October AAIA Event Recap
10 Burning Questions Founders Ask at Incorporation Stage
On Saturday, Oct 24th, Asia America Innovation Alliance (AAIA) held its second event of the 2020 series. In this event, guest speakers Morgan Guo, Shui Luo, Alex Chen, and Sean X. Zhang, along with the event moderator, Ling Loerchner, answered some of the most frequently asked questions founders ask at the incorporation state.
1. When is the best time to incorporate?
Shui: From a legal perspective, lawyers would usually recommend incorporating the corporation as soon as you can. Incorporation sets a foundation for future business activities such as team formation and fundraising. Only after a corporation is set up, can the people be united, the work products be owned by an entity instead of individuals, and the funding be acquired through the entity.
Ling: I just want to add one point: from the University spin-off company’s point of view, especially a faculty backed spin-off company, we prefer to incorporate the company at a later stage because it takes a longer time to transfer one PhD thesis into the product prototype. When the team has a demo version of the product available and is almost ready to go out for market’s feedback.
The first seminar focused on the ideation stage talking about the 3 pillars preceding your incorporation, which are the people, the product and the market. It is better to have the 3 issues resolved before the incorporation.
2. Some founders choose to incorporate their corporation online by clicking a few buttons, is it really that simple?
Shui: Incorporating a corporation is not as simple as clicking a button, as it involves much more than that. The online registration does not cover the issuance of shares to shareholders. Each corporation should have a minute book, containing corporate documents from inception to dissolution, without which there will be uncertainties and ambiguities as to the shareholding structure, management and historic changes of the corporation. No third party or government department keeps these records for a corporation. A shareholder’s agreement is paramount to a start-up corporation in that the relationship between founders, investors and employee shareholders are balanced through this agreement. Do not take it for granted that the law will always give a right to you before you ask.
There are other considerations when it comes to incorporation. One particular issue for incorporation of a corporation in Canada is to consider the CCPC (Canadian Controlled Private Corporation) status, which provides for many tax preferential treatments to corporations. For example, an enhanced SR&ED (The Scientific Research and Experimental Development) program is only available to CCPC. Other benefits for CCPC include the small deductions for small corporations, lifetime capital gain tax exemptions, deferred recognition of ESOP benefits, and etc.
Ling: For our audience from the US, you have some advantages too. Your company may apply for SBIR/STTR funding to boost your early stage startup company funding needs. These are non-equity dilute federal level early stage funding programs, and they are very attractive for the deep tech startup companies!
1. What are the duties and liabilities of a cofounder?
Shui: Founder is not a legal term but often used in legal documents of start-ups in order to differentiate it from other types of shareholders such as investors and employees. As such, founders will have certain particular duties and obligations in addition to those of a normal shareholder, such as the expectation to devote his or her life to the start-up business, the obligation to transfer the work products to the corporation, the fiduciary duty to the corporation if concurrently being a director or officer, and the restriction on disposition of shares, etc.
Subject to the shareholders agreement, founders may also enjoy certain privileges or rights that a small shareholder may not have, such as the right of first refusal, the pre-emptive right, the enhanced information right, etc.
It is worth to also note that the cap table may not always reflect the actual control of the corporation as the control of a corporation may be deviated from the shareholding percentage by either adopting a kind of super-voting shares, or entering into certain voting agreements whereby a small shareholder may exercise excessive control on the corporation. To summarize, it is important to include agreed cofounder’s duties and liabilities in the shareholders agreement.
2. Is there a golden ratio for share distribution?
Alex: Many founders are inclined to believe that there is a golden ratio for the share distribution. But in real-life practice, the ratio varies with industries and geographic regions. For example, some Canadian companies are likely to follow the Y combinator model – an equal distribution amongst the founders. But our friends in China would know that this is not a common practice overseas. Share distribution also depends on the nature of the business as well as the company culture, so it is best to look at it case by case.
3. What is ESOP? How does it work?
Shui: ESOP means that a corporation sets aside certain number of shares for the purpose of issuing options to the officers or employees who can exercise the option and acquire such shares upon the completion of certain period or achieving certain milestones, and as the predetermined exercise price is lower than the market price at the time of the exercise, the option holders can enjoy the benefit of the share price increase thus participating in the growth of the corporation. This is the beauty of the start-up corporation that causes many talents to give up their opportunities in those mature corporations and join the startup company teams.
4. Should companies hire employees or independent contractors? What are the enforceable exit terms?
Shui: It is common that corporations incline to engage independent contractors instead of employees so as to reduce cost and avoid employment liabilities. However, a mis-categorization of an employee as an independent contractor can cause the employer much higher losses. If a de-facto employee is asked to sign an IC contract rather than an employment agreement, the employer shall still treat the person as an employee, resulting in much higher employment obligations and liabilities under the common law. A good example of this is Uber driver case, which has been tried throughout the world with different results. The court’s position as to the nature of such relationship in Canada is yet to be seen.
Morgan: In the previous event, we mentioned the value of bringing on board members and external advisors early on. In terms of share ownership allocation, companies usually offer individuals anything between 0.1% to 0.25%. If you have many advisors, the total allocation of shares is usually between 1% to 5%. One point I’d like to emphasize is when you issue shares to external advisors you should consider a milestone-based vesting schedule. In order words, shares are earned when certain milestones are reached.
Ling: More and more people join the startup company, however there is a situation that some co-founders leave the startup company for some reasons. For the employment contract document, the exit terms are very important terms to keep the core technology and resource in the company.
Sean: First, there must be such “terms”. In other words, there must be agreements with people on what they can or cannot do when or after they leave. Second, these terms must be enforceable, that is, they cannot go beyond what the law requires. We have seen examples where people simply use a “template” downloaded or obtained somewhere. This is problematic. For example, you may believe it is good for the company to require your engineers never work for a competitor in Canada and have them sign such an agreement. But, a court would not enforce such a term even if your engineers signed this. You would end up with no non-compete terms at all. The lesson is you’ll need to understand why the agreement is written that way, in your country, your state, or your province, etc, and have the “terms” tailored to your case. Otherwise, you could have key terms in an agreement or agreements with your employees unenforceable.
3. Intellectual Property
1. Do you have any tips for founders who want to consider licensing their IP?
Morgan: Startups can license-in technology from other companies to ensure freedom to operate and gain rights in certain markets, they can also license out IP for additional revenue streams. A University of Calgary startup which developed a nanotech drug delivery technology recently signed licensing deals with two major pharmaceutical companies, one company will use it for cancer and another one will use for diabetes, both deals brought in millions of dollars upfront fee. No matter if you plan to do licensing in or licensing out, it is critical to clearly define the “boundary” of license — how long can licensee use the IP? What is geographic limit for IP usage? Which product(s) or service sale will be subjected to royal payment? Besides royal payment, are there other sources of income for licensor? It is important to ensure both licensee and licensor understand these boundaries — and consequences of “breaking the boundaries”.
Ling: For the licensing in or licensing out business transactions, the IP valuation will be a very important step for properly putting value to an IP. This will be another topic we can discuss for 2-3 hours. We will not dive into the details at this time. We will host another discussion in our AAIA webinar event next year.
2. When is a good time for IP protection?
Alex: From a startups perspective, there are two factors to consider when deciding the timing for IP protection. The first factor is the nature of IP, in other words, what the IP is used for. Based on my experience, you do not need to file for IP if your technology is solely used in-house. In this case, it can be considered a trade secret. However, if you have a core technology that is used publicly or is applied to a customer-facing product, then you should consider getting it protected. The second factor is the ROI. IP is costly to file and maintain, so if you are a startup that is bootstrapping, investing a lot of money on IP protection can cause additional financial burden.
Sean: One additional point on timing, from a patent law perspective. If you will make a public disclosure, you should consider whether you need a patent. If so, you should have the patent application prepared and filed as soon as possible, before the public disclosure. Otherwise, you cannot get patent protection for that disclosed technology in most countries in the world. I also emphasized that if no NDA for the disclosure is signed, even sending a PPT to only one person could be “public” disclosure. Thus, having NDAs signed sometimes goes beyond the need of protecting confidential information. It also can be a requirement for patent protection, as evidence of no “public” disclosure.
1. What are some of the risks associated with the due diligence process, and how to avoid them?
Shui: One common problem we see during investor due diligence processes is the deficiencies in minute books. As mentioned earlier, a minute book is the history of your company. Minute books will always be audited by investors in financing. Though many of the deficiencies could be rectified if all stakeholders are still reachable by the corporation, there are situations where the corporations could not rectify due to failure to locate some departed shareholders or directors, or the problems are so fundamental that it would not be viable to rectify legally or in a timely manner.
Alex: Another problem is messy cap tables. During the due diligence process, investors would pay very close attention to the company’s cap table to understand the company’s status reflected by the company’s percentages of ownership, equity dilution, and value of equity in each round of investment by founders, investors, and other owners. Including unnecessary people or VCs on the cap table can be difficult to clean up in the future. So the best practice is to always clean up the mess to ensure a clean cap table.
Sean: During due diligence, a typical problem we often see is not having IP agreements (and other agreements) signed. They lead to uncertainty in IP ownership and also increase the risk of IP infringement. Investors can become very concerned. You either have to spend extra time and money to fix the problem, or sometimes, investors simply would walk away. I also named a few other IP problems often identified during due diligence, such as IP brought in by employees, “downloaded” from the Internet, or no FTO (freedom to operate) investigation, but did not discuss these because they do not come up during incorporation stage.
2. What are the regulation and compliance considerations?
Morgan: In North America, many industries are subject to government or industrial regulations, for example, environment and medicine. For healthcare and Medtech companies, it is critical to consider regulations and compliance during the incorporation stage. In some cases, companies are unaware of the fact that their product needs to be FDA and/or Health Canada approved. For example,sunglasses, lens are FDA Class I products. FDA/Health Canada have established strict standards for safety and effectiveness for product AND the quality of design, testing, manufacturing and post-market survey. It is good practise to start communication with these regulatory bodies at early stage of your product development to understand the class of regulation, and specific codes for quality management. Your company should obtain enough liability insurance coverage for your business practises. Another consideration for medical device companies are third-party payers/insurers. Insurance companies have established underwriting standards, if you are developing novel use for a legacy technology, it is important to understand if insurance companies agree to pay for it.
Shui: Canada is a highly regulated country, even as a start-up corporation, there are still many regulatory rules to comply with. Except for the special approvals or permits required for particular industries, such as medical devices or financial services, a corporation should in general comply with the regulations on privacy, securities law and competition law, etc.
Ling: I hope what we’ve discussed above can provide some guidance for your startup companies. If you have any feedback or suggestions for our future events, please contact us at email@example.com or contact our WeChat Admin account at: “aaia-admin”. Looking forward to meeting everyone in our next AAIA webinar event.