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.
 
   ________________
[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.

        ___________________
[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.

     ______________
[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.

Basic Tax Implications for Canadian Entrepreneurs
 
Introduction
With the calendar year coming to a close and the first quarter of next year on the horizon, tax season looms large for Canadian businesses, employees, and entrepreneurs alike. It is important to distinguish the tax implications between individuals earning income from employment and self-employed individuals in an enterprising venture. This post outlines the general principles of how the tax system in Canada operates, how tax is assessed, and explores the implications for entrepreneurs operating a business in Canada.
 
The Source Concept of Income and Residency
The central document that determines the rules and processes behind Canadian tax is the federal Income Tax Act.[1] According to the Act, Canada taxes income earned based on the source concept of income. Section 3 of the Income Tax Act states that the income of a taxpayer for a taxation year is determined by… “the taxpayer’s income for the year from each office, employment, business, and property”.[2] Although there is no specific mention of when markers to use when calculating a “year”, for tax purposes, taxpayers calculate it on the calendar year.
 
Taxation is also based on the taxpayer’s residence. Canadian residents are taxed on world-wide income from all sources which are the office, employment, business, and property categories mentioned above.[3] Individual persons are determined to be Canadian based on their customary mode of life, the main indicators of which are an individual’s primary ties.[4] These include maintaining a permanent place of residence in Canada and whether or not you have a spouse or dependent(s) in Canada as well.[5] Generally, if a taxpayer permanently lives in Canada and has a family, there is no question as to the residency, and thus tax implications for that taxpayer. As entrepreneurs are generally advised to carry on their business through a corporate vehicle, there are different ways to determine residency for corporations. For corporations, the residency test looks to whether a corporation is incorporated in Canada either federally under the Canadian Business Corporations Act, or provincially with the Alberta Business Corporations Act.[6] Additionally, for companies operating in multiple jurisdictions, Courts will look to the test from DeBeers, which asks where the “mind and management” of the corporation resides.[7] In other words, one must determine where the Board of Directors of that particular company sits and makes decisions from.
 
For our purposes, individual residency is generally not an issue as most small businesses and growth companies start locally. For corporations, an entrepreneur may incorporate in other jurisdictions in which they operate in, so the mind and management test will play a large factor in determining residency, and thus the taxpayer’s tax implications.
 
Income for Businesses
The general formula to apply when calculating taxes is simple. First, the resident taxpayer determines the total of all amounts each of which is the taxpayer’s income from a source, which are listed but not limited to as office (elected officials), employment, business (entrepreneurs), or property (rental). Second, the taxpayer includes any taxable capital gains, which is income derived from the disposition (sale) of property like houses and shares. Next, deductions like moving and childcare expenses are removed from the total income. Finally, the taxpayer subtracts any office, employment, business, and property losses from their total income.[8]
 
A business is a profession, calling, trade, manufacture of any kind whatsoever and an adventure or concern in the nature of trade, but it does not include income from an office or employment.[9] Section 9(1) of the ITA lays out the initial starting point.[10] A taxpayer’s income for a taxation year from a business is the taxpayer’s profit from that business or property. However, the Act does not define what “profit” means, but common law jurisprudence indicate that profit means net profit.[11] Net profit is equal to the total revenue of a business less any expenses incurred earning that revenue, adjusted by specific rules contained in the Act. In the jurisprudence, there are a variety of cases that ask the question whether or not the impugned activity constitutes carrying on a business, or whether the activity is deemed to be a personal endeavours. However, as one of the main points the case law examines is whether or not the activity is being done for the intent to profit, and entrepreneurs go into business to make money, that is not a point that requires much discussion.
 
Deductions
Subsection 9(1) also contains the primary rule for business deductions through the definition of a taxpayer’s income from a business as the “profit from the business… for that year”.[12] As mentioned, profit from the business is defined to be net profit. This is determined according to accounting or commercial principles unless the principles are overridden by other provisions of the Act or case law. Therefore, the primary rule for deductions is net accounting profit calculations, less any reasonable expenses incurred in earning income from the business.
 
The concept of calculating profit and deducting expenses is a general rule that is subject to specific restrictions; section 18 of the Act specifically limits a deduction for certain expenses.[13] These restrictions have further exceptions from section 20 which serve to overrise section 18 and specifically allows a deduction of capital cost allowance.[14] Capital cost allowance is simply the depreciation of capital property over a certain period of time. Finally, section 67 imposes a generable “reasonableness standard” on the overall computation of profit and deductions and denies a deduction of expenses that are otherwise deductible to the extent that the amount of the expense is unreasonable.[15] Section 18(1)(a) provides that an expense is deductible to the extent that it is incurred for the purpose of earning income from a business or property. Stated colloquially by Imperial Oil, did the loss in business arise in the normal course of operations?[16]
 
The case law and Act also explicitly outlines expenses that are and are not deductible. Generally, personal or living expenses are not deductible under sections 9(1) and 18(1)(a). Additionally, expenses incurred when travelling to and from work, and expenses incurred from recreational facilities and club dues are not deductible either.[17] Some deductions like moving and childcare expenses are allowed; though not explicitly calculated in computing business income, it slots into the overall deductions framework. The rules surrounding moving expenses dictate that the deduction is limited to the income earned after the move and require the taxpayer to meet four criteria: (1) the purpose for the move must have been for work; (2) residences were actually changed; (3) the new residence must be in Canada; and (4) the new residence must be at least 40 km closer to the new work location.[18]
 
Finally, many entrepreneurs and employees are working from home in light of the COVID-19 pandemic. Section 18(12) of the Act allows for the deduction of income from a home workspace, subject to approval from the Canada Revenue Agency.[19] The CRA examines whether the spave is the individual’s principal place of business, meaning over 50% of the work occurs there, or if the space is used exclusively for the purpose of earning income from business and used on a regular and continuous basis for meeting clients, customers or patients of the individual in respect of the business.[20] According to the CRA, there are three types of workers who may qualify; these include employees, commissioned salespeople, and self-employed workers. Deductible expenses typically include utilities such as heating and electric home maintenance and supplies. Additionally, commissioned salespeople and self-employed workers can claim property taxes and home insurance.[21] Entrepreneurs may also claim a portion of their mortgage and capital cost allowance.
 
Conclusion
How an entrepreneur approaches their tax season has major implications for the overall viability of their business. Losses incurred from operating a business can be applied retroactively to past and future income, which allows the taxpayer to focus whatever resources they have into their venture. Due to the unique possibilities of potential businesses, the general rule does not enumerate the specific deductions an entrepreneur has to keep in mind, instead applying a reasonableness standard for expenses incurred. In order to gain a deeper analysis into the various tax implications to start-ups and growth companies, consultation with a tax specialist and professional accountant is highly recommended.

     ______________
[1] Income Tax Act, RSC 1985, c 1 [the Act].
[2] Ibid at s 3(a).
[3] Ibid at s 2(1).
[4] Thomson v MNR, [1946] SCR 209. 
[5] Denis Lee v MNR, [1990] TCC.
[6] Canada Business Corporations Act, 1985 RSC, c C-44; Business Corporations Act, 2000 RSA, c B-9.
[7] De Beers Consolidated Mines, Ltd v Howe, [1907] UKHL 626.
[8] The Act, supra note 1 at s 3(d).
[9] Ibid, at s 248(1).
[10] Ibid, at s 9(1).
[11] Daley v MNR, [1950]; Arcorp Investments Ltd v Canada, 2000 CanLII 16535 (FC).
[12] The Act, supra note 10.
[13] The Act, supra note 1 at s 18.
[14] The Act, supra note 1 at s 20.
[15] The Act, supra note 1 at s 67.
[16] Imperial Oil v MNR, 1947 CanLII 293 (FC).
[17] The Act, supra note 1 at s 18(1)(l); Henry v MNR, [1974] SCR 155.
[18] The Act, supra note 1 at s 248(1).
[19] The Act, supra note 1 at s 18(12).
[20] Canada Revenue Agency, Business-use-home Expenses (February 2019), online:  <https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/sole-proprietorships-partnerships/report-business-income-expenses/completing-form-t2125/business-use-home-expenses.html>.
[21] The Motley Fool, CRA Update: Work-From-Home COVID-19 Tax Break (July 2020), online: <https://www.fool.ca/2020/07/24/cra-update-work-from-home-covid-19-tax-break>.

Interest-Based Negotiation
Picture this: you’re an up-and-coming entrepreneur and starting an orange juice business. The problem is, you don’t have any oranges! So, being savvy, you go and find an orange supplier. You manage to find one and they are willing to sell you their last load of 500 oranges. The catch is, another party has approached the supplier and also wants to purchase the 500 oranges. The supplier has left it to both of you to decide who gets the oranges. [1]
 
So, what do you do? It might seem you only have two options. Either one of you gets all 500 oranges or you find a way to divide the load. Either way, someone is walking away from the supplier without all 500 oranges. So, naturally you and the other party go back and forth arguing over prices and are fighting for every orange.[2]
 
ENTER: Interest-Based Negotiation
 
What if you both could get all 500 oranges? You, being that savvy entrepreneur, decide to ASK the other party what they need the oranges for. It turns out, they are making a serum out of orange rinds. You acknowledge that you only need the juice. And voila – you decide to split the price of the load and you’ll each get the part of the orange you need! Everybody wins.
 
In this simple example, it was easy to find a solution beneficial to both parties if the right question was asked. This is the basis of Interest-based negotiation (otherwise known as principled negotiations, integrative bargaining or interest-based bargaining) - asking questions, uncovering the interests of the other party and collaborating to find a solution that works for everyone.[3]
 
Now let’s back up – what is negotiation?
 
Negotiation has many definitions, one definition is: “Negotiation is a basic means of getting what you want from others. It is back-and-forth communication designed to reach an agreement when you and the other side have some interests that are shared and others that are opposed”. – Fisher and Ury, authors of Getting to Yes[4]
 
In negotiations, people tend to think in ways that ultimately hurt their chances for the best deal, such as:
 
1.Negotiations are a zero-sum world and that the other party is an adversary.
2.Either you win or you lose.
3.You both only have your positions.
 
This thinking tends to limit negotiations, as then typically information is not shared among parties and often the best solutions are left aside. People stand firm with their positions and budging on them is felt as losing.
 
Interest-based negotiation removes the thinking of “positions” and replaces it with “interests”. Instead of demands, terms and ultimatums, you have underlying motivations, needs and concerns and THE WHY! [5]
 
The basic method of Interest based negotiations, outlined in international best seller Getting to Yes is as follows:[6]
 
People: Separate the people from the problem 
Every negotiator has two kinds of interests – in the substance and in the relationship.[7] They are interested in solving the substantive issues while also maintaining a good working relationship with the other party. Sometimes, strong emotions from the relationship of the parties can be wrapped up in the substantive issues in a negotiation and cause complications. It is essential that you disentangle the relationship from the substance and try to reach a better understanding of each party’s concerns. Base the relationship on mutually understood perceptions, clear two-way communication and a forward looking, purposive outlook.[8]
 
Interests: Focus on interests, not position

• asking why and why not;
• putting yourself in the other party’s shoes;
• looking behind positions for underlying interests; and
• crafting a solution that meets their interests and yours.[9]

 
Your position is something you have decided upon while your interests are what caused you to decide. [10] Shared interests lie latent in every negotiation, even if they are not immediately obvious.[11] Looking to interests instead of positions will allow you to develop creative solutions that can meet both party’s needs.
 
Options:  Invent options for mutual gain 
Having both a lot at stake and only thinking there is one possible solution inhibits creativity.[12] Do not settle on the first agreement made. Instead, brainstorm a wide range of options before choosing the best one. If getting to the ultimate agreement proves out of reach – try agreeing on smaller, “weaker” options like a provisional agreement or only agreeing on what you disagree about.[13] At least then some issues are discussed, and you have something to build on in the future.
 
Criteria:  Use objective criteria/standards. 
Rely on a fair, independent standard to settle differences.[14] Whether it is market value, replacement cost, an expert opinion or a particular law. People using objective criteria tend to use their time more efficiency to talk about possible solutions and outcomes.[15]
 
Best Alternative to a Negotiated Agreement (“BATNA”)
 
Your BATNA is the best-case scenario if you don’t reach an agreement. The better your BATNA, the more you can ask for in your current negotiation.[16] Understanding your own BATNA, but also the BATNA of the other party is crucial.

For example, you are at a car dealership. You are negotiating the price of a new car. Your current car works fine – you are just looking for a good deal. However, the salesperson has targets he must meet by the end of the day and is desperate for a sale. In this example, your BATNA is stronger than the other party’s, and thus you are able to push for a better price. If the deal doesn’t happen, you still will have a car to drive. It is important to remember that asking questions, doing research and putting yourself in the position of the other party is the only way for you to uncover their BATNA.
 
Knowing your own BATNA and also the BATNA of the other party not only allows you to negotiate more effectively but forces you to consider their interests, motivations and the WHY!
 
The interest-based negotiation method permits you to reach a consensus on a joint decision efficiently. Using this approach will not only benefit your own negotiations but can guide your thought process to overcome differences in many areas of life. Remember to ask questions, uncover the interests of the other party and develop creative solutions for mutual benefit.

    ________________
[1] David Wright, Law 508 – Negotiation (Faculty of Law, University of Calgary, 2019)
[2] Roger Fischer & William Ury, Getting To Yes: Negotiating Agreement Without Giving In, 3rd ed (New-York: Penguin Books, 2011).
[3] Wright, supra note 2.
[4] Fischer, supra note 2 at xxvii.
[5] Wright, supra note 1.
[6] Fischer, supra note 2.
[7] Ibid.
[8] Ibid at 23.
[9] Wright, supra note 1.
[10] Fischer, supra note 2 at 43.
[11] Ibid at 74.
[12] Ibid.
[13] Ibid at 71.
[14] Katie Shonk, “Principled Negotiation: Focus on Interests to Create Value” (13 July 2020), online (blog): Program on Negotiation Harvard Law School < https://www.pon.harvard.edu/daily/negotiation-skills-daily/principled-negotiation-focus-interests-create-value/>.
[15] Ibid.
[16] Ibid.

Sales Tax Obligations and Opportunities for Small Canadian Businesses
 Author: Vanessa Fisher

If you are a new company with plans to operate in Canada it is important to be aware of your sales tax obligations before you begin selling any goods or services within the country. This blog outlies the goods and services tax (“GST”) / harmonized sales tax (“HST”) regimes and walks through signing up for a GST/HST account online. Lastly, this blog explains how to collect and remit GST/HST to the Canada Revenue Agency (“CRA”) and provides guidance on the Input Tax Credit (“ITC”) system available to small Canadian businesses.
 
GST is a 5% tax applied to most items and services sold in all provinces and territories within Canada. Certain provinces (Ontario, New Brunswick, Newfoundland and Labrador, Nova Scotia and PEI) have combined their provincial sales tax with GST, utilizing a unique HST rate that is collected in the same way as GST.[1] When a business sells goods or services in Canada, they are required to add the applicable GST/HST rate to their selling price. The GST/HST is then collected by the seller at the point-of-sale and held until remitted to the CRA.
 
Businesses in Canada are not obligated to begin collecting and remitting GST/HST on their goods and services sold within the country until they are no longer considered a “small supplier” by the CRA. A business is no longer a small supplier once their revenue before expenses (that is, the company’s sales, not their profit) exceeds $30,000 in a single calendar quarter (three consecutive months), or over the last four consecutive quarters.[2] While collecting and remitting GST/HST is mandatory on sales that occur after this $30,000 threshold is passed, a small business can also elect to voluntarily register for a GST/HST account prior to this point and become eligible for Input Tax Credits (“ITCs”), a point I will return to.
 
How to Register for a GST/HST Account
In order to sing up for a GST/HST account, one must first apply for a Business Number (“BN”). A BN is a unique number assigned to your corporation that simplifies all your dealings with the CRA and is also necessary for filing corporate income tax, setting up payroll accounts, importing/exporting accounts, and GST/HST accounts. The registration for a BN also automatically creates an account for filing corporate income taxes.
 
The CRA’s business registration page[3] allows you to register your corporation with a BN at no cost. From there, you can create and add a GST/HST account (and any other accounts needed) on the same webpage. This process will also create a CRA e-portal for your business that allows you to update your corporate information, do your tax filings, and process payments to the CRA online.
 
How to Collect and Remit GST/HST
The GST/HST you charge your customers at the point of sale will depend on the GST/HST rate of the location where your customer is purchasing and receiving their order. The CRA calls this the place-of-supply.[4] For example, if your company is in Alberta and you sell an item of clothing for $10.00 to a customer residing in Toronto, you would need to apply the Ontario HST rate of 13% to the purchase price (for a total of $11.30), not the Alberta GST rate of 5%. In this scenario, Alberta is the place where the selling corporation resides, not the place-of-supply. However, if the customer physically comes to Alberta to purchase the clothing from a store in Alberta, the Alberta GST rate of 5% would apply to the purchase.
 
The CRA provides a useful Provincial Rates Table and GST/HST Calculator[5] to calculate what to charge on your sales to each province.
 
It is also important to note that Alberta, Nunavut, the Northwest Territories, and the Yukon have no provincial sales tax, and other provinces (as mentioned above) utilize an integrated HST, which means that only GST/HST is collected from sales in these provinces. British Columbia, Manitoba and Saskatchewan have a separate provincial sales tax (PST/RST/QST) and rules for collecting and remitting provincial sales tax are unique to the provinces. Provincial sales tax will not be considered in this blog, but obligations related to provincial sales tax should be investigated if your company ever plans to sell its products to customers in these provinces.[6]
 
Once you begin collecting and charging GST/HST (and any relevant provincial sales tax), you must also tell your customers that the sales tax is either included in pricing or will be added separately, and this information should be clearly indicated on your invoice with the rate being charged and your registration number.
 
Your business is also considered to hold GST/HST collected “in trust for the Crown” until you remit it to the CRA. This constitutes a kind of trust fund that comes into existence automatically when you collect sales tax from your customers. Failure to remit amounts collected to the CRA has serious consequences, so it is important to keep detailed records of your sales that supports the information you will send to the CRA when you file your GST/HST return at the end of each reporting period. [7]
 
Input Tax Credits and Zero-Rated Supplies
As mentioned, Canadian businesses are not obligated to begin collecting and remitting GST/HST until their sales exceed $30,000 in a single calendar quarter, or over the last four consecutive quarters. That said, for certain small businesses it might be worth voluntarily registering for your GST/HST account early, even if it is not required. One reason is to get a head-start on good record-keeping, as you will have to begin collecting and remitting GST/HST as soon as you register for your account. Volunteer registration also allows your business to make use of ITCs.
 
ITCs are basically a mechanism to offset your GST paid on expenses for the business against the GST collected from sales of the business. For example, if the GST/HST you pay on expenses incurred for your business was $1,000 for the reporting period, and the GST/HST collected from customers for your goods/services sold was $3,000, you can claim an ITC of $1,000 and therefore be required to remit back $2,000 to the CRA.
 
ITCs can be especially useful if you are registered for the GST/HST account and produce or sell zero-rated supplies. Certain goods and supplies are considered zero-rated by the CRA and therefore not subject to GST/HST charges on sales.[8] At the same time, a business selling zero-rated goods is still eligible to claim ITCs on the GST/HST paid or payable on purchases and operating expenses related to the commercial activities of its business.[9] In other words, a refund is available on GST/HST paid on certain expenses for the business despite not being required to collect or remit GST/HST to the CRA on sales. It is also advised to obtain professional advice from a lawyer and/or accountant to find out exactly what you can and can’t include as expenses in the business as this can be a complicated area to navigate.
 
Further Information
There is a wealth of information on the CRA website under the General Information for GST/HST Registrants [10] and GST/HST for Businesses [11] that provide further guidance on completing your GST/HST return and much more.

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[1] “Canada’s Harmonized Sales Tax Explained”, online: Investopedia <https://www.investopedia.com/terms/h/harmonized-sales-tax.asp>
[2] “Definitions for GST/HST (Small Supplier)”, online: Government of Canada <https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/gst-hst-businesses/definitions-gst-hst.html#smallsupplier>
[3] CRA Business Registration page:  https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/registering-your-business/bro-register.html
[4] “GST/HST rates and place-of-supply rules”, online: Government of Canada  <https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/gst-hst-businesses/charge-collect-place-supply.html>
[5] GST/HST Calculator: https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/gst-hst-businesses/charge-collect-which-rate/calculator.html
[6] “Charging Provincial Sales Tax on Online Sales” <https://www.thebalancesmb.com/charging-provincial-sales-taxes-on-online-sales-2948448>
[7] “Charge and Collect the Tax - What to do with Collected GST/HST”, online: Government of Canada                                           < https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/gst-hst-businesses/charge-collect-what-collected.html>

[8] “Zero-Rated Goods”, online: Government of Canada <https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/4-3/basic-groceries.html>
(also, in speaking with a CRA agent, I was told that coffee is only a zero-rated good as long as it is in bean or grind form and sold in packaged bags. If you brew the coffee and sell it, it becomes taxable for GST/HST purposes).
[9] “Input Tax Credits (ITCs)”, online: Government of Canada <https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/payroll/benefits-allowances/remitting-gst-hst-on-employee-benefits/input-tax-credits-itcs.html
[10] https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/rc4022/general-information-gst-hst-registrants.html
[11] https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/gst-hst-businesses.html