An early-stage company will often not have the cash flow on hand to repay investors if the debt is called. That said, in practice, few investors call in convertible debt notes as they are meant to be investments; therefore, most investors will simply renegotiate the investment when the term is up.

 
 SAFEs
SAFEs (Simple Agreement for Future Equity) were first developed in Silicon Valley as a way for venture capital investors to be able to quickly put money into a start-up without the burdensome negotiations that equity financing often entails. SAFES were created specifically to avoid the debt features and repayment obligation of convertible debt notes.[1] A SAFE, like a convertible note, does not give the investor stock in the company, but rather is a promise for future stock in the company on occurrence of the next equity financing round. Unlike a convertible debt note, a SAFE is not debt, but something more akin to an equity call on options or an equity warrant.[2]
 
Advantages:

• For start-up founders, SAFES can be beneficial because they do not act like debt instruments and therefore do not accrue interest or have a maturity date when they can be called by the investor.
• SAFEs are usually relatively easy to negotiate and quick to implement.
• Like convertible notes, SAFES do not require the company to adopt a valuation of the company early on, thereby leaving more flexibility for negotiating future financing rounds.
• SAFES keep debt off the balance sheet of an early-stage company.

 
Disadvantages:

• It has been suggested by some scholars that SAFEs are a poor match for financing conditions in Canada.[3] Canada does not have the same access to institutional venture capital like that of the Bay Area. In Canada, there may be no subsequent financing available after a SAFE investment. If financing is available, it may come from less sophisticated retail investors who will then set the valuation of the company that SAFE holders will have to follow.
• SAFEs provide no fixed rate of return and no real leverage to re-negotiate financing terms. The priority afforded debt over equity at least provides investors with some protection in the early stages of their investment because they can call the debt and have some leverage to re-negotiate terms. In contrast, SAFEs often lack this protection because they act more like an equity warrant and have no maturity date.

 
Whatever investment structure is utilized, it is important to know the pros and cons of each investment option, as a wrong choice of financing in the early stages of a growth company can have unforeseen consequences later in the company’s lifecycle. It is also advised to seek consultation with legal professionals so as to receive tailored advice for specific company and investor needs.
 
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[1] Bryce Tingle, Start-up and Growth Companies in Canada (LexisNexis Canada Inc., 2018) at 274.
[2] MARPE, “Hey SEC - SAFEs are Equity, not Debt!” (26 June 2017), online: <https://marpefinance.com/blog/HeySECSAFEsareEquitynotDe-2017-06-26>
[3] Bryce Tingle, Start-up and Growth Companies in Canada (LexisNexis Canada Inc., 2018) at 274.

Things Not to Say to An Investor
What Are Prohibited Representations, Why Are They Bad, and How Do I Mitigate Against Them?

​How Prohibited Representations AriseSecuring investments is essential for a start-up. Often characterized by their rapid growth, start-ups experience a pressing need to obtain outside financings since their internal revenue flow is often insufficient to fuel their continued growth.[i] While securing investments to finance the growth of the business is a crucial part of the entrepreneurial journey, there are various risks associated with soliciting, facilitating, and accepting investments.

This blog focuses on the first step of obtaining an investment – soliciting someone to finance the business. When to comes to soliciting an investment, a major risk that entrepreneurs must keep in mind are prohibited representations. Prohibited representations are representations often made by a business or one of its stakeholders to a potential investor for the purpose of securing financing which cannot be made according to Canadian securities laws. There two major prohibited representations with respect to communicating with potential investors: a plan to list the company on a public market, and the future price of securities.[ii]

Cannot Represent an Intention to Go Public
The prohibition on representing a business’s intention to become publicly listed is quite extensive. In addition to being prohibited from stating that a security will be on a public market or quotation system in the future, businesses also cannot state that they will apply to become publicly listed in the future.[iii] This prohibition includes merely discussing the possibility of an initial public offering in the future.[iv]

This restriction is deeply problematic for growth businesses as investment decisions often hinge on whether a business with have reliable access to future financing opportunities and if a business can provide its investors with an exit event. Due to the absence of venture capital and similar sources of financing in Western Canada,[v] the public markets can be the only reliable future source of financing. Consequently, the absence or perceived absence due representation restrictions, of a business’s intention to enter the public markets can deter investors and stunt business growth.[vi]

Cannot Represent Future Prices of Security
Being unable to discuss the future prices of securities or derivatives can have a major negative impact on soliciting investments. Since start-up businesses grow rapidly, historical financial information is not an accurate indication of how the business will perform in the future. As a result, investors frequently valuate start-ups based on their anticipated future value through discounted cash flow (“DCF”) models, terminal values, and other calculations derived from forward-facing financial information.[vii] While future securities prices may not necessarily be used in arriving at these calculations, it can be easily calculated from these valuations. [viii] As a result, entrepreneurs must be cautious about what information they provide to potential investors concerning the anticipated future value of their business.
This obligation extends to all representations concerning the future price of securities, including representations made during financing negotiations. This can stall negotiates and prevent a financing from taking place.[ix] Consequently, violations of this prohibition can be attractive to start-ups, however, as discussed below, this early securities law violation can have major repercussions down the road – both for the initial investment and subsequent financing rounds.

Cannot Misrepresent Information Affecting Security Prices
Before discussing the consequences of making a prohibited representation, it is also worthwhile noting that there is a broad prohibited representations rule which prohibits misrepresenting information that could affect the price of a business’s securities. There are two elements to this prohibition. First is that unless a security has redemption or retraction right attached to it, no person can represent that business will resell it, repurchase it, or refund any portion of its costs[x]. Second, there is an obligation that no person may make a statement they know to be untrue, misleading, and that would be reasonably expected to have a significant effect on price/value of a security.[xi] This obligation applies to not just the business’s directors and officers, but also includes other stakeholders irrespective of their relationship to the business, capturing people like the shareholders and agents of the business. 

Consequences of Making a Prohibited RepresentationTwo key risks arise if a business makes a prohibited representation. If a prohibited representation is made in connection with an investment, then the affected investor can use that securities law violation to make the investment contract voidable. This means that the investor can require the business to repurchase their shares and allow the investor to exit the business which grants the investor an immense amount of power over the business.[xii] Secondly, if the securities violations become public knowledge it can deter future investors from investing in the business. This can occur if an investor in the company reports the violation to the securities commission.[xiii]

How to Navigate the RulesGiven how central these rules are to soliciting a financing and how catastrophic their breach can be, how can a business mitigate the risk of making a prohibited representation? Unfortunately, there is no silver bullet solution, but there are some steps that businesses can take to mitigate the risk of making a prohibited representation. These can include restricting the disclosure of and regularly attaching disclaimers to the information which may contain prohibited representations, warning management about the risks of using this information, and ensuring that no prohibited representations are included in any offering memorandums.[xiv]
 
Author: Duncan Pardoe is a caseworker at the BLG Business Venture Clinic and a second-year law student at the Faculty of Law, University of Calgary.

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[i] Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (Canada: LexisNexis Canada, 2018) at 9-10 [Tingle].
[ii] Securities Act, RSA 2000, c S-4, at s 92(3)(a-b) [Securities Act]; Tingle, at 284-285.
[iii] Securities Act, at s 92(3)(b).
[iv] Tingle, at 284-285.
[v] Ibid, at 297-301.
[vi] Ibid, at 284-285.
[vii] Ibid, at 321-324.
[viii] Ibid, at 285-286.
[ix] Ibid, at 286.
[x] Securities Act, at ss 92(1)-(2.1).
[xi] Tingle, at 286.
[xii] Ibid.
[xiii] Ibid, at 249-251.
[xiv] Ibid, at 286.

“Meaningful Consent” under Canadian Privacy Law

Businesses commonly collect information in the course of their operations – customer accounts, billing information, website use statistics, email lists, and more. Privacy law questions may come up for start-ups and small businesses navigating information collection and use, particularly when selling goods or services online via websites or mobile apps. How can businesses ensure that they obtain meaningful consent as part of their personal information practices and avoid being subject to privacy-related complaints or reputational damage?
 
Canada’s privacy law regime governing private sector companies is set out in the federal Personal Information Protection and Electronic Documents Act (PIPEDA) and in substantially similar laws in Alberta, British Columbia, and Quebec.[1] One of our previous blog posts provided an overview of PIPEDA and Canada’s key privacy law principles.[2] This post focuses on the third privacy principle: consent.[3] Here, we discuss the consent principle for businesses subject to privacy laws and some practices for obtaining consent for any use, collection, and disclosure of personal information.
 
            As a quick refresher, “personal information” means any “information about an identifiable individual”, and includes information that could identify an individual on its own or when combined with other information.[4] For example, someone’s age, employment history, financial information, location information, contact lists, or even hotel check-in and check-out times can be personal information.[5]
 
            So where does consent come in? The general rule is that an individual has to both know about and consent to any collection, use, or disclosure of their personal information.[6] To make sure someone knows about a proposed use or disclosure of their information, a business must “make a reasonable effort” to tell the person the appropriate purpose for which the business will be using or disclosing the information, and generally at the time of collection.[7] PIPEDA requires “meaningful consent”, so the person has to reasonably understand the description of the purpose.[8] This requires a certain level of detail – something like “service improvement” may be insufficient for a person to reasonably understand the purpose.[9]
 
Additionally, a business cannot require consent as a condition to providing a product or service if it is asking for information that is not actually necessary for its specified purpose.[10] This may be an area for businesses to assess privacy compliance – in a 2019 survey of just over 1000 companies in Canada, 65% of businesses said that they have a privacy policy, but only 45% said that they clearly tell customers if the collection, use, or disclosure of personal information is a condition of obtaining the services offered.[11] A business can still ask for more information than it needs to carry out the purpose, but it has to give the individual a choice of whether or not to provide it.[12]
 
Ideally, a consenting customer will be notified of what the Officer of the Privacy Commissioner of Canada (OPC) calls the “key elements” impacting their privacy decisions – what information is collected, who it will be shared with, the purposes of collection, use, and disclosure, and any risks of significant harm that the business cannot reduce under its privacy and information-handling practices.[13] This can all be done in easily-understandable language that is accessible to a range of potential users.[14]
 
Tricky situations can come up where an organization may obtain consent for a specific purpose, but then uses or discloses information for a different purpose. For example, businesses cannot use products containing personal information to promote their business (a commercial purpose) without informed consent – such as a videographer using a customer’s wedding video in subsequent promotional material.[15] The OPC suggests that organizations obtain consent for any “significant changes” to privacy practices, including using data for new purposes or generally when disclosing it to a third party.[16] Businesses also have to be careful not to accidentally disclose information without consent – for example, leaving phone messages with personal information on machines that are accessible by other people.[17]
 
The way a business asks for consent and the acceptable form of consent can vary in the circumstances.[18] Some personal information is sensitive, making it necessary to obtain express consent – for example, financial or medical information, although seemingly non-sensitive information could also be sensitive depending on context.[19] Express consent would also generally be needed if the proposed collection, use, or disclosure is not what a person would reasonably expect from a business (for example, location tracking could be outside of reasonable expectations), or if it creates a risk of significant harm to the person.[20]
 
Businesses must also consider whether they are collecting any personal information from minors and adjust their practices if necessary. The ability of children to provide meaningful consent varies according to their development and may depend on which privacy law applies – for example, the OPC (federal) considers children under 13 unable to provide meaningful consent, while in Alberta it depends on the child’s understanding of the nature and consequences of the action.[21] Even if a child can meaningfully consent, the consent process must reasonably account for their maturity level.[22] If a child cannot consent, parental or guardian consent is needed to collect personal information.[23]
 
            When a business seeks consent or provides privacy information, we commonly think of a privacy policy. However, businesses can also use different tools to facilitate meaningful interactions. This is particularly important for apps where information is being viewed on a small screen and a user may not pay attention to a privacy policy when it initially pops up.[24] One tool is to set up a “layered-format” to present information.[25] This is where a business makes privacy information available in different levels of detail – it might show a summary of key information up-front and provide links to further information.[26] Digital platforms may also put together a privacy “dashboard” allowing users to easily view and change their privacy settings.[27] Attention-grabbing tools can also draw attention when consent becomes relevant, rather than only requesting consent when a user first signs up for a service.[28] A “just-in-time” notice is a small notice that might pop-up when a user is about to input personal information (for example, their age) or when they access a feature that will collect personal information (for example, their location).[29] Graphics, colours, or alert sounds can draw attention when information is about to be collected or when someone can choose whether to provide consent.[30]
 
People can withdraw their consent at any time (subject to any legal restrictions or restrictions in a contract and on reasonable notice to the business).[31] A business has to tell people about the consequences of withdrawing consent (for example, if it would no longer be able to provide certain services).[32]
 
Personal information can sometimes be collected, used, or disclosed without a person’s knowledge or consent – for example, an organization can disclose personal information to comply with subpoenas, court orders, or requests by lawful government authorities. [33] However, this will only be the case for the limited and specific circumstances set out in the privacy statutes.
 
Privacy law compliance is important, and it’s a good idea to brush up on the requirements in the early stages of a business while designing information-handling practices and setting up privacy communications with customers. It may seem like a lot learn at first, but it doesn’t need to be hard – in the survey discussed above, 92% of companies that have taken steps to comply with privacy laws said it was not difficult to bring their privacy practices into compliance.[34] If you want more information about consent or other areas of privacy law, please contact the BLG Business Venture Clinic!
 

     ____________________
[1] SC 2000, c 5, Part 1 [PIPEDA]; Personal Information Protection Act, SA 2003, c P-6.5 [PIPA]; Personal Information Protection Act, SBC 2003, c 63; Act Respecting the Protection of Personal Information in the Private Sector, CQLR c P-39.1.
[2] “Data Processing Regulations in Canada – a Primer on PIPEDA” (1 January 2020), available online: BLG Business Venture Clinic <http://www.businessventureclinic.ca/blog>.
[3] PIPEDA, s 2(1), Schedule 1, s 4.3; PIPA, ss 1(1), 7(1).
[4] PIPEDA, s 2(1); PIPA, s 1(1); “Summary of privacy laws in Canada” (last modified 31 January 2018), online: Office of the Privacy Commissioner of Canada (OPC) <https://www.priv.gc.ca/en/privacy-topics/privacy-laws-in-canada/02_05_d_15/>.
[5] Ibid; see also “Seizing opportunity: Good privacy practices for developing mobile apps” (last modified 24 October 2012), online: OPC <https://www.priv.gc.ca/en/privacy-topics/technology/mobile-and-digital-devices/mobile-apps/gd_app_201210/#fn2-rf>; “Hotel check-in/check-out times are personal information and must not be disclosed without consent” (last modified 5 December 2013), online: OPC <https://www.priv.gc.ca/en/opc-actions-and-decisions/investigations/investigations-into-businesses/2013/pipeda-2013-007/>.
[6] PIPEDA, Schedule 1, s 4.3; PIPA, s 7(1).
[7] PIPEDA, Schedule 1, ss 4.3.1 and 4.3.2; “Guidelines for obtaining meaningful consent” (last modified 24 May 2018), online: OPC <https://www.priv.gc.ca/en/privacy-topics/collecting-personal-information/consent/gl_omc_201805/>.
[8] “Guidelines for obtaining meaningful consent”, ibid.
[9] Ibid.
[10] PIPEDA, Schedule 1, s 4.3.2; PIPA, s 7(2) (in PIPA, the information cannot be beyond what is necessary to provide the product or service).
[11] Phoenix SPJ, 2019-20 Survey of Canadian Businesses on privacy-related issues, Final Report, 31 January 2020, online: OPC <https://www.priv.gc.ca/en/opc-actions-and-decisions/research/explore-privacy-research/2020/por_2019-20_bus/>.
[12] “PIPEDA Fair Information Principle 3 – Consent” (last reviewed August 2020), online: OPC <https://www.priv.gc.ca/en/privacy-topics/privacy-laws-in-canada/the-personal-information-protection-and-electronic-documents-act-pipeda/p_principle/principles/p_consent/>.
[13] “Guidelines for obtaining meaningful consent”, supra note 7.
[14] Ibid.
[15] “Videographer posts client’s wedding video on social media without consent” (last modified 19 December 2019), online: OPC <https://www.priv.gc.ca/en/opc-actions-and-decisions/investigations/investigations-into-businesses/2014/pipeda-2014-020/>.
[16] “PIPEDA Fair Information Principle 3 – Consent”, supra note 13.
[17] “Phone message left at client’s workplace disclosed personal information without consent” (last modified 30 January 2013), online: OPC <https://www.priv.gc.ca/en/opc-actions-and-decisions/investigations/investigations-into-businesses/2012/pipeda-2012-009/>.
[18] PIPEDA, Schedule 1, ss 4.3.4 and 4.3.6.
[19] Ibid; PIPEDA, Schedule 1, ss 4.3.4 and 4.3.6; “Form of Consent” (last modified 11 December 2015, currently under review), online: OPC <https://www.priv.gc.ca/en/privacy-topics/privacy-laws-in-canada/the-personal-information-protection-and-electronic-documents-act-pipeda/pipeda-compliance-help/pipeda-interpretation-bulletins/interpretations_07_consent/>.
[20] “Guidelines for obtaining meaningful consent”, ibid.
[21] Ibid.
[22] Ibid.
[23] Ibid.
[24] “Seizing opportunity”, supra note 5.
[25] “Guidelines for obtaining meaningful consent”, supra note 7.
[26] Ibid; “Seizing opportunity”, supra note 5.
[27] Ibid.
[28] Ibid.
[29] Ibid.
[30] “Seizing opportunity”, ibid.
[31] PIPEDA; Schedule 1, s 4.3.8; PIPA, s 9 (PIPA allows people to withdraw or vary consent with reasonable notice).
[32] PIPEDA, above.
[33] PIPEDA, ss 7, 7.2, 7.3, 10.1(3); PIPA, ss 14, 17, 20.
[34] See Phoenix SPJ, supra note 11.

Mezzanine Debt Agreements – A Primer for Borrowers
At many points in the life of a start-up venture, owners will have to choose between different financing options to sustain and grow their business. Subordinated or “mezzanine” debt is a popular financing vehicle for Canadian high growth companies in their earliest stages. There are many complexities to mezzanine debt that distinguish it from the typical bank loan and which prospective borrowers should consider when making their financing decisions.

What is Mezzanine Debt?
Mezzanine debt is a loan with components that give it some of the characteristics of holding equity. With both debt- and equity-like features, mezzanine debt occupies a middle ground between senior debt (i.e. secured bank loans) and common shares in terms of risks and rewards. This is especially evident when a borrower defaults on their agreement – lenders of mezzanine debt have lower priority than senior lenders in their claims against a company’s assets when that company becomes insolvent. As such, mezzanine debt is usually (but not always) unsecured, meaning that lenders are dependent on the company’s cash flows as a going concern to protect their principal.

What Gives Mezzanine Debt It’s “Equity” Feature?
The equity component is attached to the loan agreement in two ways:

1. Conversion option – gives the borrower the option to convert the outstanding balance into common shares;
2. Share purchase warrants – rights to purchase the company’s shares at a set price.

The main legal differences between the two are that in an agreement with a conversion option, using the option will cause the debt to disappear, along with all the rights and obligations of the loan. Exercising warrants will not have this effect. Conversion options also cannot be separated from the agreement. Warrants can be separated and sold off to another party. Outside of these differences, the two components are economically equivalent.[1]
​
How Much Does Mezzanine Debt Cost?
Mezzanine debt usually charges a higher interest rate than senior debt (usually 12%-15% per year).[2] Lenders may also charge a variety of fees on top of that interest, including setup fees, monitoring fees, late payment fees, prepayment fees, and so on.

Lenders are legally required to disclose the annualized nominal interest rate on their loans.[3] For example, if lender charges 1% interest per month, the lender must indicate this as 12% interest per year. However, this number does not include three things that affect the cost of borrowing:

1. The effect of compounding,
2. The effect of additional fees, and
3. The effect of prepayments.

Including these items would increase the total cost of borrowing as a percentage of the principal balance (for legal purposes known as the effective interest rate). Especially with mezzanine debt, the difference between the reported interest rate and total cost of borrowing can be significant.

Mezzanine debt often includes penalty interest to encourage borrowers to make payments on time. Penalty interest is also not included in the nominal interest rate. If the loan is secured by real property, then the lender cannot increase the interest rate even in default.[4] In this case, the borrower may see that fees are charged instead of additional interest when in default, though it is unclear whether this would qualify as interest.[5]

It is illegal under criminal law for lenders to charge interest greater than 60% per year on the amount advanced.[6] Criminal law considers interest to include all applicable fees as mentioned above. Prepayments also increase the interest rate as it lowers the amount advanced on which the interest charged is calculated, increasing the percentage as a result. The combined effects of additional fees, prepayments, and the already high interest rates can make the effective interest rate greater than 60%. Because of this, lenders will often include “black-out periods” in their agreements where prepayments cannot be made for a few weeks, especially after the loan is given or after fees are charged.[7]

What Terms Do Mezzanine Debt Agreements Have?
Mezzanine debt agreements often include provisions that the loan will be subordinate to any future senior debt agreement, so undertaking mezzanine debt would not preclude a borrower from seeking secured bank loan down the road.

If a borrower already has a mezzanine loan and later secures a senior loan from a bank, the bank may require the borrower and mezzanine lender to sign an inter-lender agreement. This protects the bank by ensuring that it has first charge all the borrower’s assets (except for assets secured by the mezzanine lender, if any). It may also set terms as to:[8]

1. The maximum amounts that may be advanced by each lender,
2. Allowable repayment amounts to the mezzanine lender,
3. An obligation of the mezzanine lender to notify the bank of any default by the borrower on its agreement, and
4. How each lender may proceed against the borrower in the case of default.

Lenders will sometimes take security in a mezzanine debt agreement. Unlike senior loans, collateral often includes assets like intellectual property, share pledges, and life insurance proceeds. Intellectual property can include trade secrets, patents, copyrighted works, and trademarks.
​
Due to the risk mezzanine lenders face in providing unsecured loans (or taking intellectual property or other assets with uncertain value as collateral), lenders tend to avoid forcing a borrower into bankruptcy in the case of default. Instead, they may convert their debt into common shares and provide additional financing. This gives the lender additional control over the business while sustaining it as a going concern.[9]

    _______________
[1] Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (Canada: LexisNexis Canada) at 386.
[2] Ibid at 383.
[3] Interest Act, RSC 1985, c I-15, s 4.
​[4] Ibid at s 8.
​[5] Supra note 1 at 390.
​[6] Criminal Code, RSC 1985, c C-46, s 347.
​[7] Supra note 1 at 392.
​[8] Ibid at 407.
​[9] Ibid at 426.

Managing the Effects of High Power Incentives on the Behavior of Entrepreneurs
 
At the age of 24, American entrepreneur, Ryan Blair sold his first company (SkyPipeline)[1] for twenty-five million dollars. Since he owned 25% of the company, Blair anticipated a big payout from the sale. To Blair’s unfortunate surprise, he learned that he was not projected make any money from it. Blair was enraged when he learned this was not a mistake but a consequence of the venture capital contracts he signed, specifically the anti-dilution and liquidation provisions they contained. In response, Blair threatened to tarnish the company’s reputation and withhold his vote to approve the transaction (his vote was required for the sale to proceed under California law).  Following Blair’s outburst, the company’s board of directors agreed to distribute some of the sale’s profits to Blair however, the amount they agreed to was still low relative to his equity ownership in the company.[2] This scenario illustrates how many entrepreneurs react to the application of high-power incentives.
 
Investors impose high power incentives to transfer considerable risk to from themselves to a start-up’s founders and management (which I collectively refer to as “executives”).Two particularly onerous high-power incentives are full anti-dilution rights and multiple liquidation preferences (similar to those in Blair’s venture capital contracts). Inexperienced entrepreneurs like 24 year-old Blair, often do not appreciate the effects they can have until their application is triggered. Thus, despite initially agreeing to these provisions, executives often feel they were treated unfairly by investors when the effects of high-power incentives take place. As a result, disgruntled entrepreneurs retaliate and engage in strategic behaviors to deliberately harm the company which may harm a start-up.
 
The behaviors of executives are significant to a start-up success and this is recognized by venture capitalists, many of whom attribute the failures (of portfolio companies) they observe to shortcomings in senior management and founders.[3] However, despite the negative effects that high-power incentives can have, they are still commonplace in venture capital contracts. Since venture capitalists still request these terms, I provide suggestions to supplement anti-dilution terms and liquidation preference or otherwise to mitigate their negative effects. I begin by describing each term and the interests they signify.

1. Defining the Provisions

 (a) Full anti-dilution rights / full-ratchets 
Anti-dilution rights are triggered when securities are issued at a price lower than the investor’s conversion price.  The most dilutive variation of this term is a full anti-dilution right, which adjust the investor’s conversion price to the absolute lowest price at which subsequent stock is issued. This provision enables the preferred stockholder to obtain enough shares to maintain their original equity position in the company by disproportionately diluting common shareholders or other investors who do not invest on a pro-rata basis.[4]

 (b) Multiple liquidation preferences 
Preferred shareholders receive some money on liquidation of the company before anything is paid out to other shareholders. Liquidation preferences may be triggered on a company’s bankruptcy or wind-up.  A multiple liquidation preference provides the investor with a right to receive between one-and-a-half and three times the liquidation price (the original purchase price plus any accrued and unpaid dividends). 
 
    2. Interests Underling the Provisions 
A venture capitalist’s main method of mitigating the risk of their investment is the valuation of an investee company.  However, as venture capitalists often recognize that entrepreneurial over-optimism can result in an exaggerated valuation of the company. Full anti-dilution rights and multiple liquidation preferences are triggered in unanticipated, non-ideal circumstances. Effectively, these terms provide the investor with “downside” protection, mitigating the risks of their investments.[5] With this in mind, I conclude this post by outlining some ways to circumvent the perverse implications of these provisions while satisfying the interests of an investor who may request them.

1. Proposed Alternatives

 (1) Lowering the company’s valuation: when a venture capitalist proposes these terms, it may be due to their inclination that the valuation proposed by a founder is too high.[6] If a venture capitalist is concerned about an overly-optimistic valuation it may be more prudent for an entrepreneur to lower the valuation of their company (to a reasonable extent), rather than relying on these provisions to fill the valuation gap.
(2) Staging investments: this reduces the amount of capital at risk at any given time and enables the venture capitalist to get more information about the business and management of a corporation before hazarding the full amount of anticipated investments. 

    2.  Managing expectations 
The strategic and retaliatory behavior I noted is closely correlated with deviations from the executives original expectations.[7] If either an anti-dilution right or liquidation preference must be used, a start-up’s executives fully should understand their implications along with the real possibility that they will take effect, from the outset.
​
    3.  Considerations to limit the severity of anti-dilution rights: 
(1) capping the dilution produced by them (for instance, at the point at which it becomes clear that management would have no meaningful stake in the business);
(2) adding a sunset clause so that this right is only effective for a limited time following the investment;
(3) making the right affected by the company’s achievement of certain milestones which themselves ameliorate the risks faced by an investor (i.e. Producing commercial product, generating certain gross revenue etc.), in these circumstances, the anti-dilution right can be affected by altering the formula used to adjust the conversion ratio or even by getting rid of the right all together; and
(4) rather than adjusting the conversion provision to the lowest price given to a subsequent purchaser, consider substituting for a weighted averaging “narrow-based” or “broad-based” formula.
     (a) “broad-based” formula: gives the venture capitalist a conversion ratio that reflects a           per share price equal to the weighted average purchase price of all subsequently issued           and outstanding shares. [8]
     (b) “narrow-based” formula: only takes into account the pricing of the shares being                 adjusted (usually just the venture capitalist’s preferred shares), along with all subsequently       issued shares.[9]  

    4.  Considerations to limit the severity of multiple liquidation preferences:  
(1) capping the returns on preferred shares so that if the company is a modest success, venture capitalists do better by converting preferred shares to common shares than they would by relying on the operation of their liquidation preference; or
(2) a viable compromise might be that the preference operates only against the start-up’s executives. This will leave the investments of other common stock holders (like the executives’ families and friends), proportionally intact.
(3) Liquidation preferences should not:

1. provide for a “change of control” mechanisms that results in a deemed liquidation in the event of an equity investment involving more than 50% outstanding shares; or
2. a liquidation preferences should not take effect on a successful exit transactions (for instance, if the company is sold and the valuation received by the sale exceeds a threshold amount). This, along with the other mentioned considerations for liquidation preferences take into account the provision’s objective - to mitigate risk if the company fails, not impair to the rewards of success.[10]

 
      ________________
[1]  Kim Orlesy, “The Difference Between Success and Wisdom With Ryan Blair” (2016), online https://www.kimorlesky.com/blog/author/kim-orlesky
[2] Ryan Blair, “Nothing to Lose, Everything to Gain: How I Went from Gang Member to Multimillionaire Entrepreneur” Portfolio/Penguin (2013).
[3] M. Gorman and W. A. Sahlman, “What Do Venture Capitalists Do?” (1989) 4 J. Bus Venturing 231 at 238.
[4] Well Kenton, “Anti-Dilution Provision” Investopedia (2019), online: <https://www.investopedia.com/terms/a/anti-dilutionprovision.asp>
[5] Bryce C. Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practices, 3rd ed (Canada: LexisNexis Canada Inc, 2018) at p. 416.
[6] Deepak Malhotra, “How to Negotiate with VCs” (2013) Harvard Business Review, online:  <https://hbr.org/2013/05/how-to-negotiate-with-vcs>
[7] Supra note 5 at p. 419.
[8] Ibid at p. 357.
[9] Ibid.
[10] Ibid at p. 364.

5 Legal Considerations for Starting a Business in Canada 

Are you looking to start your own business? Since the peak of the COVID-19 outbreak in March, over 150,000 Canadian small businesses have turned to e-commerce to support themselves during the pandemic. However, starting your own thing is not as simple as picking a catchy name and letting everyone know you are open for business. There are some legal decisions you will need to make before you start earning revenue. So, before you begin choosing your website’s colour scheme, consider the types of agreements and which legal structure is right for your business to ensure your start-up gets off on the right foot.
 
1.     Business StructureThe first decision you will need to make is how your business will be structured. Will you operate as a sole proprietor, a partnership, or will your company be a corporation?
 
A sole proprietor puts everything on your shoulders. In this business structure, you and the company will exist as one, and you will need to register and obtain a business license to get started. There are benefits of structuring it this way as there are low setup costs and you have complete control, but it comes with unlimited liability meaning that all of your assets, personal or otherwise, are linked to the business.
 
Entrepreneurs should also be wary that they do not find themselves inadvertently in a partnership. This can arise automatically when two or more persons are working in common with a view to profit. In a partnership, each individual is jointly and severally liable for all debts against the partnership as a whole irrespective of whether the debt was incurred by the business or one of the individual partners. In essence, it may be in an entrepreneur’s interest to consider if they are comfortable with the structure of a partnership and the amount of risk that partners expose themselves to.
 
If you want to be separate from your business as a legal entity, you will want to structure it as a corporation. This provides limited liability to you and any shareholders associated with the company and your liability is limited to the extent of your investment. It also is the preferred structure if you want to raise capital, which might be needed as this option is more costly and heavily regulated.
 
2.     Term SheetsWhen it comes to raising capital, most start-ups turn to venture capitalists for funding once they have exhausted their own networks (family, friends). This is where you may get introduced to term sheets, as venture capitalists use this type of document to define funding arrangements. The term sheets will outline the terms of the investment from the venture capitalists and what you will provide in return. It also defines the guidelines of how both parties will act to protect the capital being put forward.
 
3.     Shareholder AgreementsA shareholder agreement is a contractual agreement amongst the shareholders of a corporation that describes how the company plans to operate and outlines shareholders’ rights and obligations. It provides details regarding the relationship between everyone involved, the expectations of all parties involved, and how disputes will be handled if disputes arise. A right of refusal provision may also be included, which provides the holder of this clause to review any offers or transactions before it is presented to third parties or other potential investors. A shareholder agreement can provide you with a structure on how to run a company, satisfy stakeholder expectations, and set you up for entrepreneurial success.
 
4.     Employee AgreementsUnless you are planning to do everything on your own, you are going to need some people to help. However, if you are going to hire employees, you may need an Employment Agreement to outline their terms.
 
This most often includes a job title, responsibilities, how much management and employees are compensated, how many hours they must work, and many other details that protect your company and the employee’s rights.
 
In this employment agreement, it is important for entrepreneurs to have a termination provision that employees can be terminated at the employer’s discretion. This may consist of the sum of their severance that they will be paid to the employee upon termination and the length of notice required—equal to or exceeding— the relevant provincial statutory regime.
 
5.     Confidentiality AgreementsIf what you are working on is highly classified or proprietary, you might also want to consider a Non-Disclosure Confidentiality Agreement or a Non-Solicitation Agreement. Whenever someone new comes on board, or you share business trade secrets with members of your company, this agreement will protect your information from getting leaked to competitors or other entrepreneurs. A Non-Solicitation Agreement will prevent ex-employees from attempting to poach individuals they worked with or developed relationships with during the course of their employment.
 
Do You Need Some Legal Advice?Starting a business can be fun, but it does not mean you do not need to consider all of your legal obligations in order to be protected.
 
You do not need to navigate through these waters on your own. The BLG Business Venture Clinic can help you with your legal questions and guide you on how to get started with your new business. Contact us today to find how we can help you.
 
 

Artificial Intelligence and the Law: Who owns the assets created by an AI robot and what does it mean for Canadian business?
​
Many successful start-ups find success utilizing new technology to solve old problems, or to make things easier and more convenient. One such technology is artificial intelligence (AI). As AI becomes more common, it is important to understand the legal risks and ambiguity that exist. A recent Interesting Engineering[1] article raises an important question; who owns intellectual property (IP) created by AI?
​
The World Intellectual Property Organization, located in Geneva Switzerland, has an online exhibit[2] featuring the art of Ai-Da, an AI humanoid robot who has sold its works for over $1.5 million in Canadian dollars and also appeared in a music video[3] for the band The 1975. The AI program used by Ai-Da utilizes sight via camera vision, neural networks, and a paintbrush or pencil in her hand to complete its art. The AI program itself was developed by PHD students from Oxford University. The exhibit focuses on the ways AI can transform culture and industries, showing that robots like Ai-Da are likely to continue creating works or products which will make the question of who owns their work more relevant. 
 
The exhibit explores the question of how, “In a world that is increasingly governed by algorithms, many of which function completely under the radar, where does human governance end and robotic self-ownership begin?” As technology continues to advance, this will only become a larger question. Within this general question the exhibit wonders if AI can be a creator or inventor within current intellectual property frameworks, or if a human is required. The exhibit even questions what AI is since no agreed upon definition seems to exist. This is further complicated by the fact even human intelligence can be difficult to clearly define.
 
While Ai-Da may be one of the more unique and independent AI artists, it is far from alone. Google, of course, has both a program which would help to write local news articles,[4] as well as software that generates unique music[5] by listening to recordings. The news articles still involve significant human capital and inputs, and to a lesser extent the music program also is reacting to what humans are training it with, but they show first steps towards how AI could become very prevalent in society and the economy. Interestingly, a novel co-authored by an AI program[6] almost won a Japanese literary prize competing against human authored novels. In this case, the human team selected sentences and words while setting parameters for the program. It then completed the novel titled, “The Day A Computer Writes A Novel” when translated to English.
 
With new developments, many have begun to argue that intelligent robots need to be treated more like human beings. Some believe that robots in the workplace deserve ethical rights[7] as their use, and violence against them, increases. A more detailed, and legal, case is made by Ryan Abbott in “The Reasonable Robot: Artificial Intelligence and the Law.” Abbott argues that the law should not discriminate between AI and human behaviour.
 
In Canada, it is far from clear who would own IP created by an AI program. The Copyright Act[8] requires “the author was, at the date of the making of the work, a citizen or subject of, or a person ordinarily resident in, a treaty country.” This would not cover AI, or if it were classified as a computer, potentially leaving their works exploitable by others. However, Canadian law has not directly confronted the emergence of AI as a potential author and creator.
 
There are many routes that can be taken for regulating AI and how IP and employment laws apply to it. One potential avenue that would eliminate risk for entrepreneurs is to treat robots and AI like property, specifically how the law treats pet ownership. If something like Ai-Da earns money or other positive benefits, then the owners of Ai-Da could reap the rewards. Alternatively, if Ai-Da somehow injured people or caused property damage, those same owners could face the consequences. This is certainly not a perfect fix, but it is just one example of how the issue could be handled without drastically changing Canadian law. Artificial intelligence is well on its way toward being a major feature of everyday life and regulations and laws need to adapt and be proactive instead of reactive for when, inevitable, something goes wrong with AI and ends up in the courts as a dispute.
 
Other countries have already made determinations on how they will handle AI creations. The United States copyright office has followed U.S. court decisions in determining that an original work of authorship must be created by a human being.[9] Australian courts similarly determined work generated with the intervention of a computer could not be protected by copyright because it was not human produced.[10] Alternatively, jurisdictions like New Zealand, Ireland, India, Hong Kong, and the United Kingdom have gone with a different approach. The best example is that of the U.K., which through legislation has declared that “In the case of a literary, dramatic, musical or artistic work which is computer-generated, the author shall be taken to be the person by whom the arrangements necessary for the creation of the work are undertaken.”[11] They go further in defining computer generated work, clarifying it “is generated by computer in circumstances such that there is no human author of the work”,[12] which creates an exemption to any human requirements.
 
Artificial Intelligence is not going away. It is going to continue to evolve and create more headaches for those responsible for policies and laws that govern its use. Regardless of the route Canadian lawmakers take, let’s hope businesses and entrepreneurs can receive some certainty about how IP laws will treat AI creations.

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[1] Chris Young. (2020, September). New Exhibition Explores Whether AI Robots Should Own Intellectual Property. Retrieved from https://interestingengineering.com/new-exhibition-explores-whether-ai-robots-should-own-intellectual-property.
[2] WIPO and IP: A virtual experience. Retrieved from https://wipo360.azurewebsites.net/.
[3] The 1975. (2020, July). The 1975 - Ai-Da responds to ‘Yeah I Know’. Retrieved from https://www.youtube.com/watch?v=dTK9N7n8Wcg&ab_channel=The1975VEVO.
[4] Julia Gregory. (2017, July). Press Association wins Google grant to run news service written by computers. Retrieved from https://www.theguardian.com/technology/2017/jul/06/press-association-wins-google-grant-to-run-news-service-written-by-computers.
[5] Devin Coldewey. (2016, September). Google’s WaveNet uses neural nets to generate eerily convincing speech and music. Retrieved from https://techcrunch.com/2016/09/09/googles-wavenet-uses-neural-nets-to-generate-eerily-convincing-speech-and-music/.
[6] Chloe Olewitz. (2016, March). A Japanese A.I. program just wrote a short novel, and it almost won a literary prize. Retrieved from https://www.digitaltrends.com/cool-tech/japanese-ai-writes-novel-passes-first-round-nationanl-literary-prize/.
[7] https://www.cnbc.com/2018/12/27/now-is-the-time-to-figure-out-the-ethical-rights-of-robots-in-the-workplace-.html.
[8] Copyright Act, RSC 1985, c C-42. Retrieved from https://www.canlii.org/en/ca/laws/stat/rsc-1985-c-c-42/latest/rsc-1985-c-c-42.html.
[9] Andres Guadamuz. (2018, October). Artificial intelligence and copyright. Retrieved from https://www.wipo.int/wipo_magazine/en/2017/05/article_0003.html.
[10] Ibid.
[11] Ibid.
[12] Ibid.