Seven Deadly Sins of Start-Up Companies

The following sets out seven major areas which commonly cause serious problems for start-up companies seeking to raise venture capital or complete a merger or going public transaction.  These seven areas were chosen because they are common to virtually every start-up venture, are easily over looked, and are generally less expensive to deal with earlier rather than later.

The following is intended for general informational purposes only and should not be construed as legal advice.  You should seek competent legal advice concerning any specific transactions or issues affecting you or you business.

1. Lack of Attention to Corporate Basics

• You don’t necessarily need to incorporate on Day 1, but you should know how and under what circumstances you will transfer the business to a corporate vehicle.
• Consider whether a joint venture, proprietorship, partnership or limited partnership structure will be more appropriate than incorporating in the initial start-up phase.
• Choose the right jurisdiction of incorporation for your needs.
• Consider whether a holding company (domestic or off-shore) should own the intellectual property assets and license an operating company to use them.
• Consider the tax implications of your structure early on and often.
• Avoid complex and inflexible structures whose benefits may be questionable.
• Ensure that all share issuances, changes in directors and officers, material contracts and major financial transactions are supported by written directors’ resolutions.
• Keep copies of all material contracts, resolutions and corporate filings in the corporate minute book and keep the minute book up to date.
• See Appendix “A” for some common corporate structures.

2. Problems With Prior Corporate Finance Transactions

• Avoid exclusive corporate fundraising arrangements.
• Ensure all share issuances comply with all applicable securities laws.
• Avoid allowing too much dilution for the amount of capital raised.
• Avoid taking on too many minority shareholders without adequate control over them (e.g. shareholders’ agreement, power of attorney, call/redemption rights).
• Avoid issuing of the wrong types of securities; standard voting common shares (or securities exchangeable for or convertible into common shares) are generally preferable.
• Use a written subscription agreement when issuing securities.
• Avoid issuing securities to consultants, creditors, companies, out of province residents and members of the public without first obtaining competent legal advice.
• Keep in mind that you must comply with the securities laws of every jurisdiction which has a substantial connection with the offer or issuance of any securities.
• Keep in mind that investors will typically not want to see their investment used to remedy past securities violations.
• See Appendix “B” for some securities law basics

3. Unrealistic/Inadequate Business Plan - Although this is a topic unto itself, the following points relate to common problems created by many business plans in connection with a corporate finance transaction:

• Keep in mind that your business plan will often be the starting point for an offering memorandum, information circular, prospectus or other major disclosure document.
• Avoid including statements in your business plan which will have to be removed or substantially altered in a disclosure document.
• Keep your business plan concise, clearly written and sufficiently comprehensive to address all major business challenges and, most of all, accurate
• Provide citations for all research in the plan and keep copies of the source documents.
• Include brief current biographies of all directors, officers, founders, major shareholders (>10%) and key advisors
• Keep financial projections realistic and achievable.
• See Appendix “C” for some Offering Memorandum basics.

4. Inadequate Protection of Intellectual Property Assets

• Know what you own; own what you know.
• Document the development and ownership of all proprietary knowledge from Day 1.
• Register your intellectual property rights as quickly and thoroughly as possible (trademarks, copyrights, patents, industrial designs, integrated circuits (mask works) for each country in which protection is warranted), and budget accordingly.
• Ensure all trade names, brand names and domain names are available for use before you start, and then protect them.
• Obtain written waivers and assignments from all employees, consultants and other developers of the intellectual property.  Use written agreements.
• Consider implementing a confidentiality and inventions policy.
• Use non-disclosure agreements prudently rather than indiscriminately. Seek advice when in doubt.
• Ensure all technology transfer agreements are in writing and have been thoroughly reviewed by a competent professional for tax and legal issues.

5. Unrealistic Business Valuation

• The basis for your valuation must be reasonable and defensible.
• Until you have a history of revenue or are otherwise in a position to have a Chartered Business Valuator prepare a formal valuation, the only measure of value may be the capital invested to date.
• Keep in mind that the terms of the investment you are seeking will indicate in an implied value for the business-if it is not realistic, prospective investors will likely decline to invest.

6. Inadequate Plan for Use of Proceeds

• Be prepared to demonstrate how the investors’ money will increase the value of the business.
• Avoid unstructured credit transactions which expose the investors’ money to being used to repay past debts (especially shareholder loans and promissory notes).
• Don’t automatically reject restrictions on the use of proceeds particularly where the restrictions are consistent with achieving your business objectives.

7. Inadequate Management

• Avoid management teams with poor track records, poor business reputations and a lack of experience.  Conduct your own due diligence on any directors/officers introduced to you by others.
• Seek directors/officers who add value (i.e., strong business/financial contacts, specific relevant experience and/or specific relevant expertise).
• Identify critical contacts, experience and expertise necessary to implement the business plan and seek advisors to fill any gaps in the management team.
• Avoid directors who will not be consistently and readily available to management.
• Delegate prudently to ensure key personnel are not distracted by unnecessary concerns.

Appendix “A”

Basic Corporate Structures

Some corporate structures are more appropriate than others depending upon your business goals.  The following table sets out some examples.

Appendix “B”

British Columbia Securities Laws Basics

1. Legislation

• All trades of securities by a BC issuer or to a BC resident are subject to the Securities Act (British Columbia) (the “Act”).  In addition, trades conducted in or having a substantial connection to BC may also be subject to the Act.
• The securities legislation of other jurisdictions may also apply to any given trade.
• The BC Securities Commission (“BCSC”) is responsible for the implementation and enforcement of the Act.
• The BCSC is in the process of implementing many significant policy and legislation changes which will affect start-up companies in important ways.

2. Prospectus and Registration Exemptions

• Many people mistakenly believe that the Act only applies to “public” companies.
• In fact, all trades of securities, include all share issuances and resales, to which the Act applies must be made under a prospectus filed and receipted by the BCSC and must be made only by persons registered to trade securities in BC unless there is an available exemption from the prospectus and registration requirements under the Act.
• Typical exemptions used by start-up companies include:
  • The “founders” exemption,
  • the “private issuer” exemption,
  • the $97,000 exemption,
  • the $100,000 property acquisition exemption,
  • the “directors, officers and employees” exemption,
  • the “Offering Memorandum” exemptions, and
  • the “resale” exemptions.
• Before you rely on any exemptions under the Act, the issuer must determine that the exemption is available.  For example “private issuer” is a defined term under the Act and is not the same thing as a “private company”. Most start-up companies will be prohibited by both the Act and their articles from issuing securities to the “public”.  Who is or is not a member of the “public” can often be difficult to determine and competent legal advice should be sought.

Other Important Safety Tips

• With very few exceptions, all securities issuances should be made pursuant to written subscription agreements structured in accordance with the applicable exemptions.
• The Act requires certain documents to be completed by the investor in some circumstances.
• The issuer is required to make a statutory filing with the BCSC with respect to some trades.
• Once you lose your “private issuer” status, you cannot get it back (although in some cases you may be able to effectively do so by way of a corporate reorganization and/or continuance to another jurisdiction).
• Although there are parallels to the “private issuer” exemption in many other jurisdictions, standard BC company articles often lack sufficient provisions to comply with the “private issuer” rules of those jurisdictions, with the result that the “private issuer” exemption may not be available to the issuer for trades involving those jurisdictions.
• The penalties for contravening the Act can be severe and expensive.  However, many violations can be remediated if addressed directly and early on, although the curing defaults is almost always considerably more expensive than the preventing them.
• Unremediated securities violations can be fatal to major financing, merger or going public transactions and are the focus of the due diligence reviews of both the parties to the transaction and the regulatory authorities.

Appendix "C"

Offering Memorandum Basics

An Offering Memorandum is a prescribed disclosure document which must be prepared and delivered to prospective investors in order for an issuer to rely on certain exemptions from the prospectus and registration requirements under the applicable securities legislation.

1. Basic Components - The Offering Memorandum will generally contain the following categories of information about the issuer, among other things:

• Risk Factors
• Name of Issuer and incorporation details
• Description of the securities offered
• Details of the offering
• Prospectus exemptions to be relied upon
• Nature of the business of the issuer
• Nature of the project to be financed
• Use of proceed by the issuer
• Share and loan capital structure of the issuer
• Directors, officers, promoters and principal shareholders of the issuer
• Conflicts of interest involving various parties
• Continuous reporting obligations to investors
• Financial Statements
• Material Contracts
• Income tax consequences
• Certain other prescribed statements
• Financial Statements may be unaudited if the issuer has completed less than one fiscal year but must be as of a date within 60 days of the date of the certificate attached to the Offering Memorandum.  If the issuer has completed a fiscal year, audited financial statements must be included and unaudited financial statements for a stub period may be required.
• The form of subscription agreement to be used for the offering is normally included in the Offering Memorandum.

2. Additional Considerations

• The Offering Memorandum must be prepared in accordance with the requirements of each jurisdiction in which securities will be sold and must generally be filed with the securities regulatory authority for each such jurisdiction.
• The Offering Memorandum is usually prepared by a securities lawyer and typically costs $10,000-15,000 or more, depending on the complexity of the matter (excluding filing and accounting fees).
• The Offering Memorandum is a defensive document designed to provide relevant information to investors and avoid liability of the issuers and its directors, officers and promoters for misrepresentations. It should contain statements of fact and avoid promotional.
• The use of financial projections and other “future-oriented financial information” is restricted.