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 www.Pinskylaw.ca • View topic - Staying Out of Court While Staying in Business

Staying Out of Court While Staying in Business

Post about issues related to startups

Staying Out of Court While Staying in Business

Postby Pinskylaw.ca » 11 Jan 2014, 16:19

1. Introduction

A business begins with an idea, one person's plan, invention, or a concept that may, become part of a profit-making enterprise. Developing a going concern business around that idea or concept usually involves a number of people, each of whom offers a specific, often indispensable asset or skill. One person may bring money, another expertise in design or marketing, and a third contacts with vendors or customers. Successful businesses are most often built upon a combination of several individuals' resources and talents. Almost two-thirds of all business start-ups fail within three years. The causes are myriad. The market for the product or service offered may collapse, there may be inadequate capital for the business to produce and distribute the product, government approval for the sale of a regulated commodity or for the payment for a regulated service may take too long to obtain, or competition from established entities may be too fierce. Companies also frequently collapse from disputes and litigation between the very people trying to make it profitable. In many start-ups, a few individuals serve as owners, managers, and employees and perform most of the key functions; if a dispute arises or their interests diverge, each owner's focus shifts away from pursuing mutually beneficial profit-making opportunities to the individual's position in the disagreement. An unresolved conflict between partners, joint venturers, or shareholders of a company may destroy an otherwise promising endeavour. Destructive disputes and litigation are particularly prevalent in small businesses because the stakes for the individual investor are so high. Most investors prefer to diversify their holdings to hedge against losses, but small business owners often pour all of their assets plus borrowed funds into their ventures. For the entrepreneur, business failure can mean personal financial ruin. Furthermore, owners of start-ups anticipating losses or marginal profitability over the short term often opt not to incur the legal and accounting fees and similar costs of fully assessing and allocating the burden of potential risks. Since many courts are reluctant to interfere in business relationships except in cases of extreme misconduct (though ironically many entrepreneur litigants are less sophisticated in legal matters and more in need of judicial guidance than larger corporations with in house or retained lawyers) small business owners must be particularly careful in choosing partners and associates.

2. Protecting a Bright Idea

When a group of entrepreneurs pools its talents and resources to start a business, the individuals involved are at least implicitly agreeing to share both the risks and rewards of the venture. How those risks and rewards are to be allocated among the investors (at least for the short term) must be determined at the beginning of the commercial relationship and reduced to writing. This agreement must specifically set out each participant's contribution to the project - monetary investment, labour, or otherwise - as well as his or her share of future profits and losses. The process of negotiating the terms of the agreement involves the first two steps in advancing the start-up. First, the inventor around whose idea the start-up is created must determine that consideration for which he will part with sole ownership of his invention or concept. An idea is the intellectual property of the person who thought of it. However, the idea by itself is probably worth very little. The inventor must enlist the help of others with skills in business operation, marketing, human resources, and similar areas to develop a profitable endeavour. Those participants often become equity investors in the business. They are reimbursed for their contributions directly from the business' profits. While the inventor is entitled to fair consideration for the invention or concept itself, to secure the indispensable assistance of other members of the business team the inventor must both accept a finite schedule of remuneration and turn over some level of operational control of the business. The innovator's compensation should commensurate with the level of risk involved in the venture and with the costs incurred to develop the idea. The greater the likelihood of future profitability (and the greater the accrued costs of development) the more money the person who conceived of the idea should receive. The result must be a mutually beneficial, fairly balanced distribution of the risks and rewards among all involved.

Attracting capital and simultaneously protecting the idea from unnecessary disclosure is the second step. The inventor must safeguard the idea's value by preventing disclosure to or appropriation by third parties. Forming a business team naturally entails the disclosure of sensitive information: the potential profitability of the invention (what makes it attractive to qualified prospective investors) must be conveyed to future team members who will demand adequate information in order to make the best investment decision. However, shared information could also be used by others to establish or benefit a directly competing endeavour. This increased potential for competition (and the prospect of a decreased market share) makes the concept less valuable. As a result, the most qualified potential investors will closely scrutinize the extent to which the project's intellectual property is protected.

3. Rights and Responsibilities of the Business Team

As with all start-ups, the organizers must choose the business form that best serves their needs. This selection entails the third step: minimizing the risk of loss to the investors while apportioning operational control of the enterprise. Individual liability is minimized by assuming a legal identity distinct from the investors. However, creation of a business entity decreases each individual investor's control over his or her investment. Partnerships offer the most operational control to the individual investor. A partner has the right to fully participate in the management of the business and can force the dissolution of the partnership at will. However, a partner is personally liable for any business debt whether or not he acquiesced in its accrual or even had knowledge of its existence. Limited partnerships and limited liability partnerships (or professional LLPs) offer to investors more protection from individual liability. Corporations are the most formally structured of the business forms and can still offer the entrepreneur both pass-through taxation and limited liability. The records that a corporation is required to maintain are particularly useful to the owners of very small entities when they are personally sued for corporate debts. These documents can help establish that the corporation and its shareholders are in fact distinct entities.

Choosing an operational form is the first step in contracting rights and responsibilities among members of the business team. It addresses two key, but narrow, issues: tax liability and individual (as opposed to entity-level) responsibility for corporate obligations. Regardless of the form chosen, the business team must specifically allocate the bulk of the rights and responsibilities among themselves. This should always be done in a writing formally approved by each member. For one, if the owners of a partnership or corporation fail to adopt a set of governance guidelines, the federal or provincial business acts will impute those guidelines for them. Second, a well-drafted agreement is a “road map” to which the business team members can refer if questions concerning rights or obligations arise. It also helps lawyers, accountants, and other professional consultants to advise the business if there is a dispute. The written agreement between organizers/members of the enterprise must reflect a consensus in three major areas: (1) contribution requirements, (2) management rights, and (3) rights to distribution. Contractual provisions concerning contribution and distribution codify the financial arrangements agreed to by the investors. Management rights, including the rights of individual owners to make key decisions, policies, and procedures for day-today operations, a system for resolving disagreements among the owners, and causes and procedures for dissolution should also be part of the written agreement. Important issues particular to the business must be addressed in the operational agreement. For example, the contract should assign ownership of and use rights to intellectual property exclusively to the business and restrict dissemination of proprietary information by individual owners during and after their involvement with the enterprise. The agreement should set out in plain and unambiguous language the circumstances under which the entity can operate outside of the usual course of business. In sum, adopting a well-written agreement setting out the rights and responsibilities of each member is as important as selecting the right business form. Even though partnership agreements and corporation shareholders' agreements are not always required by statute, an agreement is the optimal means of ensuring a balance between the rights and responsibilities of each member.

4. Self-Interest vs. Entity-Interest

The profitability of a small business is in large part a function of the owners' and investors' personal contributions of money, time, and effort. The business team works for the benefit of both the entity and individual and the individual's return will be determined by the success of the entity. The owners must be willing to share operational control of the business and must have confidence that their teammates are fulfilling their obligations and not self-dealing at the business' (and each other's) expense. The fourth step entails personally profiting from the business relationship while acting in the entity's best interests. Some legal mechanisms are in place to establish a basic code of conduct. The owners of a business must deal with each other fairly. Directors and officers of a corporation have a statutory obligation to act in good faith and in the corporation's best interests. Partners owe a fiduciary duty of loyalty to the partnership and to each other. Managers and shareholders of a corporation likewise have a fiduciary duty to act in good faith and in the best interests of the business. A fiduciary duty is defined as a duty of undivided loyalty that is greater than the obligation of fairness implied in an arms-length transaction. It requires the obligated party to promote a collective, long-term interest and not personal, short-term interests. In general, partners, officers, directors, and employees have a fiduciary duty to the businesses with which they are affiliated. They owe a duty of loyalty to the entity itself and cannot compete directly with it, usurp its commercial opportunities, or use commercial assets for personal profit. Each must account to the others and hold in trust for the benefit of the entity any personal profits derived without the entity's consent, any profits connected with a transaction concerning the formation, business, or liquidation of the entity, and any profits from use of entity property. The existence and extent of any fiduciary duty between the owners of a closely held enterprise depends on the enterprise's business form and the applicable law. Courts will scrutinize the questionable conduct of partners in partnerships. Jurisdictions differ on the extent to which fiduciary duties exist between officers, directors, and shareholders in closely held corporations. The “majority view” holds that owners of a closely held corporation are fiduciaries akin to partners. The “minority view” only recognizes a heightened duty of officers, directors, and controlling shareholders to the corporation itself.

The statutory remedies available to oppressed corporate shareholders are equally ineffective in both promoting fair dealing and efficient dispute resolution. Provincial and federal business acts remain focused on addressing the needs of larger, publicly traded corporations and not on entrepreneurial endeavours or closely held start up corporations. The business acts have been amended to accommodate the proliferation of closely held corporations primarily by offering the shareholders opportunities to contract out of the minority shareholder trap using the bylaws or separate agreements. The acts have also broadened the authority of courts to involuntarily dissolve corporations for oppressive conduct by a majority shareholder. However, there is no uniform standard used to define “oppressive”, abusive conduct, repeated violations of fiduciary duties, and inconsistency with the minority shareholders' reasonable expectations have been used in different jurisdictions to justify an involuntary corporate dissolution. To improve the likelihood of a start-up's success, the prohibition against self-dealing codified by the common law of fiduciary duties should be incorporated into an entity's governing documents and into any separate contracts with officers, directors, partners, and employees. For example, to attract sophisticated minority investors, closely held businesses owners must provide protection from the minority shareholder trap. Under a traditional corporate governance system, minority owners are restricted in their ability to influence corporate decisions (and to protect their investments). In a publicly held entity, a minority shareholder who disagrees with the majority has the option of selling his stock to a third-party purchaser. However, there is no market for the shares of a closely held corporation. A minority shareholder unable to influence the company's decision-makers or to recoup his initial investment is at best relegated to the position of a limited partner with no governance rights. At worst, majority shareholders exploit this disadvantage by forcing minority owners to sell their shares for a reduced value or at a loss. The law of fiduciary duties has provided a legal framework for granting relief to minority shareholders caught in this trap, but protections for such investors must be specifically adopted in shareholders' agreements to maximize their effectiveness.

5. Profit Taking without Undercapitalizing the Business

Small business owners should profit from their efforts. Entrepreneurs who do not see a reasonable return for the money, time, and work that they invest will have little incentive to continue in business. However, profits must be taken without jeopardizing the enterprise's ability to continue to grow and make money. The fifth step entails paying investors enough to encourage continued participation in the endeavour while retaining sufficient operating capital for the business to prosper and grow. One of the biggest problems for small businesses is inadequate or inconsistent cash flow. An entity profitable by accounting standards may lack the liquidity to pay for materials, wages, taxes, and other necessary expenses. Even when the business' balance sheet shows excess cash, prudent planning demands that the entity maintain adequate reserves to handle future hardships. The entity must be able to weather unexpected increases in vendor costs, costs of growth including increased labor or fixed capital demands, natural disasters, tax increases, increased regulatory expenses, or economic downturns. Accordingly, small business owners must carefully consider the entity's long-term viability when determining what to distribute to investors and what to reinvest in the company. Exacerbating the cash flow problems experienced by many small businesses is the reluctance of many banks, venture capitalists, and other investors without direct ties to the entity to loan it money. Assessing the risk of investing in a start-up is difficult; the viability of the business plan is unproven, potential lenders may be unfamiliar with the entrepreneurs' skills in operating and managing a business, and there may be insufficient collateral to secure repayment. The increased risk of loss means that entrepreneurs who can obtain financing will pay higher interest rates. Furthermore, banks and other lenders will want to closely and continuously monitor the credit-worthiness of the enterprise. Additional monitoring costs decrease the return on investment and are a disincentive to small business loans. At the very least, the increased cost to the lender will be passed on to the entrepreneurs. Accordingly, small businesses must establish their own reserves both to lower the perceived risk to financial institutions of lending it money and to insure sufficient liquidity in the event that borrowing money is not an option. The under capitalization of the business can have additional consequences for the owners. Inadequate capital is a key indicator of both a lack of creditworthiness and of an increased risk of loss for lenders. Under capitalization may also result in a court “piercing the corporate veil” and holding individual owners liable for corporate obligation. Inadequate capital is a key consideration of most courts in determining whether or not the corporate form has been adhered to by the shareholders.
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