“Do I have any potential personal liability as a new director/officer of a technology start-up?”

At the outset, let me refer you to a short 5-page article on our website dealing with Important Considerations For Corporate Directors.

The short answer is … yes … corporate directors do have potential personal exposure (both at common law and by statute) in various areas involving the companies whose boards they serve on.

Common examples include liability for unpaid Harmonized Sales Tax (HST) or unpaid employee source deductions.

Clients often respond with some surprise on the basis that they’ve understood that the whole point of incorporating is to shield themselves from personal liability and protect their personal assets (among other tax/commercial reasons to incorporate).

While Canadian corporate law does have a central concept of their being this protective “corporate shield” which generally limits a shareholder’s liability to his or her equity or debt investment (hence the phrase “limited liability”), this is really just the beginning of the discussion.

Despite this “corporate shield”, shareholders or other individuals can still be personally liable for corporate debts/liabilities in cases where they (A) provide company creditors with personal guarantees or (B) serve as corporate directors/officers (whether by formal appointment or “in fact” or by virtue of the terms of a “unanimous shareholder agreement”).

In these situations, the central concept of limited liability is overridden by other rules respecting personal guarantees or liabilities of directors and officers.

But the discussion continues … as there are a number of methods available to reasonably manage one’s personal exposure for director and officer liabilities.

These methods are canvassed in more detail in the short article mentioned above and include:

• becoming active in risk management/gaining timely access to corporate information;
• relying on experts and understanding available statutory “due diligence defenses”;
• knowing when and how to properly resign;
• seeking indemnity from key shareholders (where available); and
• obtaining D&O insurance coverage.

Also, most typical corporate by-laws will provide for rights for directors/former directors to be indemnified by their respective companies for costs incurred defending or settling litigation involving these companies where good faith was present. Canadian corporate law statutes also have indemnity provisions to protect directors/former directors who acted in good faith, etc. The leading Supreme Court of Canada decision in this area (i.e., Blair vs. Consolidated Enfield Corp., [1995] 4 S.C.R. 5) and the decisions following it have created (for now) a very favorable environment in Canada for director indemnification and generally place the onus on companies to establish that corporate directors did not act in good faith, etc.

In many situations, becoming a corporate director and officer is often NOT OPTIONAL where you’re an active founder (or the only founder) of your start-up.  However, becoming a director of a company that you are NOT ACTIVELY INVOLVED WITH is inherently more risky so extra precaution should be taken in these circumstances.

For readers who have already skipped to the end of this blog post, the 3-key “take-aways” are:

1. understand that the concepts of “limited liability” and “corporate shield” only go so far;
2. appreciate and utilize the methods and techniques available to reasonably manage your potential liabilities as new corporate director/officer for a tech start-up; and
3. read the short article referred to above.

There are lots of ways to lawfully reduce the tax burden … both in terms of the taxes you pay on corporate income as you start and grow your business and in terms of the taxes you pay when you sell your business (especially the shares of your business).

As a corporate lawyer, I have learned that taxes are EVERYWHERE and follow you with each and every step you take in starting, growing and selling your business.

Anytime income is received, expenses are incurred, assets are purchased or assets are sold … and regardless of the dollar amounts involved … some tax rule shows up which can, if you let it, chip away at your best efforts to earn an income and build wealth.

In percentage terms, taxes represent one of the most significant “costs” you will incur in operating and/or selling your business … but ironically … this is a cost frequently ignored by many of my clients. 

Some either “accept” taxes as part of their business environment while others simply don’t pay close enough attention until taxes start to take a large enough bite out of their incomes or sale proceeds.

Do yourself and your business a favour … spend some time with your accountant or other tax advisor to understand the legal steps you can take now to lower your corporate and personal income tax burden and to also lower the taxes you will pay eventually once you sell your business.  

The time you spend with your accountant or other tax advisor should be viewed as an “investment” not an “expense” as, invariably, the amount of tax savings available to you (both in the current and future years) will significantly exceed the cost of the advice you get.   The numbers “work” really well!

Also, it will serve you very well to get into the mindset of “TAXES EVERYWHERE“.

By this I mean that you should accept that tax implications arise in all sorts of ways which are very often NEITHER logical nor intuitive.  

Again, if you are spending money, receiving money or buying or selling anything, there is likely some tax implication that, with a bit of planning, can be eliminated or mitigated.

Because in serving my clients, I learn everyday about what works and what doesn’t work in the REAL WORLD of starting, growing and selling businesses.

My incremental knowledge base and experience grows daily through participating in the decisions my clients make.

While my role is to provide expert advice and insight on a variety of substantive and strategic issues, my clients are the ones making the ultimate decisions and taking the ultimate risks.

It’s essentially a process of informed experimentation or educated trial and error. Sometimes things work out beautifully.  Other times, the outcome falls short of the mark.

Learning over time what tends to work in some situations and what tends not to work in other situations is quite fascinating.

There are many factors at play here including preparation, intuition and probability/statistical theory.

As you can appreciate, I’m hired to help clients achieve results and, figuratively speaking, get from “A” to “B” if you will.

Third party negotiations are a critical component of getting those results because ultimately “people do business with people” and the art of understanding what causes people to behave in different ways is essential in getting from “A” to “B”.

So let me share two (2) key aspects of becoming a better negotiator – Content and Timing.

To be absolutely fair, this is not based on my world view alone … but rather the cumulative empirical results of client “trial and error” over many years.

CONTENT

If you own and run your own business, you are constantly creating, managing and ending relationships with a variety of stakeholders – your partners, your landlord, your staff, your bankers/creditors, your customers, your suppliers, tax and regulatory authorities … the list goes on.

What this also means is that you are constantly NEGOTIATING whether you realize it or not and whether you like it or not.

So … why not get really good at it?

The first step is to understand “what” needs to be negotiated – i.e., content.

What are the specific deal points that you want or need to put on the table?

How can you possibly do a good job of negotiating if you aren’t aware of the key items you should be negotiating?

Ok … so this raises an obvious question … how do I figure out WHAT needs to be negotiated in advance so I’m properly prepared?

The answer is 3-fold:

1. Benefits & Risks: sit down and think carefully about what benefits you want to derive from the negotiations and what risks you need to avoid or manage.
2. Ask Your Peers/Mentors: talk to a few other respected business peers & mentors about the same issues and leverage their experience.
3. Discuss With Your Advisors: seek input from a lawyer who has extensive experience in the relevant area.

It doesn’t matter whether you are about to go into discussions with your landlord about a lease renewal or with your key employee about new equity incentives or with your key customer about a long-term purchase arrangement.

In each of these cases, you should prepare a detailed list of potential deal points (i.e., content) that you want to put on the table.

This potential deal points’ list gets prepared by following the 3-step process above.

Also, to help you with this critical exercise, I’ve developed a short 6-page document called Thinking Your Way Through Commercial Agreements which includes 40 QUESTIONS that are relevant to many  negotiations.

TIMING

We’ve covered the “content” part of this blog post so you understand the importance of being clear on “the what” to negotiate and I’ve provided some tools above to assist with developing a detailed potential deal points list.

Now let’s turn to timing.

So you’ve followed the process about and have a solid 20 potential deal points on you list and feel well prepared going into your negotiation.

But … how and when do you introduce these 20 points to the other side?  Do you put everything on the table from the outset?  What “timing” rules should you follow to enhance the odds of getting as much of your 20 points’ wish list as possible?

Obviously, every situation is different and your relative leverage/bargaining position isn’t always super strong … so you’ll need to exercise some judgment in this area.

However, let me share with you a few “timing” thoughts that often (but not always) prove true in the real world:

1. Lead with Your Deal Breakers: You might as well front-end the most important items and lead with the deal breakers. If your potential new hire will not start for less than $45,000/annum or if your landlord won’t renew your premises lease for more than 3-years, you might as well find that out very early in the process to avoid wasting your time and theirs.
2. Build Consensus Early On:  Assuming you’ve moved past the deal breakers, next it’s good to introduce the deal points that are important but also likely to be acceptable to the other side.   Getting to “yes” on several key issues early on can build important momentum.
3. Pile On The Small Stuff Near the End:  Time and again, I’ve seen small (but important) deal points which get flatly rejected at the outset of negotiations.  The same “small things” are often quickly accepted if introduced near the end of the negotiations when deal fatigue sets in and everyone just wants to “move on” and get it done with.  This is especially effective in major financing or M&A transactions which last several weeks or months and involve lengthy agreements.
4. Negotiate the Puzzle … not the Pieces:  Be mindful of the reciprocal nature of negotiations.  In many cases, “you give” in order “to get”.  But you need to hang on to some negotiating “ammo” in order to play this game.  If you concede lots of small things along the way, you may have no “ammo” left at the end when the other side raises a big point and you have nothing left to ask for because all your bullets were shot along the way.   I picked up on this as a young lawyer in 1996. I was involved in merger negotiations with some guys from Boston. Their counsel was many years my senior and understood the “Puzzle” concept very well.  The deal stalled in the “7-th inning” and the guys from Boston flew up to Toronto to try and break through the impasse. Negotiations started off by our side outlining our short-list of 15 remaining deal issues. As I read off each of these 15 points, the other side was trying hard to respond to each one piece-meal but their lawyer silenced them and just made notes while his clients impatiently listened.  When I was finished reading my list, they got up and sat in the next room for @ 30 minutes and came back with their response which was along the lines of “… we’ll give you #2, #5 and #11 if you conceded #1, #3 and #14 …“, etc. Had this lawyer not silenced his client and allowed him to negotiate each item separately along the way, his negotiating flexibility would have been severely compromised (to our benefit).  I have never forgot this valuable lesson!

I am hopeful that, by (A) better preparing for the “content” aspects and (B) better understanding the role of “timing”, you will ultimately negotiate better agreements!

Unfortunately, there are a number of “myths” out there on this topic … so I thought I would clarify the current law in this area.

Sometimes this question surfaces in a theoretical way – i.e., by clients who are going through the exercise of putting a shareholder agreement in place and are curious about whether this issue (i.e., marital separation) is something that needs to be covered off.

Sometimes this question surfaces in a very practical way – i.e., by clients who are in an unhappy marriage and need to understand the rules in order to plan their affairs and decide what steps to take (if any) to address their marriage woes.

Many business lawyers understand that Ontario family laws can (possibly) operate to affect private company shares and so, partly out of prudence and partly out of ignorance, you will see many shareholder agreements address marital breakup in several ways including by:

• having founders’ spouses “sign away” any rights to founders’ shares ; or
• granting a “call option” to the company/unaffected founders to purchase the shares of the affected founder (at predetermined pricing and other terms) if his or her matrimonial situation appears to compromise ownership of shares of the target company.

However, if in reality (as I will suggest below), the outcome of marital separation rarely disturbs the ownership of private company shares, then shareholder agreements should really be tailored to what courts do or don’t do when it comes to private company shares.

I’ll circle back on this at the end of my post.

Ok … so let’s dive right into the real issue here:

Is an Ontario judge likely to order the transfer of private company shares from one spouse to another to resolve a matrimonial breakup?

To help us answer this critical question, I’ve turned again to veteran Canadian family law lawyer Andrew Feldstein of The Feldstein Family Law Group.

Readers will recognize Feldstein’s name from my recent post on Picking the Perfect (Business) Partner.

As Feldstein notes, “… Ontario family law is fundamentally about ‘equalization of net family property’ … the key phrase here is equalization NOT division … there is generally no automatic sharing or splitting of assets … each spouse will have their separate personal balance sheet which will change in value over the marriage and have a specific valuation at the date of separation…“.

Ontario’s family law legislation has a set of somewhat complex rules which attempts to calculate the relative increase in each spouse’s personal balance sheets during the marriage.

This statutory formula attempts to sort out which spouse has enjoyed the larger personal balance sheet “growth” and equalize the difference so the spouses end the relationship in a manner that allows them to (in theory) share their collective “fruits of the marriage”.

For example, one spouse may have a personal balance sheet that has grown by $400,000 more than the other spouse during the course of the marriage and hence owes the other spouse a $200,000 “equalization payment”.

This $200,000 amount is initially just a payable owing by one spouse to the other.

This payable can be satisfied in a number of ways – i.e., transfer of interest in the matrimonial home or cash settlement.

It does not necessarily involve splitting up or transferring any private company shares.

According to Feldstein, “… Ontario courts recognize that the ownership and operation of a private company is a very delicate and intimate matter that should not be disturbed by the court to resolve a matrimonial dispute … except as a last resort.  

The spouse who is owed an equalization payment generally wants (and needs) CASH … not illiquid private company shares … and the unaffected shareholders don’t need or want that spouse to have any ownership or legal rights over their private company.  

The Ontario family law bar and judiciary understand these private company realities and will try and find a way for an equalization payment to be satisfied without disturbing the private company status quo…“.

For the above reasons, it would be quite rare for private company shares to be used as currency to settle an equalization payment.

Nevertheless, this might be the (rare) outcome where the payor spouse is asset rich but cash poor and his or her only significant asset available to make an equalization payment is his or her private company shares.

However, Feldstein does note one (1) very specific situation where a spouse entitled to an equalization payment may have a stronger case for a transfer of private company shares using the theory of a “constructive trust”.

Consider the case where a husband and wife start a business together. The husband is the sole shareholder listed in the minute books but the wife is very involved in the business, has contributed significant sweat equity over the years, draws a regular monthly salary and wants to remain involved in the business after separation.

In this special case, reflects Feldstein, the wife may be very happy to receive private company shares to satisfy an equalization payment and may be able to successfully argue that, given her history with the company, she actually has a legal interest in her husband’s shares in the form of a constructive trust (i.e., the husband has always held her interest in his name but for her exclusive benefit).

So … if the reality of current Ontario family law is that (absent the special “constructive trust” situation) courts will rarely disturb private company share ownership to satisfy an equalization order, then how should your shareholder agreement address this issue?

Readers of my blog already understand my philosophy on shareholder agreements -i.e., they need to focus on Forecasting the Probable.

Hence, if Ontario courts are quite unlikely to order any transfer of private company shares to satisfy an outstanding equalization payment, then shareholder agreements need to bear this in mind and tailor an appropriate “call option” that can only be exercised if/when the company is advised by corporate counsel that a family law judge is likely to actually order the transfer of private company shares to a payee spouse.

This makes sense to me and is akin to “hitting the nail with a hammer” rather than with a block of concrete or other inappropriate blunt instrument.

Here’s a true story highlighting the problems with inappropriate family law clauses in shareholder agreements:

In 2004 I acted for a shareholder who was in the middle of separating from his spouse.  He was 1 of 5 shareholders of a private consulting company.  His partners had been trying to get rid of him for years.

Their shareholder agreement contained a “matrimonial” call option that was exercisable upon separation (i.e., not upon a judge’s order transferring shares to the spouse which isn’t really known until late in the process).

Since their matrimonial situation would have likely resolved itself without any transfer of private company shares, his partners were able to opportunistically “jump the gun” and force him out (notwithstanding that they likely would not have to worry about his wife as a new shareholder).

Had this agreement contained a “call option” that only became exercisable upon a judge’s “order” (rather than upon mere separation), odds are this call option would have expired before it could have been exercised and my client’s partners would be left to negotiate his exit outside the shareholder agreement … most likely at a much higher price!!!

So I hope, with Feldstein’s assistance, I’ve now set the record straight regarding how the Ontario family courts currently are likely to deal with private company shares and how you can tailor your shareholder agreements to properly (and fairly) address this important issue.

[WARNING: Family laws significantly vary from one jurisdiction to the next.  This post is written strictly from an Ontario law perspective.  If your situation involves facts outside of Ontario, the treatment of private company shares in your jurisdiction may be very different from what is described above.  Please discuss with your local advisers.]

It’s extremely well written in a very engaging, fictional style that makes this 150-page inexpensive book easy to read, cover-to-cover, in quiet summer weekend or vacation afternoon.

As an M&A lawyer, I think this is a must read for many of my readers and clients who don’t realize that they are NOT on the path to building a SELLABLE  business … and specific things they can start doing tomorrow to change this.

In this post, I want to focus on a single specific idea offered in Warrillow’s book which dovetails nicely with my recent posts on employee equity and alternatives to giving your staff shares.

The author points out that “… sharing equity can get messy and time consuming and why dilute your equity and complicate things when you don’t have to…”.

As an alternative to equity, his book discusses rewarding employees by creating a “stay bonus” tied to future employment.

The “stay bonus” is essentially a long-term incentive plan.  It’s based on giving employees targets and a corresponding cash bonus for achieving those targets.

Here’s how it works:

1. A cash bonus is paid to a performing employee at the end of the year AND a further exact amount is earmarked into a special pool for that same employee.
2. After 3-years of building the special pool, the employee is allowed to withdraw 1/3rd of the pool amount.
3. Essentially, this pool grows in value each year based on the employee’s personal achievement of his/her cash bonus but they cannot access the extra money until 3-years after earning it.
4. As the book states “… if they ever decided to leave, they would be walking away from 3-years worth of bonuses sitting in the pool…”.
5. This concept is coined a “stay bonus” and that’s exactly what it’s hoped to be.
6. It operates like an employee performance account where funds are deposited and withdrawn based on the rules you create which are tailored to your company’s own needs, size and culture, etc.

The book concludes “… as an employee, I’d much rather have an understandable cash bonus plan over being a minority shareholder in a closely-held small business … only use equity as a last resort for motivating and retaining your staff … consider alternative forms of long-term incentive plans…”.

Obviously, there are lots of combinations and permutations to the form of “stay bonus” described in Built to Sell.

You can easily custom tailor the variables – i.e., performance metrics, money and time – to suit your own company.

What I like about “stay bonuses” is that they are relatively simple to implement and can be made more complex if desired (e.g., the funds could be deposited into a trust account if it was desired to move them “off balance sheet” and out of reach from the company’s creditors).

Yes … I totally acknowledge that cash is king so stay bonuses are not going to be attractive to many start-ups.

However, giving equity costs cash too in the form of out-of-pocket legal and accounting advisory costs necessary to properly structure and document a solid equity arrangement.

So the out-of-pocket cash you save by avoiding equity can be easily earmarked to a stay bonus plan and you’re cash-flow neutral in the end … plus you don’t have the additional SOFT COSTS that come with equity (i.e., dilution, complexity, administration, management, governance, etc.).

In the end (as I’ve said before in other posts), the decision about which tools you’ll use in your company to motivate and retain your staff is highly personal. Sometimes equity is the right call for you … sometimes a stay bonuses is the better decision.

I can’t tell you what’s right or wrong for you … but your employees can … in the sense that you need to really KNOW what will motive them and avoid guessing.

“Give the people what they want” I say … just make sure you retain control because, after all, you’re the only person in your company whose business card says F-O-U-N-D-E-R.

]]> http://www.dpclaw.ca/blog/employee-retention-do-stay-bonuses-really-work/feed/ 0 http://www.dpclaw.ca/blog/how-to-pick-the-perfect-partner-lessons-from-a-family-lawyer/ http://www.dpclaw.ca/blog/how-to-pick-the-perfect-partner-lessons-from-a-family-lawyer/#comments Thu, 07 Jul 2011 02:22:40 +0000 Jordan Dolgin http://www.dpclaw.ca/blog/?p=960 Read More »]]> I had a really interesting lunch earlier this week with veteran Canadian family law lawyer Andrew Feldstein of Feldstein Family Law Group.

As a child of divorced parents, I couldn’t resist asking Andrew to give me his take on how best to pick the perfect mate and, of equal importance, how to keep the “music playing” throughout the years and avoid a messy break-up.

As I listened carefully to his answers, I soon realized that all of his feedback was highly and equally relevant in the business world.  After all, people do business with people and the human condition doesn’t magically stop just because someone walks through their office door.

A significant part of my practice involves helping clients plan for (or respond to) shareholder disputes.  I spend lots of time helping clients start and build their businesses and, as you can imagine, I also get pulled into my fair share of painful, expensive and lengthy “corporate divorces” (as I tend to call them).

While I’ve written and lectured a fair bit on Managing the Corporate Divorce, I’m really an optimist at heart and thought it would be valuable to my readers to turn this topic on its head and approach it with a positive spin and talk a bit about … how to stay together.

Leveraging Mr. Feldstein’s experience, here’s some insights into better picking and keeping your business partners:

• MONEY:  How does your partner deal with money? Are they frugal or careless with this precious resource?  A former (almost) law partner of mine was a classic example of this.  While the rest of the lawyers liked to shop at Walmart, this guy had Prada shoes delivered via courier to the office and liked to wear $20,000 watches.   No one extrapolated that his approach to managing the firm’s resources would parallel his personal spending habits and that this would create serious conflict around the table. Fortunately, he never joined the partnership.  In retrospect, we had no business considering him for partnership … his approach to money was totally at odds with the philosophy of the firm.
• DEALING WITH CONFLICT:  How does your partner deal with conflict? Does he or she tolerate conflict or avoid it like the plague or, even worse, create conflict when bored? Conflict is inevitable and is either addressed in a healthy way or people suffer in silence for years while they avoid it and pretend “everything’s OK”.
• SKILLS SET:  What skills are you missing and are they possessed by your partner?  Aristotle was on the money when he acknowledged that life is a struggle to “know thyself”.  Many good partnerships involve people with complimentary but different skills.  For example, some of us love to sell while some of us like to manage.  A successful business needs both.
• PERSONAL STYLES:  As a child, Mom was the go-to parent when I needed reassurance or a confidence boost (or permission to drive the family car).  On the other hand, Dad was always the voice of reason and caution.  I relied on both of them … but for different things at different times.   In your business, it’s good to have a range of personalities around the table.  Someone needs to generate the wild (but occasionally brilliant) ideas and someone needs to watch the bank balance. Someone needs to be enthusiastic during the rough patches and someone needs to say “lets sleep on this”.
• GROWTH PLANS:  How many couples struggle over the decision to have children?  Not surprisingly, this topic is not universally discussed before marriage and can be a source of major conflict during a marriage.  Apply this in a business context:  how many partners discuss their vision for the scale and growth of their business?  While we all think “bigger is better”, not everyone is prepared for the sacrifice and risk that accompanies significant corporate growth.
• CORE VALUES: Differences among partners can be extremely valuable as noted above.  However, when it comes to essential “core” values, either partners are aligned or they’re not.  I’m not talking just about ethics and culture but also the philosophy underlying the essence of the business.  I’ve seen some businesses adopt a “kibbutz-like” culture of equality while others emphasize meritocracy and performance.  Shared core values are critical for the long-term success of any partnership … personal or business.
• RELATIVE CONTRIBUTIONS:  You may be the only income-earner in your family but if you truly don’t value (inwardly and outwardly) your spouse’s non-income earning contributions involving the management of the family, children and household, then your partnership will suffer.   In business, some partners will be responsible for revenue generation and others will contribute in ways that cannot easily be measured on an Excel spreadsheet.  Unless you come up with ways to appropriately measure, benchmark and value the contributions made by all partners, resentment may develop leading to division and, in extreme cases, breakup. If non-income producing partner’s relative contributions aren’t “measured”, then odds are they’re not “valued” … and if they’re not valued then one partner may soon feel the other is redundant or easily replaced.   This usually does not end well for anybody.
• COMMUNICATION:   We all know the value of good communication but we all know that many of us are weak communicators.   Either we lack the skills to communicate effectively or we fall prey to various communication barriers.  As mentioned above, conflicts will arise and can only be resolved with effective communication which requires both talking and listening.  Knowing when to talk and when to listen is vital.   Every corporate divorce arises, to some degree, because people stop communicating (assuming they had this skill to begin with).
• LUCK: Picking the “perfect” business partner may involve the ability to screen/qualify for some of the factors listed above.  It may also involve good instincts.  But … frankly, it may simply involve plain old good luck.   We all know that friendly couple that “lives up the street” who seem to have a solid relationship. Yes they work at it but it doesn’t seem to take too much work.  They seem well suited … like 2 adjacent pieces of a puzzle.   Luck does play a role.  Some partnerships are classic cases of “oil and vinegar” or “square pegs in round circles”.  The fit is poor. I see this sometimes when drafting shareholder agreements for new clients.  I will do my best to help them but, as the fit is so poor, I quietly realize that the agreement I’m drafting is really a divorce playbook rather than a solid operating manual. Oddly, I have some clients who have maintained a healthy business partnership for decades … all on a handshake … no shareholder agreement.   What’s their secret sauce?  There’s no secret sauce … they were just very lucky to have selected very compatible partners.

So … there you have it … some valuable insights from a seasoned divorce lawyer that I hope you can use to screen for a better business partner and avoid an (often) painful and expensive shareholder dispute.

Now I want to discuss a different but equally painful problem … that of the “phantom shareholder“.

But first … let me set the stage properly.

Unless you’ve intentionally created a “lifestyle” company, odds are you’re building your business to sell it one day.

So you need to be mindful of exit planning in all aspects of building your business and this includes avoiding situations that can seriously impair your hopefully “graceful” exit.

In every sale transaction, whether it involves the sale of products, land, assets or shares, every buyer NEEDS to know you are the OWNER of what you are selling.  If your buyer can’t get comfortable that you are “the owner”, your transaction either won’t close or will close at a significant price discount.

So … here’s the question:  who are the owners of the shares of your company and can you deliver 100% of those shares to your buyer as part of your exit?

Hopefully, the answer to this question is a simple and resounding “YES”.

After all, you’re the founder and should know who all your shareholders are and know what your minute books/corporate records say … OR DO YOU?

Here’s a few examples of phantom shareholder situations:

• Remember that accounting student (Sarah) you hired during the early days of your start-up.  You had no money and exchanged a few emails offering to give Sarah 5% of your company in exchange for helping you with your bookkeeping.  She subsequently left after 3-months and you’ve never heard from her since.  No shares were formally issued and you’ve long forgotten about your equity offer to her.  In any event, you’re certain that a couple of casual emails can’t possible establish any legal obligations.
• Remember also that website designer (Tom) who thought your company’s offering would radically change your industry and agreed to discount his rates in exchange for shares in your company.  He did a great job on your site and you paid his discounted bill in full a long time ago … but no shares were ever issued. The promise of equity was vaguely buried in his terms and conditions and, as the radical change never transpired, both you and Tom have forgotten about the equity piece.

Now imagine you’re in the middle of negotiating the sale of your company and you get a call or letter from either Sarah or Tom (or worse … their lawyer) advising that they’re so happy to hear you’ve agreed to sell and reminding you of your equity promise and wondering when they can drop by and pick up their cheque?

You understandably panic and call your lawyer and dig up the relevant documents or emails with Sarah and Tom and realize you left all this hanging and now these “loose ends” have become real issues that need to be quickly managed before they jeopardize your deal.

Humor aside, the above hypothetical situations can and do happen every day.  

The Sarahs and Toms of the world are classic “phantom shareholders” and haunt the closets of many private companies and will surely impair your exit if you fail to take steps to avoid or neutralize them.

Ok … so now you know what a phantom shareholder is and why you should care.

The good news is that it’s not too difficult to avoid this problem.

In a perfect world, you could just simply never offer shares to any former employees or consultants.

However, in the real world, you just need to be clear in your documentation or emails that any preliminary promise of equity is expressly and strictly conditional upon all parties signing all legal documentation (including a suitable shareholder agreement or acknowledgement) necessary to authorize and to issue shares of your company.

You’ll need to consult with your legal counsel on the exact language to use on a case-by-case basis as each situation is going to be unique.

The simple concept I’m highlighting here is that the key to managing the phantom shareholder issue (other than avoiding it altogether) is to ensure that all preliminary promises of equity to employees, consultants or others are expressly drafted as CONDITIONAL PROMISES.

This puts you in a stronger bargaining position with the Sarahs and Toms of the world especially where these conditions (i.e., lack of formal documentation) were never satisfied.

This is no “slam dunk” as any good litigator will tell you … and hence why serious care should be taken in drafting all equity promises (especially conditional equity promises).

Bottom line … you need to be wary of phantom shareholders and the damage they can do to your exit … but consider using the “conditional equity promise” if you can’t avoid preliminary share offers to prospective employees or consultants.

This will help you take the Tom out of Phan-Tom!

As my readers know from one of my recent posts, cash is the “oxygen” that feeds all start-ups.

In those early days, it’s not uncommon to take cash from anyone (or everyone) by issuing more shares to friends and family.

So … after several years of raising $5,000 here from Uncle Joe and $10,000 here from your golfing buddy or next door neighbour, you wind up with 30, 40 or more small shareholders.

None of these investors has signed any type of shareholder (or other) agreement and, worse, you haven’t had any form of contact with a number of these small shareholders for months or years.

You probably couldn’t find them if and when you need them to attend a formal shareholder meeting or sign some documents which your lawyers tell you must be signed by ALL shareholders to be effective, etc.

In the short-term, you’re not really concerned because the “too many shareholders” problem doesn’t interfere in the slightest with your running the daily operations of your company.

However, eventually here are problems you will likely face from having TOO MANY (SMALL) SHAREHOLDERS:

• no serious angel or institutional investor will finance your company … because, odds are, you’ll be unable to get all shareholders to sign the new shareholder agreement necessary to close your financing
• no serious purchaser will pursue the sale of 100% of your company … because, odds are, you’ll be unable to get all shareholders to sign the purchase agreement and deliver 100% of the shares to the purchaser
• you can’t obtain a proper quorum or achieve required voting approval levels needed to pass a variety of matters which shareholders, under corporate laws in many jurisdictions, are required to approve (e.g., corporate reorganizations, changes to your articles, name changes, asset sales, etc.)

So do you (or someone you know) suffer from the “too many shareholders” problem?

Not surprisingly, I’ve had to address this situation a few times over the years in my practice and there are a few obvious (but undesirable) choices:

For example, you might consider:

• trying to buyout some shareholders (at fair market value … maybe with an upside kicker if needed)
• trying to get all shareholders to sign a comprehensive shareholder agreement
• using corporate law provisions (if available) to squeeze out the minority hold-outs

Unfortunately, none of these options is particularly attractive.

The buyout option will consume lots of time to negotiate especially with small shareholders who often have an inflated sense of value and will surely negatively respond to the message you’ll be sending – i.e., “we don’t love you anymore“.  This adversarial approach is often doomed to fail from the start.

The comprehensive shareholder agreement option is highly unlikely to fly.  When was the last time you were able to get 40 unrelated people to quickly read and quietly sign a 40-page detailed agreement (especially if some of them have independent advisors looking over the document)?

Corporate law squeeze outs may or may not be available in your jurisdiction and will be costly and time consuming to implement as all the “I’s” and “T’s” will need to be dotted and crossed by your legal counsel and accountants.

So … what to do?

Another approach that might assist in your situation involves drafting a simple but effective document which, for purposes of this post, let’s call a Shareholder Acknowledgment (which sounds somewhat friendly and neutral to suit this somewhat delicate situation).

This is a relatively short document prepared to be signed separately by each shareholder (both large and small) on a one-by-one basis.

It may provide for the following:

1. If the majority (see discussion below) agrees to sell the company (assets or shares), the signing shareholder agrees to also sell or vote with the majority.  This is essentially an exit “drag-along”.
2. If the majority agrees to enter into a new shareholder agreement treating everyone fairly (either as part of a financing or otherwise), the signing shareholder agrees to also sign the new shareholder agreement.  This is essentially a financing “drag-along”.
3. If the majority agrees to approve any other matter requiring shareholder approval under applicable corporate laws, the signing shareholder also agrees to vote its shares with the majority.
4. Lastly, the signing shareholder agrees that if reasonable efforts fail to obtain his or her signature on any documents to implement any of #1, #2 or #3 above, the President (or another senior officer) can be granted authority to sign such documents on his or her behalf.

The concept of “majority” in this Shareholder Acknowledgment can be set at whatever percentage or threshold works for your company (i.e., typically somewhere between 51% and 75%).

By using individualized acknowledgments, you can avoid having to get ALL shareholders to sign the same document.

Odds are you won’t be able to get all shareholders to sign this Shareholder Acknowledgment … but hopefully you’ll be able to get most and this will dramatically improve your status quo.

Because this is an “inclusive” not “exclusionary” approach, shareholders will hopefully react in a positive way.

The “sell” is that your company is basically stuck-in-the-muck and can’t move forward without being able to demonstrate to the world (especially funders and purchasers) that everyone is rowing their oars in the same direction.

No shareholders are singled out for exclusion.  All shareholders are asked to participate equally for the benefit of the company and everyone’s collective future.

Care must be taken to ensure that the drafting of this document is very clear and that its scope is very reasonable in order to enhance the likelihood that, upon challenge, a court will enforce this document as the majority intends.

While this is by no means a “perfect” fix, it may be the path of least resistance when compared to the other alternatives listed above.

Hopefully, the lessons here are obvious:

1. check out my recent blog posts on alternatives to equity and avoid the “too many shareholders” problem in the first place; and
2. try not to issue shares to anyone (especially small minority shareholders who are retired and likely to travel the world) without some form of written agreement or acknowledgment that puts you squarely in the driver’s seat when it comes to controlling your company.

Lastly, PLEASE DON’T TRY THIS AT HOME ALONE! While I’ve described the general approach and some of the specifics, you will need professional legal and tax advice to properly implement any type of shareholder acknowledgment or similar tool.

I concluded that your staff may not need or want “equity” and ASSUMING they did could become a very costly, wasteful and painful “corporate experiment” for you as founder.

In this post, let’s assume that your employees want the direct economic benefits of equity (i.e., capital gains upon sale and the possibility of dividend income) but you, as founder, want to avoid the complexities, costs and changing reality that flows from actual employee share ownership.

So … how to achieve your objectives in a less complex and inexpensive way?

One idea is to offer a “contract-based” solution.

Rather than grant options or issue shares and embark upon the whole process of implementing a tax/corporate reorganization with the usual option agreements, ESOPs, shareholder agreements and the like, consider rolling the entire “relationship” into a contract which, for purposes of this post, we’ll call an “Equity Participation Agreement” (or EPA for short).

[For purposes of this post, an EPA is different from a "phantom" stock arrangement as no attempt is made to provide employees with any rights or any form of security that attempt to track or mirror actual company shares.]

An EPA could be designed to provide your employees with the direct economic benefits of share ownership without actually issuing any equity and making them option-holders or shareholders of your company.

Some of the attributes of an EPA might include:

• rights to receive from the company some fixed (or formula-based) payment upon a future liquidity event (e.g., share sale, asset sale, merger, IPO, etc.);
• rights to receive from the company some fixed (or formula-based) payments in tandem with any dividends once declared by the board on outstanding issued shares; and
• termination (and/or buyout or repurchase) of these rights arising upon events which end the employment relationship (e.g., death, disability, resignation, termination of employment, etc.).

The above are just examples of some of the features which can be added to an EPA.  As a creature of contract and subject to applicable legal constraints, an EPA can become as flexible and unique as necessary to suit your corporate vision.

The goal is to offer (and exercise control over) the direct economic benefits of equity ownership without the usual cost, complexity and consequences of traditional “equity” arrangements.

So … where you think your staff might be more highly motivated to perform better and stay longer with something “equity-like”, you can certainly consider an EPA … but please read the next paragraph!!!

CLOSING NOTE: As employees never become shareholders under an EPA and only acquire “contractual rights”, the tax consequences to both the employee and your company will be different (and likely less favorable to your employees) as compared with traditional equity arrangements.  Also, the conferral of these contractual benefits may have consequences under applicable employment and securities laws.  The tax, securities and employment law consequences will vary from jurisdiction to jurisdiction so you will still want professional legal and tax assistance if you wish to explore an EPA structure for your company but, generally, these structures should be less complex and less costly to implement than your usual equity structure.

I get asked this question a few times each month from clients or prospective clients who want to explore the idea of giving some (or many) of their employees some type of “equity” participation or incentive. Not a bonus pool or profit sharing plan or phantom stock scheme … no … actual equity or options to acquire equity.

In reply, I often answer with a question of my own:

“Do you KNOW what your employees really want or need to perform highly and stay with your company over the longer-run?”

There’s a reason I ask this question.

Obviously, my client is focusing on employee productivity and retention as she or he should be.

However, there’s often this HUGE (and often false) assumption that every employee wants or needs to own shares of their private company employer and, as soon as they become a shareholder, they will magically perform at much higher levels and acquire this overwhelming desire to remain employed for as long as it takes for you to sell the company at a significant exit value that will be shared with them.

Don’t get me wrong.  Some employees really value the whole “pride of ownership” thing that comes from share ownership and reviewing corporate financials and attending annual meetings and getting to cast their vote (albeit small), etc.

However, many employees could care less about the intangible “soft” stuff that share ownership brings.

Rather, for them it’s a case of “SHOW ME THE MONEY” in classic Hollywood Jerry Maguire fashion.

They want to be well paid TODAY … not just on the “if/come” should your company be sold one day.

They don’t want shares that have limited (or no) liquidity, will never pay a dividend and are meaningless from a voting perspective because you still have 90% (or more) of the company.

The time and cost involved in properly setting up an employee option or share purchase plan is not to be underestimated.

Here’s a snapshot of some of the things involved in this process:

• determining what class of shares to give your staff
• determining whether to use an option or purchase plan
• determining strike prices
• determining vesting timelines/milestones/acceleration
• determining the implication of employee resignation, termination, death and disability
• determining whether financing will be included
• obtaining tax advice from both employer and employee perspectives
• implementing tax reorganizations, if necessary
• preparing detailed option documentation
• preparing detailed shareholder agreements
• determining administration and management of the plan

As you can see, involving your lawyers and accountants will be integral to the process and hence the planning and implementation costs can be considerable.

Also, here’s a snapshot of some of the consequences or “realities” of having employee share ownership:

• disclosing annual financial statements (and possibly other corporate information)
• considering minority shareholder rights
• preparing for annual and special shareholder meetings
• ensuring proper management/administration of employee share issuances for new participants
• ensuring management/administration of employee share sales for departing employees
• incurring ongoing professional fees relating to all of the above

As you can see, employee share ownership brings with it additional costs, governance, administration and, to some degree, loss of control.

While a lot of this is manageable via proper contracts and plan documentation, your company will never be the same!

So … why do all of this if your employees don’t need or want it?

Why do all of this if it will only have a marginal impact on employee productivity and retention?

In the end, if you focus on 1st principles and common sense, you’ll see that the #1 most important consideration before embarking on the whole employee equity thing is … give the people what they want … which means you’ll need to figure that out first!!!

Once you know what your staff wants or needs to work harder, work smarter and stay with you longer, then you’ll be well-equipped to “hit the bulls’-eye” and spend your time and money wisely.

Please don’t get me wrong.  I have a number of clients with some form of employee equity arrangement and they can (and do) work wonders for productivity and retention in the right circumstances.  However, these are not for everybody.

My point simply is that I encourage you to challenge your assumptions early in the process!

Stay tuned for my next blog post called “Employee Equity Alternatives” which will discuss a novel alternative to employee equity which some readers may wish to consider … or at least be aware before they seriously consider employee equity arrangements.