Tuesday, April 18, 2006

Some Considerations for Entrepreneurs

Some Considerations for Entrepreneurs
Rajwans.com, April 2006
by Jindra Rajwans

Setting Up Your Business

When setting up a business, one must consider a number of factors, including among others, financing, the marketability of the products and services to be provided to the customer (whether it is business to consumer (B2C) or business to business (B2B)), cost, price, competition, hiring workers if necessary, marketing, distribution, outsourcing, accounting, legal issues, etc.

Although the list of things that an entrepreneur must deal with is non-exhaustive, due consideration must be taken in establishing the best legal structure for your business, as the legal structure may have a significant impact on a business’ bottom-line, and either increase or decrease an owner’s potential liability.

There is no one best legal structure for all businesses. Rather, depending on the nature of the business, one legal structure may be more advantageous than another. The most common legal structures that are used to operate a business are (i) corporations; (2) partnerships; and (3) sole-proprietorships, and each have their distinct advantages and disadvantages.

Incorporations

The most common type of business is the corporation and one of the greatest advantages of incorporating a business is that there is limited liability of the shareholders for the debts, obligations, and liabilities of the corporation since the corporation is a separate legal entity. This means that in case a corporation becomes bankrupt, the shareholders will not lose more than their investment into the corporation, subject to some exceptions, such as when a shareholder has provided a personal guarantee for all the debt and liabilities of the corporation. In cases where a business operates as a partnership or sole proprietorship, the partners or individual himself or herself, as the case may be, is personally liable for all the debts and liabilities of the business.

Other advantages of incorporating include potential tax advantages such as tax deferrals, and lower corporate tax rates which are generally lower than personal income tax rates. Moreover, a corporation has perpetual existence which means that until dissolved or wound-up, the corporation can change its shareholders, directors, and officers.

A further potential benefit of incorporating is greater access to capital since a corporation can issue shares or sell bonds to attract capital. In addition, a financial institution may feel that a loan to a corporation is a safer investment than a loan to a sole-proprietorship, although this may not always be the case.

Since the corporation is a separate legal entity, a corporation can sue or be sued, enter into contracts, acquire assets and liabilities, and be found guilty of a committing a crime.

Although corporations are more expensive to set up than either a sole-proprietorship or a partnership due to filing costs and professional fees, the potential benefits related to tax rates, access to capital, and limited liability may justify carrying on business as a corporation.

Shortly after the business has been incorporated, the next step is to organize it by completing the Minute Book. A company is “organized” when the shares have been issued, by-law(s) have been approved, directors have been elected, officers have been appointed, and all the relevant filings of the notices to the appropriate government bodies have been made. Normally, a lawyer will assist with the organization of the business, and it is wise for each shareholder to consult with his or her accountant on tax related matters in connection with share ownership issues.

A business may be incorporated federally or provincially. One benefit of incorporating federally is that a named federal corporation is entitled to use its corporate name in each province in which it carries on business. A provincial corporation does not have this name protection advantage, and in some cases, a provincial corporation may be required to use another corporate name in another province.

Entering into a Shareholders Agreement

For a corporation that has more than one shareholder, it is often very beneficial that a unanimous shareholders agreement be entered into which is signed by all of the shareholders of the corporation. A shareholders agreement is a contract which typically governs the voting rights attributable to the shares held by the shareholders, and matters relating to the management and affairs of the corporation by the directors, whose powers can be restricted by such an agreement.

It should be noted that there is no standard shareholders agreement. Rather, each shareholders agreement should be tailored according to the specific facts of the situation and needs of the corporation and its shareholders. A shareholders agreement should clearly outline what the shareholders have agreed to in advance upon the occurrence of a variety of events. One major benefit of having a shareholders agreement is that it gives the shareholders the opportunity to think through many scenarios that may occur, and such a process can unveil many unspoken assumptions on important issues.

Although each shareholders agreement should be made for its particular purposes, most agreements cover common issues such as:

  • What happens if a shareholder wants out of the business and wishes to sell his or her shares? What about third-party offers? - Is there is a right of first refusal?
  • Is there a “shotgun clause” dealing with ownership buyouts?
  • Who has authority to make important decisions?
  • What mechanism is in place in case there is a dispute? Arbitration?
  • What is the total financial exposure and legal liability of the shareholders?
  • How is the Board of Directors determined?
  • Can a shareholder be forced out of the company?
  • What is the ownership structure of the company?
  • Who are the officers and managers?
  • How is a quorum for meetings determined?
  • Are there restrictions on offering new issues of shares (e.g. anti-dilution clause, tag-along provisions, pre-emptive rights)
  • What are the shareholders commitments to the company? (e.g. disclosure of any conflict of interest)
  • What happens if a shareholder passes away or is incapacitated?
  • Are there management contracts? What do such contracts say about confidentiality and non-competition?
  • What happens if the company requires further funding to maintain operations? How is the obligation to provide such funding distributed among the shareholders?
  • Are there shareholder loans to the company, and if so, how are those obligations handled?
  • How is the valuation of a share determined?
  • Do shareholders require life insurance?
  • Does the company require insurance? If so, what kind?
  • How will the officers and directors be compensated?
  • What decisions require unanimous shareholder or board approval?
  • What events call for the dissolution of the business?
  • What happens if a shareholder breaches the agreement?

As part of the process in drafting the agreement, each shareholder should obtain tax advice from his or her accountant or tax advisor to ensure that future earnings are appropriately dealt with.

The process of drafting a shareholders agreement is extremely useful because it allows the opportunity for the shareholders to thoroughly and honestly evaluate their roles and commitments to each other and to the corporation. It is also an opportunity to for the shareholders to gauge the interests and motivations of their fellow shareholders prior to the occurrence of certain events.

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