One of the most important decisions to be made when preparing articles of incorporation, and kept in mind throughout the existence of a start-up corporation, is its capital structure. It is the capital structure, or capitalization of corporation, which enables its founders/owners to allocate (1) the risk of loss; (2) control; (3) participation in the profits during the existence of the corporation; (4) distribution of the assets of the corporation upon the liquidation or dissolution of the corporation; and (5) the re-purchase of capital.
The term equity security refers to the shares of a corporation. A share has been described as a chose in action, personal property and personal estate. A share is a fractional part of the capital of a start-up corporation. As a fractional part of the capital, a share confers upon the holder rights to a proportional share of the assets of the corporation, whether by way of dividend or upon a distribution of assets on winding up. The start-up corporation’s assets, however, are the property of the corporation and the shares of the corporation are the property of the shareholder.
Share capital is divided into authorized capital and issued capital. The OBCA does not provide for authorized capital as such, rather, the OBCA and its regulations require the articles of incorporation to set out the classes and any maximum number of shares that the corporation is authorized to issue, and if there is to be more than one class of shares, the conditions attaching to each class. Nevertheless, the concept of authorized capital is still valid – it is simply the amount of capital which a start-up corporation, by its articled, is authorized to issue. Issued capital is that part of the authorized capital which has been issued to the shareholders. The OBCA requires that shares be fully paid for in cash or cash equivalent before they can be issued. The un-issued capital of a corporation is the un-issued balance of the authorized capital.
Typically, the founders of a start-up will have a vague idea of what the relative values of their contributions to the proposed business should be. A typical situation might involve an inventor whose ideas or product development have formed the basis for the start-up, a financial founder whose role will be to invest needed capital in the start-up and a service founder whose chief contribution to the startup will be to provide services. Accordingly, issues may arise with respect to valuing the contributions of, and the shares issued to, each founder. Valuation is important for a number of reasons. First, the corporate law may limit the types of consideration a corporation may take for issuance of its shares. The value of any non-cash consideration should, therefore, be reasonably determined and recorded in the corporate minutes.
If the founders had determined that each would receive one-third of the shares of the startup, the relative value of the non-cash contributions, including the contribution of the service founder, could be determined by the cash contribution of the financial founder, and the tax consequences measured accordingly. For example, if the financial founder invests $100,000 for a 1/3 interest, and the two management founders each receive an unrestricted 1/3 of the shares in exchange for their services, the two management founders will be taxed on the value of the shares received for their services and will be required to report such amounts as compensation for services rendered, at ordinary income rates. Given the amount paid by the financial founder, that value, and thus the amount of compensation, could be $100,000 each. Accordingly, it may be advisable instead to structure the initial capitalization so that each founder puts in a relatively small amount of initial capital, with the financial founder loaning additional amounts to the corporation. Or, the financial founder could receive convertible preferred shares convertible into 1/3 of the common shares, with the other two receiving common shares, which should be worth less than the preferred. This is a sensitive tax area that should be reviewed carefully with tax lawyer.
Another essential inquiry relating to the issue of how ownership interests are to be divided relates to the expectations of the investors with respect to those interests. For example, the financial investor may be looking primarily for a guaranteed return, and would be willing to trade some upside potential for security. Therefore, the use of preferred shares or convertible debt may be an alternative for that founder. Similarly, if a management founder is to receive his shares position solely for future management services, it may be prudent to tie his shares interest to a vesting schedule over time, or in accordance with performance benchmarks, or both.