The Problem with Using Shares as Compensation for Future Services

The Problem with Using Shares as Compensation for Future Services
 
For growth companies, offering shares as compensation to employees and contractors can be effective early-stage strategy. This is especially true for companies still waiting to see revenues coming through the door. However, there are important considerations to keep in mind when using shares as compensation. This article will outline the issues with using shares as compensation for future services, and then discuss two possible solutions to this problem.  
 
When can shares be used as compensation?
Both the Alberta Business Corporations Act and the Canada Business Corporations Act outline that shares cannot be issued until the consideration for the share is fully paid.[1] This presents a problem when a corporation wishes to issue shares for future services. Based on the wording of these Acts, a share issuance given for future services would be an improper issuance.
 
What can happen if shares are improperly issued as compensation for future services?
There are currently two different views in the case law on what results when shares are improperly issued. The first line of cases has found that an improper issuance results in the shares being a nullity, while the second line of cases has instead used what is known as the "contextual" approach and allowed the courts to fashion the remedy to the situation.
 
According to the line of cases which follow Javelin International v Hillier, if shares are issued for inadequate consideration, the issuance is considered a nullity.[2] This case, and the others which followed in its footsteps have noted that the legislation outlines that shares shall not be issued until consideration for the shares is fully paid. According to these cases, the use of the word "shall" signifies that without proper consideration, the issuance must be considered a nullity.
 
In Alberta, the nullity stream of cases appears to have been rejected by the Alberta Court of Appeal in favour of the contextual approach. In Pearson, The Court of Appeal highlighted that corporate legislation does not spell out what should result if an improper issuance occurs.[3] The case expressly outlines that an improper issuance of shares under section 27 does not automatically make the shares void.[4] Other courts have come to a similar conclusion as Pearson, and determined that in the absence of guidance from the legislation, it is up to the courts to determine the proper remedy in situations where shares are improperly issued. In this situation, courts have typically taken one of three positions:
 
(a) The shares are a nullification;
(b) The directors are liable for the improper issuance; or
(c) The shareholder is permitted to pay the subscription price to validate the issuance.[5]
 
While this approach does offer the potential for an improper share issuance to be remedied, corporations will not want to rely on the discretion of the courts to validate their share issuances. Instead, two potential solutions are proposed below.
 
Potential Solutions
There are two potential avenues that a corporation may take that may allow it to issue shares as payment for future work.
 
One Canadian scholar has suggested that the shares may be issued as consideration for entering into an employment agreement with the corporation.[6] However, if a corporation wishes to do this, it must keep in mind that section 27(3) of the Alberta Business Corporations Act requires that the consideration for the shares be "the fair equivalent of the money that the corporation would have received if the share had been issued for money."[7] Therefore, the value of having the employee join the company must equal the fair market value of the shares being issued. This will typically only be possible in the early stages of a corporation's life.
 
The other strategy that a corporation may use requires further foresight. This strategy involves an existing shareholder transferring a portion of their shares to the contractor or employee. In this scenario the shares will have already been issued to the founder for good consideration. The founder is then free to deal with her shares as she sees fit.
 
In order to execute this type of plan, it can be wise for a corporation to issue a founder extra shares when the corporation is founded for the purpose of later transferring those shares to new employees or contractors. Alternatively, the founding shareholders may agree to transfer shares to a new employee or contractor on a pro-rata basis.
 
Conclusion
Granting shares to potential employees and contractors in exchange for future work may be something a growth company wishes to do in its early stages. If it does do this though, it must ensure it does not run afoul of corporate legislation. The shares should either be transferred from the holdings of a current shareholder, or the shares must be issued in consideration for entering into an agreement with the company.
 
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[1] Business Corporations Act, RSA 2000, B-9, s 27(3); Canada Business Corporations Act, RSC 1985, c C-44, s 25(3).
[2] Javelin International Ltd. (Receiver of) v Hillier, 1988 CarswellQue 28, 40 BLR 249, para 24.
[3] Pearson Finance Group Ltd. v Takla Star Resources Ltd., 2002 ABCA 84, para 9.
[4] Ibid, para 22.
[5] Marshall Haughey, "Issuing Shares for a Promissory Note", (2014) 24:8 Can Current Tax 85, at 87.
[6] Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (LexisNexis Canada, 2018), at 154.
[7] Supra Note 1, s 27(3).