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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.
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“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:
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:
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]
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.
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.
(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] 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. |
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