Starting and growing a business is an exciting journey with abundant opportunity, but also one filled with its fair share of challenges and risks. Early-stage startups often operate with minimal cash flow, and it is no surprise that legal protection is a frequently overlooked aspect which is often sidelined due to tight budgets and daunting startup costs.
While legal protection may not be the most glamourous aspect of entrepreneurship, it is undeniably one of the most important. After dedicating an enormous amount of time, money and energy, the last thing you want is for your hard work to be derailed by preventable legal issues. As startups scale, they face numerous challenges and there is no shortage of potential pitfalls that can threaten their success.
Businesses that falter often fail to observe otherwise avoidable legal safeguards that are meant to protect the business from the very people who created it. This is known as failure to founder-proof.
Founder-proofing, at its core, is proactive as it takes steps to protect the business from the founders themselves. It ensures that your years of hard work, innovation, and investment are safeguarded against the unpredictable nature of business dynamics.
Startups are built on trust, collaboration, and a shared vision. However, when things do not go as expected, such as in cases of termination, demotion, or being sidelined in key decisions, it can be perceived as disloyalty or betrayal. In response, founders may engage in ‘strategic behaviours’ that may harm or even destroy the company, such as not relaying key information, focusing on less important tasks, and transmitting confidential information. This brings us to an essential question: What can founders do to founder-proof their businesses?
At the highest level, founder-proofing is achieved by implementing legal and organizational strategies to mitigate risks associated with founder dynamics. While there are many methods to safeguard a business, there are three concepts that entrepreneurs should prioritize: shareholder agreements, corporate governance and power balance.
Shareholder Agreements
One of the most problematic areas for startups is the shareholder agreement, a legal document that governs the relationship between shareholders. Among small private companies, the Unanimous Shareholder Agreement (USA) is particularly common.
According to the Canada Business Corporations Act, a USA is: "An otherwise lawful written agreement among all the shareholders of a corporation, or among all the shareholders and one or more persons who are not shareholders, that restricts, in whole or in part, the powers of the directors to manage, or supervise the management of, the business and affairs of the corporation."
The inherent structure of a USA involves limitations and a lack of flexibility, which may present significant challenges for startups that operate in a dynamic and faced pace environment. A USA is often incompatible with the evolving needs of startups in several ways:
It removes discretion from directors and transfers it to shareholders, who may be passive investors or otherwise lacking the necessary operational insight to make informed decisions. Further, Canadian corporate legislation does not provide a clear governance framework for shareholder decisions within a USA, adding further complexity. Ultimately, removing discretion leads to a slow, cumbersome decision-making process, which is the exact opposite of the agility that startups need.
Shareholders lose the freedom to pursue their own interests as they become subject to the same fiduciary duties as directors. These enhanced obligations can create significant challenges as there are no clear mechanisms in Canadian corporate law to release shareholders from these duties.
Amending or terminating a USA can be extremely difficult. Canadian corporate legislation lacks clear guidelines on how a USA may be modified or dissolved. Once a startup has outgrown a USA, ambiguity may hinder the company’s growth trajectory and deter potential investors.
While a USA may not always align with the dynamic needs of a startup, this does not mean that shareholder agreements should be entirely avoided. A well-drafted shareholder agreement that clearly defines the rights, responsibilities and obligations of the parties involved can be of great benefit to a startup company
There are certain aspects of shareholder agreements that startups may wish to approach with caution. These include rights of first refusal, pre-emptive rights, piggyback rights, drag-along rights, shotgun clauses and stringent termination clauses requiring unanimous shareholder consent. These sorts of provisions will be addressed in more detail in a future blog.
These sorts of provisions will be addressed in more detail in a future blog, where we will explore their implications and how they can be tailored to suit a startups evolving needs.
Corporate Governance
Establishing an effective corporate governance regime is a crucial element of founder-proofing, which helps ensure the long-term success and stability of a company.
It is in the founders’ best interests to establish an effective board of directors from the outset, as sophisticated investors will often impose their own directors if the board is perceived as ineffective or weak.
Board of Directors
There are several key strategies that startups can follow to build an effective board:
Ensure that all stakeholders understand that the composition of the board will evolve over time as the company grows and its business needs change.
The balance of power should be held by directors independent of management and not beholden to any one group of shareholders. This independence establishes objective decision-making and fosters investor confidence.Devote significant time and effort to building a strong and independent board. A common mistake is appointing friends or family members who lack the necessary qualifications or experience to provide meaningful contributions. Finding high quality independent directors can be a challenging task; however, offering competitive compensation packages can help attract top-tier independent directors.
Passive directors should be removed from the board as they can have a detrimental impact on the company’s progress by making uninformed or poorly considered decisions, wasting time during meetings by offering input of little or no value, or neglecting to provide meaningful assistance to management.
No single founder should have disproportionate power to allow the appointment of additional board members.
Formal Governance Practices
Many startups operate without formal corporate governance practices, leading to inefficiencies and challenges in the long run. Establishing regular and structured governance practices is a crucial part of founder-proofing.
One of the most important steps in building formal corporate governance practices is holding formal board meetings on a regular basis. These meetings should typically be conducted at least four times a year. Meetings should only consist of directors in order to clearly distinguish their roles from those of management. This distinction is crucial to streamlining and resolving potential future disputes.
It is crucial that proper notice and documentation be maintained for these meetings. A notice of directors’ meeting, along with a proposed agenda, should be distributed well in advance and formal minutes should be recorded for every board meeting. However, it is important to ensure that meeting minutes are not exhaustive summaries of discussions, as they are considered somewhat public documents and may be subject to external scrutiny.
Power Balance
One of the initial challenges that startups face is the division of management rights and equity. Founders are typically issued stock early on in a startup’s life; however, unforeseen circumstances, such as a founder not contributing, a change in plans, quitting, conflicts, or loss of motivation can turn founder stock holdings into a significant issue for the company. Startups should be wary of granting disproportionate power to their founders as this may lead to significant governance issues. Providing unchecked authority may allow an individual to act in their own interests rather than in the best interests of the company.
Startups should implement mechanisms to ensure fairness and protect the business’ long-term interests, such as:
Redemption provisions that allow for the cancellation of some or all of a founder's shares should they leave the company or fail to meet certain milestones or expectations.
Shares that are conditionally held in escrow and released to the founder over time based on specific conditions. Bleeding shares over time can help prevent founders from accumulating a large amount of power. If certain events occur, such as resignation, termination, or death, the remaining shares can be returned to the company for cancellation.
Conclusion
Ultimately, founder-proofing is an essential strategy for startups looking to safeguard their long-term success. By proactively addressing legal and governance risks, entrepreneurs can prevent their companies from being derailed by avoidable issues.
At SVR Lawyers, we understand the unique challenges startups face and can help structure legal protections tailored to your company’s needs. If you need guidance, please reach out to a member of SVR’s corporate law group.
References:
Bryce Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice.