What’s a cooperative?

There are a lot of different models available to people to set up their businesses, but one of the most underused is the cooperative model. Frankly, I find it odd that so few startups consider using a co-op, given the shift towards people-centric companies, corporate social responsibility, social enterprise, crowdfunding, and the sharing economy. In many ways, co-ops are ideal for these types of ventures, since the primary aim of a cooperative is to benefit its members. It’s up to the members to decide what “benefit” means, so co-ops are often about more than just maximizing profits.

Perhaps unfamiliarity breeds avoidance. The co-operative corporation is an odd beast, and far less common than corporations, partnerships, and proprietorships. A lot of folks don’t even know the co-op exists as an option. Hell, a lot of business lawyers I know have never touched the things, and just gloss it over in the “other” category when talking about business structures. Its weirdness makes it difficult to understand. Co-ops are a mash-up of business and not-for-profit corporations, with partnership-esque decision-making, which are sort of public companies, and report to a separate branch of government than every other business in Ontario.

the-people-dont-know-their-true-power-tc-cartoon-sad-hill-newsIt’s high time we blew the dust off the ol’ girl, and maybe you won’t think co-ops are so weird and scary after all. You might even start to think that your business would do well as a co-op, in which case, we should talk.

There are a LOT of possible variations in co-ops, so I’ll stick to the basics in this article. The goal is to give you an idea of the broad strokes, and I’ll leave the details for later articles. I’m going to talk about:

  • What a co-op is
  • Advantages and disadvantages
  • Types of ownership
  • Types of co-op
  • The basics of financing a co-op, and
  • The basics of decision making

So what is a Co-op Anyway?

Co-operatives are democratically-run businesses governed by those who use their services – their members. Co-ops generally rely on member participation to make the wheels turn. Members pool their money, goods, or services, have a say in decision making, and share in the profits or losses of the co-op’s business. Members can be human people, corporations, and not-for-profits.

cooperative-movementAs we’ll see below, a co-op can be set up with shares, like a business corporation; or without, like a not-for-profit. Co-ops with shares can sell them to members and the general public to raise capital. Co-ops without shares may operate as not-for-profits, and apply for charitable status.

Decision making is one-member, one-vote, so each member has an equal say. Members can be broken down to stakeholder groups, where each group’s votes may be weighted differently, kind of like in a partnership.

Once they reach 35 shareholders or lenders, co-ops become somewhat like a public company, and have to distribute information about the business and its finances to potential investors. The annual financial statements of a co-op must be audited, to ensure that the co-ops accountants are preparing the statements by accounting norms. Ontario co-ops are regulated by the Financial Services Commission of Ontario, rather than the Companies Branch

Advantages

  • Egalitarian – while corporations can allow their stakeholders to participate in ownership through stock option plans and the like, such plans are often carefully controlled to prevent those stakeholders from controlling the company.
  • Democratic – each member has an equal say.
  • Cheaper to set up and run than stock option plans or large partnerships – though the rules governing co-ops can be a bit tedious, many of the rights and responsibilities are written in the law, rather than being custom creations
  • Shared resources – members can get access to more and better equipment or facilities, increased negotiating power when buying/selling, shared marketing costs, etc.
  • Networking and education – members have access to people who face similar challenges, and make contacts up and down the supply chain.
  • Limited liability – a co-op is a “person” in the eyes of the law, which takes on its own liability. Members and shareholders personal assets are protected, and they only stand to lose what they invested.
  • Flexibility – co-ops have a huge array of options on goals, structure, financing, decision-making, and services.
  • Double or triple bottom line – benefits to the members aren’t limited to a share of the profits.

Disadvantages

  • Startup costs – are typically higher than for simple incorporations or partnerships. It takes more legal and accounting work to get ’em off the ground.
  • Offering statements are required to raise money – which takes time and money to prepare, and there are ongoing disclosure requirements.
  • Annual financial statements must be audited – which adds an extra annual operating expense.
  • Decision making can be slow and difficult – especially when there are a lot of members, or stakeholder groups with different interests. Think of how much of a pain in the ass the membership meetings of a condominium can be…
  • Unfamiliarity – because there are relatively few co-ops, compared to other business forms, government and foreign entities may have a hard time wrapping their heads around how to deal with you.

Membership Shares, or Members?

You have two options when incorporating a co-op – ownership through shares, similar to a regular ol’ corporation – or control by members, similar to a not-for-profit corporation. Choosing between the two usually comes down to two things:

  • Whether the co-op’s purpose is to operate like a business and turn a profit, or to provide a service on a break-even or non-profit basis; and
  • How much capital is needed to get started and run the co-op. The greater the need for capital, the more likely it is you’ll lean towards shares.

Consult with your lawyer and accountant before choosing which way you’ll go.

Shares

Shares are just a bunch of rights in the co-op. Most of these rights centre on control (voting), profits (dividends), and ownership (right to a share of the net profit if the business is sold or wound up). Every co-op with share capital must issue at least one type of “membership shares”. Each membership shareholder gets one vote at members’ meetings to do things like electing the directors, setting the rules (bylaws) of the co-op, choosing an auditor, approving annual financial statements, and major business decisions like selling or dissolving the co-op. Different types or membership shares may have slightly different rights.

You also have the option of creating and selling different types of “preference shares” to raise money. Like a regular business corporation, you can get pretty creative with the rights that the preference shareholders have, like priority on dividends, to be bought out or redeemed, to be paid part of the proceeds of liquidation, to receive information, and to receive a portion of the net profits of the co-op each year as a patronage return.

Members

For co-ops without share capital, there are only members, who fill much the same role as membership shareholders, above. The biggest consequence of this type of co-op is that its only financing options are membership fees, loans from members to the co-op, and loans or other debt from outside sources.

Multi-Stakeholder Co-ops

In these bad boys, members are organized into stakeholder groups, depending on what they contribute to the co-op. Each stakeholder group has certain rights as a group, such as appointing directors to the board, or to receive a lower or higher share of the co-op’s profits.

Types

There are four basic types of co-op in Ontario

  • Worker-owned

    Exactly what it sounds like. Only workers can be members of the co-op, and at least 75% of employees of the co-op must be members. An example would be Toronto’s Co-op Cabs, where each taxi license holder is a member of the co-op, and gets a share of the net profits of the company rather than revenues from their specific cab.

  • Consumer

    Businesses, often in retail, which are owned by their customers for their mutual benefit. Resources are pooled to buy in bulk, then the savings are passed on to the members. The most common are credit unions, green energy, insurance, and grocery stores. I’ll lump housing co-ops in here too.

  • Producer

    Producers of a certain product, or a certain category of goods band together to share common expenses like warehousing, equipment, shipping, and marketing. Most people have seen farmers’ co-ops, which often have warehousing and large equipment, as well as buying farm supplies in bulk. Producer co-ops could work for any business from lumber, to crafts, to booze.

  • Multi-stakeholder

    Here, many different groups of interests recognize that they’re all in the same boat, and band together for common gain. These groups could include workers, producers, service providers, consumers, and supporters of a certain cause. Health care and social services are common areas for this form. There’s a big push towards sustainable food co-ops right now, bringing together farmers, land owners, seed banks, grocers, and restauranteurs.

Dolla Dolla Bills Y’all

A co-op model can allow a business to take a fundamentally different path than a regular corporation. The directors of corporations are voted in by shareholders to maximize the value of the shares. Co-ops exist for the benefit of their members, which can far broader than simple monetary gain. That’s not to say that a co-op can’t turn a profit. It’s just up to the members as to how far up the priority list profit falls. The rules on how money comes into and flows out of a co-op are different than regular corporations too.

Money In

Besides profits from the sale of goods, the most common fundraising method is membership fees – an annual fee that members must pay to stay members. In most cases, this isn’t a large sum. Co-ops can also charge fees for use to members or the public – like an hourly rate for use of equipment and facilities, or for sales leads they generate for their members.

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Debt Financing

As with any business, a co-op can borrow money, known as debt financing, from a variety of sources. Co-ops can, and often do, require their members to loan money to the co-op, which is common in agricultural co-ops where production is cyclical. They need the cash up front to float the year’s operations, and the loans are paid back when the harvest comes in. They can force members to re-invest profits earned from the previous year as member loans as well.

Co-ops can borrow from banks, government, and other private lenders, same as any other business. They can also apply for government grant funding.

Equity Financing

Co-ops with share capital can raise money by selling preference shares. The magic number is 35, meaning that if there will be 35 or more people who own securities (shares and debt) when the sale is done, the co-op has to file an “offering statement” with the Financial Services Commission. This is similar to, but less demanding than, what a corporation must do before “going public”. The goal of the offering statement is to ensure that the investors know what they’re investing in. The exact requirements vary depending on the co-op, but the result must be a full, true, and plain disclosure which answers any reasonable question an investor may have. There are a few exceptions which mean you don’t have to file one for small numbers of investors, and small amounts raised.

Money Out

Aside from paying operating costs, wages, tax, and debt, there are rules about how the profits of the co-op are paid out. What’s left after operating expenses are paid, but before tax, is called the “surplus”.

A co-op can set aside some or all of its surplus to create a “reserve fund” of retained earnings for its future expenses, and it can pay out the surplus through dividends and patronage returns.

Dividends

Dividends are paid out of a co-op’s after tax income. The member or shareholder is taxed on the dividend (not as regular income), meaning some tax credits are available to them.

The maximum dividend allowed on membership shares is the prime lending rate +2% per year. There’s no cap on dividends to preference shareholders, so the rate of dividend is what’s set out in the Articles of the co-op.

Dividends may be paid in more shares of the co-op as well, which allows the business to reinvest the profits, and increase the equity holdings of the shareholders.

Patronage Return

This posh sounding term is the profit share a member is entitled to based on how much business they’ve done with the co-op. This is the main way in which members receive their profits. Patronage returns are paid out of the pre-tax income of the co-op, and are taxed as income for the member.

Different rules apply to different types of co-op, but the way patronage returns are calculated is set out in the bylaws. Worker co-ops, for example, pay patronage returns based on hours worked, or total compensation paid each year. Producer co-ops may account for the relative profits earned from different products contributed to the co-op (a ton of strawberries may turn a higher profit margin than a ton of potatoes. No offence to potatoes.)

Non-members may also be paid a patronage return, so long as the return for non-members is the same or less than what’s paid to members.

Decision Making

As with a corporation, co-ops have three levels of decision-making – members, directors, and officers.

Members

Each member, or membership shareholder, has one vote at meetings of the members. Members have to attend a meeting in order to vote – they can’t send a proxy to vote in their place.

Most votes are decided by a simple majority of votes, after a resolution has been discussed. The key decision members are called upon to make is to elect the board of directors, or removing them if need be. They also approve audited financial statements, and vote on resolutions proposed by members.

Members have a say in other major decisions, which require a 2/3 majority to pass. These include changing the articles of the co-op, adopting new bylaws, and approving the sale or merger of the co-op.

5% of members can call a meeting, or propose member resolutions. 10% of members can force a directors’ meeting to pass a new bylaw or resolution.

Directors

Elected by the members, the directors have a fiduciary duty to run the co-op in the best interests of the members. All directors must be members of the co-op, and there must be at least three directors on the board. The board is responsible to set the strategic direction of the co-op, and appoint the officers to manage its day-to-day affairs. They vote on things like approving new members, budgets, major contracts, and expansion plans.

Officers

Appointed by the directors, officers oversee operations, and supervise the lower-levels of leadership. Officers are employees of the co-op, and except for the President and chair of the board, they don’t have to be members. The duties of the different offices are listed in the Cooperative Corporations Act. Most co-ops will delegate a certain amount of decision-making power to officers, such as the ability to sign contracts up to a certain amount, to hire and fire employees, and to do the co-op’s banking.

Conclusion

So, there you have it, co-ops in a nutshell. This is by no means a complete guide to co-ops in Ontario, but I hope it proves to be a useful starting point. If you’re looking at starting a business or non-profit, take a good, give co-ops due consideration.

There are a ton of good resources out there for information gathering, including a whole series of guides from the FSCO, and the Ontario Co-operative Association that can help you to get started.

As always, I’m happy to help you birth your cooperative business baby. Reach out.

 

Mike Hook
Intrepid Lawyer
mike@intrepidlaw.ca
@MikeHookLaw

Risk Management for Event Promoters

Date:  Wednesday, September 23, 2015 – 19:00 – 21:00
Location: The Richmond, 477 Richmond St. W. #104
Price: Free, but a donation to GlobalFire’s capacity building mission to Nicaragua is requested. Donations over $20 are eligible for a tax receipt.

Anyone who’s ever got it in their head to throw an event knows there’s a financial risk involved. What you may not know is just how much legal risk you’re taking on, or how to protect yourself. If GI Joe taught us anything, it’s that knowing is half the battle… so join me on September 23, 2015 to get in the know about how to limit your liability as an event promoter. This event will be useful for those who organize events, or deal with event organizers for:

  • Music – concerts, clubs, raves, and festivals
  • Food & Drink – festivals, pop-ups, markets, taste-and-buy
  • Sports – tournaments, leagues, charity runs, competitions
  • Weddings
  • Travel – group or themed trips
  • Public gatherings – rallies, pillow fights, yoga-ins
  • Conferences

This event will feature a presentation on the key ways that you can manage your risk, a Q&A session, then the cash bar will be open, and youll have an opportunity to network with other local event promoters of all stripes. If there’s enough out of town interest, I will webcast it as well.

This event will be a fundraiser for my upcoming deployment to train first responders and provide access to clean drinking water in rural Nicaragua with GlobalFire. There’s no set cover charge, but I ask that you pay what you can. Contributions over $20 are eligible for a tax receipt.

It’s an open invitation, so please feel free to circulate the event to people in your network who may be interested.

The Facebook event page is here:https://www.facebook.com/events/935981106467567/

Speaker Bio:

I’m a small business lawyer in Toronto, working with socially, environmentally, and ethically responsible entrepreneurs. In my spare time, I’m also an experienced event promoter, small business owner, and international disaster response volunteer.

You can learn more about me, and what I do by visiting my website at: http://intrepidlaw.ca/

For more information, you can reach me by email at: mike@intrepidlaw.ca

Beware the Entrepreneurship Industry

This may be a controversial post. You’ve been warned. This post is from my point of view as an advisor to small business. I realize that I occupy a place in the “industry” landscape, and that like the bigger wheels in the machine, I too turn a profit from providing services to small business. As a lawyer, however, I have a duty of loyalty to my clients – called a fiduciary duty. It isn’t optional, it’s the law. This means a bunch of things – to be competent and diligent in my work, to act in my clients’ best interest, honesty, and to keep your information confidential. Most of the other people you’ll come in contact with in the business world don’t have such a duty – and therein lies the risk that we call “doing business.”

I’ll get to the point.

I’ve noticed a trend towards the industrialization of entrepreneurship these days, and the more I think about it, the less comfortable I am with it. When I say “industry”, I’m talking about making labour systematic. The same business model that created the assembly line to make business more “economically efficient” is now being applied to entrepreneurship. There’s big money to be made. Investors and big business have realized that in many cases it’s more economically efficient to buy innovation than to innovate.

But how do you groom small, innovative businesses into ones that will slip neatly into the world of big business, and global financial markets as they grow? The answer is to industrialize entrepreneurship. As this system gains momentum, there’s an explosion of organizations which provide ready-made solutions to most of your small business needs.

Most of these organizations exist to make money….

… off of you…

… and none of them owe you a duty of loyalty.

I’m not saying that these organizations are out to get you. There are plenty of amazing collaborators out there. All I’m saying is that a healthy dose of caution, and an unhealthy dose research before getting into bed with them is in order. Any time you give up equity (shares) in your company it’s like taking on a business partner. They invest time, money, and resources in making your company grow. With the money comes the expectation of profit. You, as the one with the business or idea, will want to be assured that your partners will pull their weight, and that you’ll have a way out if they don’t. In return, there are some pretty thick strings attached to the investment. They’re gamblers in a way. Gamblers with a much bigger stack than you, more experience in these kinds of deals, and an uncanny ability to lawyer plucky little startups into the ground if they feel wronged. Choosing the wrong horse to hitch your wagon to could cost you your business.

In this article, I’ll talk about two of the big growth sectors in the entrepreneurship industry – high risk investors, and growth programs. I’ll deal with high risk investors first – angel investors and venture capital. Then I’ll move on to the growth programs – incubators and accelerators.

High Risk Investors

The starting point to understanding high risk investors is to understand the basic business proposition from the investor’s point of view. Angel investors, and to a greater extent, venture capital, are betting on the success of your business. In return, they demand returns commensurate with that level of risk. Particularly for VC, they may invest in ten companies, and only get a return on one – meaning the one that hits, they’ve got to make all the money back that they invested in all ten, plus a healthy profit margin – otherwise they’ll be out of business. That means they’re going to do almost everything in their power to make sure that they get their money back. This includes attaching strict, investor-friendly terms to the financing. This also includes using their networks and contacts to spur growth. They’re putting a lot of eggs in your basket, and approach the deal accordingly.

Angels

An angel investor is a wealthy person or group of investors who are willing to pony up startup capital for businesses that they think will succeed. Some angels specialize in raw startups, while others are only interested in companies that have already reached a certain critical mass. While the term “angel” might make them seem benevolent, they’re planning on making money off of your work. Their investment buys a part of your company – between 10-50% typically – and often gives the investor a say in how the business is run. They think they can make money on your idea – and if you don’t do it for them, they may take the reins and do it themselves. Angels see the end-game too, where they can realize the return on their investment. Cashing in. This often means selling the business – either to a third party or by taking the company public. If your end game is different, you may have found the wrong angel. If selling isn’t their goal, they might intend to grow your company in a way that benefits their other business interests.

Angel investment is attractive because as soon as they’re on board, it’s in the angel’s interest to use their connections and experience to help the business. A good angel can open up supply or sales channels that were previously out of reach, guide you through tough negotiations, and provide mentorship to help you develop your business skills. On the other hand, an angel whose intentions aren’t so angelic could take control of the business, fire you, and force you to sell them your shares at a discount. If they have a bad reputation in the business community, you could be tainted with that as well. I’ve seen all of these things and more. Do your homework, and get advice before, during, and after negotiations with angel investors.

Venture Capital

Venture capital is a different beast altogether. VC is usually a fund where many professional investors, serial entrepreneurs, large companies with innovation budgets pool their money together. The fund is managed by specialists who look for high-growth, high-potential businesses to invest in. Usually they’re looking for an “adolescent” business, rather than a raw startup, will invest for several years, and expect a return of around 10 times what they invested over that time. VC will usually get paid out first – often within 1-2 years – and take a percentage of ownership of the company. Venture capital is usually a one-way ticket to an initial public offering, and your investors will do what they must to ensure they get a return. They’ll appoint board members to shepherd their investment, and often have a good deal of say in hiring for key positions. They may replace you as the CEO if they have someone who’ll do better. The investment will usually be a high-interest loan, and secured with shares in the company which will pay the VC back first if the company goes belly-up. The exit plan almost always involves taking the company public. VC is more complex than that – but the important take-away here is that it’s very, very pricey money.

VC is attractive because, if it works, you get rich when the company is sold or taken public. VCs will lend based on their valuation of the idea, rather than their ability to secure their investment on the assets of the company, like a bank would. The downside is, once the VC comes on board, the business ceases to be your baby. Your interests aren’t aligned – the VC is looking out for their investment, not for the best interests of you, the company, or the employees. Most venture capital funds focus on building up the pool of money they manage, rather than mentoring and guiding the business – they’ll often appoint outside board members to represent their interests. The strings attached are large, and tied tightly.

Dealing with High Risk Investors

High risk investors can take your business to the next level in a hurry, and are sometimes the only viable option to fund your research and development. This is especially true for businesses built on ideas, rather than physical assets. Be very, very careful about who you’re dealing with, and understand the deal that you’re making before you sign on the dotted line. Do your research. Get legal and accounting advice. Shop around, and keep these in mind when you’re exploring your options:

  • First, foremost, and always remember – if they’re willing to fund you, then you have something they want. You have leverage in negotiations, and should only take a deal that works for your company.
  • What’s the business/industry background of the people you’re dealing with? What other companies have they worked with, and what results did they get? Talk to those companies, and get a no-bullshit assessment.
  • Who will be appointed to your board? How many other boards do they serve on?
  • Who are their advisors – accounting, legal, etc – and do they come as a package deal? Are they encouraging you to get independent advice before signing?
  • What’s their exit plan? Does it mesh with your vision for the business?

If the investor can’t give you a good answer to those questions, or stands in the way of you finding the answers on your own, run away as fast as you can.

Predatory investors can be hard to spot… until it’s too late. I’ve got a bunch of horror stories from people in my network who jumped at what looked like a good deal… and when they landed, the investor owned the company, and the founder ended up with only a fraction of the value they’d built. They’re smart people who make their living by getting other people to do the grunt work for them… and unscrupulous investors know how to cover their bases. Be cautious, and put in the time and effort to understand them, their goals, and what they expect of you before committing.

Growth Programs

Incubators & Accelerators

These two get lumped together because they fulfill roughly the same role at different stages of a company’s growth. They are, at their core, great business models, and can do a whole lot to nurture the development of your company, and your business skills as a founder. The basic premise is that they’re in the business of investing in startups. An established business person, or group of ‘em, will bring in a company, or group of ‘em, and invest in the company in hopes that it will grow. Most will invest a combination of money, marketing, office space, production and design support, mentorship, and access to their personal networks. They’ll set a pretty rigorous training schedule in business skills, which members are required to go through. In return, they take a piece of your company.

Incubators are typically a long-term involvement, around 2-3 years’ worth, with no set schedule for growth. Most will bring in companies of a similar type into a common working space in hopes that ideas will flourish. Often, incubators will put their own management teams in place – directors and officers – once the grunt work to bring the idea to fruition is complete. Incubators typically take up to 20% of your company for the role they play in incubating your idea.

Accelerators are usually a set business development program to spur rapid growth – hence the name. The program takes place over 3-6 months, and is aimed at companies that have reached a certain stage of development. That program typically involves a couple of “funding rounds” from VC, and may also involve tacking directors and officers of their choosing on to your management team, or full-on replacing the founders in those roles. Accelerators usually take less than 10% of your company for their services.

Who Sails the Ship?

The most value in a growth program is the network that comes along with it. When done right, incubators and accelerators can provide value that’s almost unparalleled. You can get specialized advice and training that will help you to understand and speak the language of business, interpret financial statements, and refine your pitch. Most valuable is the access you get to their well-established business network of advisors, mentors, financiers, and other graduates of their program. That cuts both ways, however. When you climb aboard that train, you’re committing to doing business the way they teach you to do business. While some incubators and accelerators have altruistic intentions, many more are an elaborately constructed way to make money off of your efforts, or to cherry-pick talented business people for their own organizations. It’s a business farm, and you’re the cash crop.

For example, law and accounting firms view successful incubators and accelerators as a way to get new clients. I’m one of them, as an advisor at Ryerson’s DMZ, and a mentor at HumberLaunch. I’ve met several clients that way. Strangely, in the cash strapped world of startups, my competition is largely huge national law firms. These firms will offer cut-rate startup packages, as a loss-leader.  They take a hit on their fees in the short term, in hopes that you’ll grow enough by the time the discount period runs out that you’ll have enough in the bank to pay their rates. That business development strategy means that they’re looking to minimize their short term losses incurred by giving away their services. This can mean standard-form business agreements that aren’t customized to your situation and business. The work is pushed to junior lawyers, law students, and clerks to “cut their teeth” on. A free client’s phone calls are returned after the paying clients’ work is done. That said, big firms have specialized skills, particularly to grow startups into publicly-traded companies, that sole practitioners like me just don’t have. Do your homework.

Dealing with Growth Programs

Moral of the story is, as it was for investors, to know who you’re getting into bed with before signing on the dotted line. Any time you give up equity in your company, you’re taking on a business partner. Like any other partner, you want to make sure that they’ll pull their weight, and know what’s involved in getting yourself out of the deal if need be. The excitement of winning a business plan or pitch competition, or beating out hundreds of other applicants for one of a few positions shouldn’t stop you from doing your due diligence. Here’s some questions to know the answers to before you commit:

  • Who owns the incubator or accelerator?
  • How much of your company do they take, and what conditions are attached?
  • Who are their lawyers, accountants, marketers, and preferred investors? Are you free to choose your own, or do you run with theirs? What’s their interest and relationship?
  • What expectations are there of you?
  • What’s the exit plan? Are they building your company to sell, or take public?
  • Do they have your interests at heart, or do their loyalties lie with the person they have a pre-existing relationship with? What’s the advisor’s interest?
  • Who else have they launched? Did they deliver what was promised? Did their goals shift under the influence of the advisor network? Talk to their “graduates” and grill them on their experience.

Conclusion

Angel investors, venture capital, incubators and accelerators are all tools that are available to help you build your business. As with building anything, it’s important to use the right tool for the job. The right deal is a solid foundation from which to launch your company – you’ll get the mentorship, support, and training to bring your idea to market, build lasting business relationships, and make a bunch of money in the progress. The wrong deal can cram your square peg of a business into the round hole of their interests, and drag you down the long, unpleasant road to failure.

Be strategic. Think about what the end-state will be, when all is said and done. If you’re 100% owner now, and an incubator takes 20%, accelerator takes 10%, and venture capital takes 30%, what does that leave you with? Remember, you’ll be the last to get paid. What if the on-paper value can’t be pulled out for a certain number of years? Is 40% of a $10 million company more valuable to you than 80% of a smaller one? Is your product a flash-in-the-pan, or is it something that will still be relevant when you can cash out? Are you comfortable working with, and being beholden to the people you’re doing business with for that amount of time?

There’s no such thing as certainty in business. That’s what makes it simultaneously frustrating and fun. Do your research, and I strongly strongly strongly recommend getting experience, professional help to review, understand, and negotiate the deal before you sign over part of your company. At the very least, legal, accounting, and ideally an impartial business advisor/investment banker with experience in the types of deals you’re looking at.

After all, “All things will be clear and distinct to the man who does not hurry; haste is blind and improvident.”
– Livy, Ad Urbe Condita Libri, 9 BC

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw

Record-Keeping 101

In a recent blog, I mentioned how important it is to keep detailed and accurate business records. We lawyers will harp on the importance of having records of certain things as evidence in case someone sues your ass. For myself, a compulsive organizer, I figured I’m pretty much on top of keeping what I need to keep… until I met Lisa Ricciuti. Lisa is a fellow entrepreneur who helps businesses to develop effective information management systems. She sports a couple of Masters degrees in Library & Information Studies, and Archival Studies, plays bassoon like a champ, and has a penchant for craft beer. What follows is a guest blog, penned by her, which will help you to understand why good record-keeping is important, and some tips on how to get yourself started.

Over to you, Lisa!

Record-keeping 101: A Few Basics

With so many things going on as a small business owner it’s easy to let the paperwork pile up.  “I’ll get to it later,” we say, shoving papers into a folder marked “Misc.” or saving documents into a desktop folder named “Important Sh*t.”  Most of the time this “filing system” remains undisturbed until disaster strikes in the form of a lawsuit, deadline, computer crash, virus, or security breach.  Suddenly it’s really important to know what you have, where it’s stored, and how you can access it.

There are laws and regulations setting out minimum recordkeeping requirements – what must be kept, how it must be maintained (e.g. where the data is stored), and for how long. For example, accounting, corporate, and employee records all have different rules. Laws apply to businesses that collect & use personal information of customers, suppliers, and contractors. Limitation periods for lawsuits apply to your business, which will also influence what you keep and for how long you keep it.

A number of options exist, almost all of which can be customized to meet the needs of your business.  For many small business owners, the cost and effort involved to set up a sophisticated recordkeeping system isn’t warranted, but that doesn’t mean that your choices are limited to “save everything” or “do nothing.” Although “doing nothing” may seem tempting at times, it leaves your business open to unnecessary information risks, most of which could be easily avoided by documenting (and implementing) processes & procedures related to your routine business.

The “let’s save everything, just in case!” policy

This type of policy has the potential to be damaging and costly.  On the surface it may seem like an easy and quick way to do what the law requires and your business needs;  however, it is no substitute for managing business records based on sound policies and defined procedures.

First of all, the “Save Everything” policy can never be enforced unless you plan on disabling the delete key.  Unless you’re prepared to do that, you won’t be able to comply with your own policy, let alone enforce it with your staff.

Secondly, saving everything comes with a number of hidden costs that are often not considered, including the price of digital storage.  While the price of digital storage has dropped significantly in the last decade making it seem like an attractive option, there are costs that go along with maintaining and managing it.  The more you keep, the more time and money you’ll spend to back up, restore, and manage the volume you’ve accumulated.  It also makes searching for data more difficult, costing you valuable time.  Additionally, some records must be kept where the business operates, which may limit or prevent off-site or cloud storage.

Thirdly, saving everything makes it really easy to lose track of what’s there.  Just imagine what you would care about in the following scenarios:

  • Hacking or security breach
  • Virus
  • Disaster (physical or digital)
  • Lost/Stolen/Damaged hardware (thumbdrive, laptop, smartphone, tablet, etc.)

If you save everything, how could you know what was compromised?  If you had to do a restore, would you want to restore everything, or just the things that have value for you or your business?

Tips

If you are starting a new business, it may take some time to figure out which types of documents you are creating and how they need to be managed.  Even for established businesses, the influence of mobile work options and new technologies requires many organizations to re-think the best ways to manage documents and information.  Following the tips below will give you a starting point for thinking about your recordkeeping. Even if you decide to call in an information professional, implementing some of these best practices will make it easier (and cheaper) for them to help you.

  • Identify which business records must be made and kept because you need them to operate or they are required by law.  
  • Determine how long each category of business records must be kept in addition to any other recordkeeping requirements such as those related to handling personal information or maintaining data where the business is operated. This is often based on a combination of business need and legal requirements
  • Save strategically. Set rules about when and how you will dispose of records that are no longer useful, even those that only exist electronically.
  • Understand where/how your business is creating records. This includes, but is not limited to: email, social media channels (e.g. Tweets, Facebook/LinkedIn posts, YouTube channels, blogs, etc.) and all paper/electronic documents.
  • Identify core business records, organize them, and know where they are stored. For example documents related to incorporating or registering, contracts, agreements, financial statements & other financial records, professional opinions (e.g. legal/financial), meeting minutes and infrastructure.
  • Develop policies related to records & information management. Enforce them.
  • Standardize naming conventions for documents, folders, and tags (labels). This means everybody names everything the same way.  Communicate this to your staff, or if you work alone, write it down for reference.  Even having everybody record the date the same way can make a big difference.  For example: Vendor – Document Type – Date (MMM/YY) = OfficeMax – Receipt – Mar15. 
  • Define & document core processes & procedures. Records are often created to record a transaction point in a given process.  When processes are streamlined and defined, it makes it easier to identify when a record must be captured to validate/verify the work performed.
  • Devise rules for handling drafts and versioning. Some questions to consider: Will you keep all the drafts and the final version, or just the final version?  How will you track versions as it moves to completion or in collaborative projects?
  • Designate time to deal with the paperwork, even if it’s in an electronic format. This can be a great Friday afternoon project.

Additional resources:

ARMA (Association of Records Managers and Administrators) International

AIIM (Association for Information and Image Management)

Or try searching in your area for an Information Management Professional!

Lisa Ricciuti
Smart Info Management Services
The Deletist Blog
@thedeletistblog
lisa@smartinfomanagement.com

Lawyer Stuff 101 – What Does a Business Lawyer Do?

This is the second in my series of articles on how you, a business owner, can use your lawyer most effectively. The most frequent conversation I have when meeting with new clients is to explain the role of the lawyer in advising a business. Many have never worked with a lawyer before, or worked with one in a different area. Why are we useful, and what the hell do we actually do that adds value to your business? Once you know what we do, it’s much easier to use us effectively – saving you time, money, and heartache as your company evolves.

A lawyer’s job is to help businesses to understand and manage risk. Full stop.

On Risk

Most entrepreneurs are going into business because they have a great idea – a product or service that they believe they can sell. The act of going into business is risky in and of itself. You’re putting your time, money, reputation, and relationships on the line. The business world is a scary place, especially when you’re the small fish in the pond. Your competitors are constantly working to out-manoeuvre you. Your employees, contractors, investors, customers and suppliers have expectations and problems of their own. The tax man knocks on your loudly and frequently. There’s a maze of regulations to navigate.

Many of those risks are sight unseen for entrepreneurs. Some manage to bob and weave through them by chance, blissfully unaware of close calls. Often in a first meeting I have the unpleasant task of lifting the veil, and giving them a peek at the troubled waters they’re sailing in. Sometimes the business owner walks away with more worries on their mind than they came with. It’s not a fun realization for them, and it’s my least favourite part of the job. It is, however, reality.

The risks exist whether you realize they do or not. Would you rather not know, and be blindsided when something happens, or understand where the risks lie, what the potential consequences are, and be able to make plans to avoid them and minimize their effect on your business?

Keep your head in the sand if you like, but Stats Canada has found that 20% of startup businesses fail within the first year, and 50% don’t survive three years. The businesses that succeed tend to have sound legal and accounting advice from an early stage. If you have sound advice, and the business still fails, you’ll likely end up on more stable ground afterwards – with your personal assets, reputation, and relationships relatively intact.

Lawyers help businesses to manage risk in three main ways:

  • Advising on sound business practices
  • Advising on appropriate legal structures and relationships, and
  • Advising when insurance is wise

Each of these risk management techniques ties in with the others. I’ll talk about each in turn.

Sound Business Practices

The most common, cheapest, and often most effective is to cover your own ass by doing business the right way. Most of these don’t need a lawyer to dream up or implement.

The most common business disputes are about differences between what was promised and what was delivered, billing and payment disputes, employer-employee relationships, and on-premises injuries. Businesses frequently deal with Consumer Protection Act, employee safety, and harassment and Human Rights Code complaints. Complying with government regulation – such as licensing, zoning, Building Code, Fire Code, access for disabled persons, anti-spam, import/export rules, and tax are also sources of friction and risk. It can be a lot to deal with, but there are a few habits that’ll make life easier for you:

  • Do your reading. There is a ton of information out there from government websites, regulatory bodies, accountant and lawyer’s blogs, insurance companies, incubators, entrepreneur groups, and industry publications. Read it all. A responsible business owner knows what laws and regulations govern their industry, and what they need to do to colour between the lines.
  • Put it in writing. If there’s a dispute, what actually happened doesn’t matter – only what can be proved. Written records are more convincing than memory. If you do business over the phone or face to face, keep notes and send a follow up email summarizing what was said and agreed upon. Put employee job descriptions in writing.
  • Keep everything. Having things in writing is useless if you delete it too soon. The limitation period (meaning, the amount of time someone has to bring a lawsuit) in Ontario is two years after the problem is discovered. Do the math, and figure out how long to keep the records after dealing with someone. An IT nerd can burn years and years of data to DVD for you if storage space is an issue.
  • Don’t over-promise. Sometimes the pressure to make a sale can be immense, especially in the cash-poor early days of a business. It’s hard enough to keep people happy even when you do what you say. If you over-promise and under-deliver, or take on work you’re not equipped to do, it’ll come back to bite you in the end. The rear end…
  • Have policies in place. Especially if you have people working for you. There are tons of free resources from the Ministry of Labour, and HR professionals that can get you started. It’s wise to bounce these off your lawyer to make sure they’re current.

As your company grows, your lawyer and other advisors can help to flesh out the practices and policies in a way that suits your business.

Legal Structures

Here’s where I come in. While business practices are a good start, there’s no substitute for on-point legal advice to help minimize business risk. Legal advice costs money, and if you’re in the habit of seeking it before acting, you may wonder what the actual value added to your business is. Legal advice is a bit like bear repellent – the only way you know it’s working is that there are fewer bears around… but if a bear shows up on your doorstep with a lawsuit, the value becomes much more clear. Maybe I went too far with this analogy… I digress…

Sadly, much of what I do is work to clean up my clients’ self-inflicted messes. They try to save money on legal fees by trying to be their own lawyer. Sometimes the damage is irreparable. I’ve watched businesses go down in flames because of vague, improperly drafted contracts. I’ve seen clients held hostage by independent contractors because they didn’t put anything in writing before work started. I’ve seen people’s businesses stolen out from under them because they didn’t think independent legal advice was worthwhile. Even when the business is salvageable, they often end up spending two or three times as much to fix the problem than they would have on legal advice in the first place.

The business lawyer’s role usually falls in one of three categories:

  • Internal relationships. Clearly setting out the roles, responsibilities, and expectations between the founders of the business is essential. Sooner is better – ideally before the business starts to make (or lose) money. No matter what the form of business is, and no matter how good the intentions are at the start, as soon as money is involved, people’s recollection of the deal and expectations can change in a hurry. A house divided against itself cannot stand.
  • The back end of the business. Not only should your business structure make sense from a tax perspective, it should protect the founders, and facilitate long-term growth as much as possible. There are several forms of business available, each with their benefits and obligations. Choosing the right one, and keeping it in good standing with the government and other regulators is critical. Lawyers know what records need to be kept, and what approvals must be secured before taking certain actions. Investors and potential buyers will want to see that the proper decision-making processes were followed in running the company.
  • External relationships. Customers, suppliers, employees, investors, creditors, partners, joint-venturers, government, regulators, landlords, tenants, neighbours, industry associations, and advisors will all be looking out primarily for their own interests, as you should be for yours. Contracts are useful to set out what’s expected of each party, which I covered in detail in an earlier blog. Call your lawyer before trying to enter, break, or change a contract. You may also need help understanding what regulations apply to your business, and help you to colour between those lines.

Insurance

I’m no expert in insurance – my knowledge is limited to knowing when to recommend when it might be appropriate, and how it fits into your overall risk-management plan. I typically recommend insurance options to cover the gaps between your business practices and legal structures, and the risks you can’t hedge against that way.  A few of the common types are:

  • Commercial general liability. This coverage can cover slip & fall and other bodily injury, defamation, emotional pain and suffering, false advertising, medical expenses, and tenant/occupant liability.
  • Disability & key person. As discussed in my articles on contingency planning, these policies can help keep the business afloat if the owner/operator or a key employee is killed or injured and unable to work.
  • Directors & officers. A company can agree to protect its directors and officers in the event that they’re sued for things they did in the course of their duties.
  • Business interruption. Protecting against loss of income in the event of fire, flood, equipment breakdown, and other events beyond the business owner’s control.

Written opinions of lawyers, accountants, and other professionals which recommend a specific course of action as being legal or viable can also be a form of insurance. Your business should be able to rely on those opinions to make its decisions. If an opinion is wrong, and the business suffers losses as a consequence, it’s up to the professional (or their insurer) to make it right.

Bear in mind that insurance is a contract as well – so read it. Know what you want to be covered for, and make sure it’s included in the policy. Have an idea of what amounts of coverage you need for each type of insurance. Ensure it covers liability occurring in the places where your products or services will be delivered. Do some research into the reputation and claim denial rate of the insurance company you’re thinking of dealing with. Call your insurance agent when starting a new aspect of your business. Insurance is supposed to provide peace of mind – which ain’t much use if you don’t actually know what you’re covered for.

You probably already know that there’s a lot more to entrepreneurship than meets the eye, if you’re doing it well. Getting legal advice can be a delicate balancing act as far as cost vs. benefit – especially when cash is tight in the early stages. Sometimes you need more work than you think, other times you need less. Each business’ needs will be different, and the only way to know for sure is to ask questions. Know what you don’t know, and get an expert when you need one. I happen to know a guy…. 😉

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw

Legal Aspects of Business Succession Planning

At long last, I’m celebrating the new year by finishing off this series of succession planning articles. I’ve already talked about the big picture, and how to make sure your business can continue to run if something happens to you. Now it’s time to talk about how you can retire. This isn’t something that should be done in a hurry – it’s wise to give yourself a few months to make the plan and expect it to take years to live out the plan.

There are four main ways that business owners hand over control and operation of small businesses to a successor:

  • Passing the business to a family member,
  • Selling the business to management or employees over time,
  • Selling the business in one fell swoop, or
  • Passing the business in your will (if you want to stick it out ‘til the bitter end…)

Despite the different terms I’m using, all of above except the last are selling the business as far as the tax man sees it. Each of these routes allows you to cash out – or extract the value you’ve built up in the business. Even though the end result of each is similar, the legal path you’ll need to walk to get there is different in each case, with some common elements between them. I’ll talk about each option below. What will work for you depends on what you want, the tax costs, and what is realistic for your business, successor, family, and employees.

Before I dig into the guts of succession, I’ll touch on a few issues that will pop up no matter which way you opt to go – both of them have to do with the almighty dollar.

Valuation

No matter what route you choose, valuing the business will be a pain in the behind. Valuing a business for sale, transfer, or estate purposes can be tricky. As you likely know already, “tricky” is usually lawyer-speak for “expensive,” so brace yourself.

There’s no single formula to value a business. The bigger and more diverse the company, the trickier it is to value. “Tangible assets” – like machinery, inventory, and accounts receivable – are pretty easy to put a price on, while “Intangible assets,” – like client lists, intellectual property, social media influence, or a recognized brand – are more difficult. Equally tough is when you, the owner, are a big part of the business’ worth.

Businesses can be valued by a number of different ways, but the two most common are:

  • Agreement between the buyer and seller
  • Valuation by an accountant, auditor, or certified business valuator

Agreement on price is the cheapest, but the price that you agree to with the buyer might not be the amount that tax is assessed on. You report the sale price, but the CRA will deem the sale to have been made at fair market value. Funnily enough, the CRA rarely finds that the sale happened at a lower value than what was reported. You may end up on the hook for more taxes than you calculated, which cuts into your retirement nest egg.

The CRA and tax courts tend to stick to valuations made by certified business valuators (very expensive), and sometimes accountants (moderately expensive) for tax purposes. Hiring one of those dudes to value your business could cost more than you’re willing to spend… but sometimes the up-front cost of paying a valuator is lower than the potential long-term cost of an extra tax bill. It’s worthwhile to at least have the conversation with your accountant.

Tax Efficiency

Speaking of the CRA, most transfers or sales of businesses can be made cheaper by getting sound accounting advice on how to minimize the tax on the transfer. The more the business is worth, the more likely it is that the transfer will be tax-driven. “Tax-driven” means that your accountant is telling your lawyer how to arrange the purchase and sale so that you (and possibly the buyer) pay the minimum tax possible.

A note of caution on accountants – not all of them know tax. Many small business accountants are good at preparing annual income tax returns, and helping to manage cash flow, but aren’t experts on the tax implications of selling a business. Even if you’ve been with your accountant for years, don’t be afraid to shop around. Moral of the story? Get accounting advice early in the succession planning process.

With that out of the way, here’s the rub:

Four Ways to Transfer Your Business to a Successor

Passing to Family

Selling or passing all or part of the business on to a family member can be a sale, gift, or some combination of the two. There are a number of ways to work this, but what’s best for most small businesses is a gradual transfer of operational control and profit share.

On the operations side, a gradual transfer of responsibility gives your successor a chance to get up to speed on how the business works, build relationships with key customers, advisors, and suppliers, and allows you to pass on the lessons and values you’ve picked up along the way.

As far as profit sharing, if the business’ cash flow can stand it, you may want to continue to draw some sort of income from the company. If not, an incremental buy-out by the next generation or the business itself – usually 5-10% of the value of the business per year – might give you 10-20 years of “income” out of the value you built in the business. That incremental buy-out is usually good for the successor as well, as they don’t have to come up with all the money to buy the company right away. It could also be done as an incremental buy-in, where some of the successor’s pay is in shares, which dilutes your ownership of the company over time.

So long as you own shares in the company, you should consider life insurance. The more your stake is worth, the more this makes sense. Insurance policies pay out directly to the beneficiary – your successor or the company itself – to buy back the shares, and keep those shares out of your estate.

The typical legal documents involved in a family succession include:

  • Unanimous Shareholders’ Agreement – which can set out the terms of any buy-out or buy-in, valuation, insurance, and your continued role in the company, if any. Each shareholder signing it should have independent legal advice.
  • Share Freeze – is a fairly complex transaction where the value of the company “freezes” at a certain date, and you’re issued shares that reflect that frozen value. The successor gets new shares which will capture any further growth in value. The company then buys back the freeze shares over time and cancels them. Your freeze shares could have dividend and voting rights that allow you to continue to share in the profits and management of the company.
  • Trusts – where your shares are managed by someone else on behalf of your successor. These are useful when one or more of your successors doesn’t yet have the age or experience to run the company completely. Trusts are also useful if you’re separating ownership and operations of the business between two or more people.
  • Will – if you pass away before the transfer is complete, you can set out how your shares are to be dealt with. Ensure that the terms of your will match with the terms of any shareholders’ agreement, trust documents, and so forth.
  • Powers of Attorney – if you’re incapacitated before the transfer is complete, who will oversee the management of the company, and manage your shares? Any requirements or restrictions on how the attorney is to act should be set out. This must jive with all the other documents.

On the tax side of things, transfers of property to family members are not at “arm’s length”, and are taxed differently than sales to non-family members.

Selling to Management or Employees

Long-term managers and employees can often feel like family, and a transfer to them can be done much in the same way as to a family member. It can also be done in concert with transfer to a family member – perhaps 51% control of the business will stay in the family, while 49% will go to the employees who will continue to run it. If the employees or managers have the funds available to buy right away, it can be a one-and-done sale, or a phased buy-out or buy-in. These transfers are typically done over 3-5 years, and are “arms-length”, meaning that different tax rules apply than to transfers to family.

Assuming that you’re being bought out, rather than simply giving the shares to the employees, this process will be more formal and legalistic. You should insist that the buyer get independent legal and tax advice so they can’t come back later and say that they didn’t get what they bargained for.

Before writing anything up, you should hash out with the buyer the broad strokes of how the transfer will be structured, and how the buyer will finance the purchase. It can be any combination of:

  • Employee stock option plans – where employees are paid shares as part of their pay, and your ownership and control of the company is diluted over time.
  • Purchase and sale agreement – a contract between the buyer and the seller that sets out all of the key terms of sale. It can include employee stock options, or it can be a straight up purchase of the assets or shares of the company.
  • Shareholders’ agreement – as above.
  • Service agreement – especially if it’s a one-and-done purchase, the buyer may want your services and advice as an employee or independent contractor. They may want you to continue to sit on the board, or to serve as an officer of the company.
  • Indemnity and releases – where the company agrees to protect you for the consequences of legitimate actions you took while a shareholder, officer, or director of the company, and release you from any liability for actions taken after you transferred ownership or control. These are often included in the purchase and sale agreement.

The buyer should conduct due diligence before buying, particularly if you’ve been the one to handle the back-end workings of the business such as dealing with lawyers and accountants. It’s important that the buyer knows what they’re buying, the financial history and projections of the company, and that the books and records are in good order.

Lastly, you’ll want to make sure that your will, trust documents, powers of attorney, and domestic contracts jive with the deal you’ve made.

Selling to Third Parties

If you can’t find anyone in your family or business who’s willing or able to take over from you, it may be time to prepare your business for sale. I won’t go in to too much detail, as I’ll cover sale of business in a separate article, but it will require some legal work to prepare for due diligence.

Due diligence is when the buyer digs through the corporate records to make sure that they know what they’re buying. You should be proactive to make sure that the minute book, employee agreements, accounting records, lists of assets and liabilities, leases, real estate ownership and mortgages, intellectual property, debts, shareholder relations, taxes, and licenses are in good order.

Passing the Business in your Will

Many business owners approach is “I’ll just pass everything in my will.” This is a mixed-bag approach that chooses to duck the costs of preparing and implementing a succession plan, while sacrificing certainty and control.

The upside to this approach is that there’s minimal headache and expense for you in the here and now. It can work very well when your successor is clear – perhaps an only child who’s been working in the company for years, and knows what you know.

The downside is that you may handicap the next generation’s ability to run the company. If the business is asset-rich, but cash-poor, the tax bill on the estate might cripple the company. You will have no control over what happens after you’re gone. Your beneficiary will be stuck with making the tough decisions you’ve abdicated from. It also risks infighting between beneficiaries, or with the company controlled by people who don’t know or care about the business.

I’m not saying leaving the company in your will is a bad decision – just know what risks and benefits you’ll be passing on to your successor before you make the choice.

Phew, that was a long one… I promise I’ll write something more entertaining soon…

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw

Legal Aspects of Business Continuation Planning

This article is the second in my series on what’s involved in planning for the worst. In the last one I gave an overview on who and what is involved in the process. This time I’ll lay out some of the legal work that may need to be done in order to put your plan into effect. The goal here is for your business to continue relatively smoothly if you die or are incapacitated. The most obvious benefit is that you or your beneficiaries will have a chance to receive the value of the business – which could be lost if you’re not there to run the business.

There are a bunch of great resources out there, largely from insurance companies and banks, about business continuation planning. Though it may seem like a lot to wrap your head around, the legal side is fairly simple. The first step is to identify what the essential parts of your business are. What’s the bare minimum that must be done in order to keep the doors open? Who’s capable of doing those things? What’s to become of your control of the business, and your share of the profits? Once you’ve figured that out, your business advisers can help you to get the paperwork done. That paperwork typically includes:

Continuation Plan

While not necessarily a legal document itself, it becomes enforceable when the directors or officers of the corporation resolve to adopt it. The continuation plan should include who is to assume what responsibilities, who is to oversee the transition, what is to happen with loans that are personally guaranteed, key contacts at customers, suppliers, service providers, advisers, and creditors, insurance policy information, where business records are kept, and any other information that someone taking over your role will need to know about the business.

The continuation plan should be kept in the company’s minute book.

Shareholders’ Agreement

A shareholders’ agreement is a contract between the owners of a company as to how they’ll run the corporation. It can also force those who become shareholders in the future – perhaps resulting from your death or incapacity – to do certain things in running the business. I’ve talked about why you should have one for your business in an earlier article. I’ll write another one soon about what should go in to one… but the continuation plan for the death or incapacity of key people should be part of the shareholders’ agreement. If you have one in place already, work with your lawyer to make sure it jives with the continuation plan. If you don’t have one in place, it’s a good idea to make one.

Insurance

Though it’s not a purely legal issue, insurance is an enabler for most continuation plans. It’s common for the company or your co-owners to take out insurance on you, and the other main players in the business. There are a number of different types of insurance, each with strengths and limitations. The goal is to ensure that there’s cash available to tide the business over and find someone to fill in for the person that’s been lost. Each business will be different, and a good insurance agent can give you the full slate of options, and help you to choose one that works for your company.

It’s important that your insurance agent and lawyer get in touch to discuss the policy you’ve selected so that the legal documents mesh with the policy. Your lawyer can also help you to understand what’s covered, and what’s not under the policy. Once you understand where the gaps are, you can come up with ways to minimize the risks that remain.

Corporate Documents

Picking someone to step into your shoes is one thing. Giving them the lawful authority to make decisions in your place can be another one altogether. You should consider appointing the chosen one as an officer of the corporation, and giving them conditional authority to speak and sign to bind the company in legal documents. They should know where the corporate records are kept, and be put in touch with key advisers including the corporation’s lawyer, accountant, and insurance agent.

When the continuation plan is made, you should ensure that your business books and records are up to date and complete, including the minute book, government filings, and accounting records. Your successor will have enough to deal with already, without having to deal with figuring out what state the company is in first. The corporate minute book should also include a resolution approving the contingency plan, which will prove useful in dealing with outside institutions – banks in particular.

Wills & Domestic Contracts

Not only should you have a will in place that deals with your interest in the company, but it should be in harmony with the continuation plan. If the corporation has decided that your control of the business should pass to one person, but your will passes all of your property to your spouse, there’s a huge potential for conflict. Many people use separate wills for their personal and business assets. Domestic contracts – while painful to negotiate – can be used to protect control of the corporation as something that’s not included in the marital assets in the event of separation or divorce.

Powers of Attorney

A Power of Attorney for property is a legal document that authorizes someone to act for you in making decisions in the event that you’re incapacitated. Banks and other creditors will want to see this, possibly along with the resolutions authorizing the contingency plan and granting signing authority before they’ll deal with someone they don’t know. These are usually made or updated at the same time as your will.

Employment Contracts

Many owner-operators work without a written contract of employment in place with their company. It’s generally understood that as an owner-operator, your responsibilities and risks are almost indefinite. It is a good idea to put an employment contract in place with yourself – a description of duties, salary, and benefits at a minimum. This will help to set expectations for what’s expected of and given to your replacement.

A current employee who steps up into your role will be taking on a great deal more responsibility, and assuming more personal risk in the form of director or officer liability than they had before. This type of change to the employer-employee relationship is something that should be down on paper to protect both of you. Salary, responsibilities, and expectations may all change in the new contract. It’s also good practice to give some form of protection, called indemnity, to those who run the company.

If there’s nobody in your company who could step up to run it, a manager may need to be hired from the outside. If you want to have any say over their role, and any limits on their authority, you’ll have to set those out in advance. Again, the starting point could be your employment contract.

Again, insurance can be used to cover some or all of the expense of hiring, training, and paying a new employee.

Practicalities

Training your possible successor is the most important piece of the puzzle. They may show the potential to run the business by having the right skill set, but will probably need time to be brought up to speed on how the business works. It’s never too early to start. The up-sides of having someone who’s capable of running the business are many – you may even be able to take a holiday for once!

It’s also important to be mindful of avoiding trying to run the business from beyond the grave. A properly trained and equipped successor will still have their own ideas, and should have the flexibility to see them to fruition.

Conclusion

When a thorough continuation plan is made, it’s a major step towards peace of mind for you and your dependents. If you’re laid up with an injury or illness and the business founders without you, you may not be able to pay for your own care. If you pass away, and the business you’ve worked so hard to build follows closely behind, your dependents may be left high and dry. If the business goes under, your employees and others who rely on it for their livelihood, could be in dire straits. While it’s an uncomfortable thing to talk about and plan for, it’s the responsible thing to do.

I’m happy to help you start the process, and I’ve got a good team of specialists who can guide you through the finer points of tax, employees, insurance, and financial planning should you want the help. The next article, on how to plan for your retirement, will be on its way soon!

Now, to counter all those gloomy thoughts I’ve put in your head, here are some very cute animals trying to look tough.

See you soon…

 

 

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw

Contingency Planning for Small Business

Owning your own business is kind of like giving birth to a needy child. It will fill your days with all manner of excitement, some good, some bad. There also comes a time when you need to start considering what happens to the child if and when you’re not around to take care of it anymore. What happens if you get sick? What if you kick the bucket? What if personal or family problems prevent you from running the business day to day? How the hell are you ever going to retire? None of those things, save perhaps retirement, are pleasant brunch conversation, but they must be had. They’re the first step in making contingency plans. Without such plans, the well-being of your family, employees, and company may be left in limbo – legally, financially, and business-wise. Contingency plans are certainly not decisions that should be made hastily, nor should they be made alone.

This is the first in a series of three articles I’ll be writing on the topic of contingency planning for your small business. This first one will be a general overview of who and what steps are involved in the process. The next two will touch on:

  1. Business continuation planning – if you become sick or incapacitated unexpectedly, and
  2. Business succession planning – how to retire and get the value you grew in the business out of the business.

Goals

Each business owner will have a different view of what they want out of “retired” life, but there are a few overarching goals that should be built into any succession plan:

  1. to make a smooth transition to a successor;
  2. to see the business in good hands going forward; and
  3. to have financial security in retirement or during illness or incapacity.

Timeline

When I say not to make the decision hastily, I mean it. There are a bunch of hard decisions that you’ll need to make. Your decisions will affect the people you care about the most – friends, family, employees, collaborators, customers/clients, suppliers, and so on.

For business continuation planning, give yourself a couple of months to put the plan together. This will give you time to have those tough discussions, get meaningful feedback and advice, gather the appropriate information, and get all the paperwork done. You want to ensure that the plan you’ve made is feasible, and will work even if the worst case scenario happens. You may also have to start training your staff to do what you do, which can take considerable time as well.

For business succession, allow several months to make the plan, and at least 3-5 years to ease the plan into effect. All of the same steps for business continuation planning apply here, but with a different end-game. So, if you’re a baby boomer who’s looking to make a slow, graceful exit from the business, the time to start planning is now…

Who’s involved?

It’s one thing to decide who you want to carry the flag for you, and another thing altogether for them to want to pick it up and run with it. There are two rounds of consultation to do – one with those affected by the plan, the other with the advisers that will help you piece it together.

In the first round of talks, you’re trying to figure out who’s willing and able to take over the business. At the end of the day, it’s up to you and your co-owners to choose, but I pity the fool who tries to pass their affairs on to someone who doesn’t care to take over, or doesn’t have the ability to run the business effectively. The folks you should talk to include:

  • Family members – particularly your spouse, children, and others who could be beneficiaries in your will
  • Business partners/co-owners/other shareholders
  • Friends with an interest in the business
  • Managers and senior employees
  • Major creditors

After those talks, you should have a pretty good idea of who’s willing to take over, what knowledge gaps need to be filled to get them ready to do your job should you not be able to. Then it’s up to you and your co-owners to choose who will take over, and when.

Once you’ve got a plan, it’s time to figure out how to put it into action. This is where your advisers earn their keep. You should talk to your:

  • Tax planning accountant**
  • Lawyer
  • Insurance agent
  • Banker, and
  • Major creditors

I put two of these bad boys – ** – next to the tax planning accountant for a reason. Many small businesses have an accountant who does their books and prepares tax returns each year. This accountant may be great, but they’re not necessarily a tax planning expert. A CA who focuses on tax planning can help you to get your money out of the business with minimal taxes. Your accountant will take the lead in planning how it’s to be done, your lawyer will do the grunt work to set up all of the structures, and your insurance agent will help you figure out how it’ll all get paid for.

The People Factor

As you well know by now, a successful business is only as good as the people who run it. If your business is doing well enough to prompt you to make contingency plans, then it’s also doing well enough for you to start grooming your employees to take more responsibility in it. When the employees are running a bigger piece of the company, you’re able to phase out gradually. This means training them to do what you do, allowing them to make mistakes and correct them, and developing their leadership skills. This learning curve may take years, so start doing it right away.

There’s a saying in the army that “no plan survives first contact with the enemy”, meaning that every plan looks great on paper, but things rarely ever go according to plan. It’s wise to build contingencies into your contingencies. Pick more than one worthy successor, or have more than one option. That way if your #1 choice jumps at a different opportunity, falls ill, or turns out not to have the leadership skills needed to take the business forward, you’re not up a fecal watercourse with no means of mechanical locomotion.

Conclusion

This was a very brief overview of the contingency planning process. In the next article, which you can find here, I’ll dive a little deeper into business continuation planning, and some of the legal stuff that’s involved in it.

If you’re looking for a more in-depth discussion of contingency planning, the Canadian Federation of Independent Business has an excellent guide up for free. The Government of Canada has published a quick online guide, and most banks and insurance companies have similar publications.

See you again soon!

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw

Record Label Contracts

Few artists would want to be considered to be “in business” for doing what they do, but like it or not, as soon as you get paid for it, you’re a sole proprietor. For artist-entrepreneurs, the art lies in the creative process – those endless hours working your fingers to the bone, trying to get that sound out of your head, and into others’ ears. Everything else is business. For a record label, owning the rights to do what you need to make your business viable is the key… and ambiguous contracts will come back to bite you in the long run. In this post, I’m going to talk about one of the first high-stakes legal issues a label and recording artist will face – the record label contract.

Contracts, generally:

A contract is a binding agreement where two parties exchange something of value, called “consideration”. The artist gives up certain rights to their creations, while the label helps you get it to market, and hopefully you both make money. Contracts are rarely an issue when everything goes according to plan… but if things go sour, you can bet your bottom dollar (or, pay it to a litigation lawyer…) that the label will use the contract to get as much for itself as it can. So, it is soooooo frickin’ important to understand what you’re signing, and agree to all of it before you sign it.

Contracts are a two-way street – a business relationship that relies on trust, and common interests to succeed. Therefore, there’s almost always room to negotiate – to remove things that you don’t like, and add in things that you want. You may be really good with keys and chords, but not so slick with the legalese – so it’s a smart idea to get a lawyer to help you interpret and negotiate the contract. The best time to look for a lawyer is at the start of your career, before you go too far down the road on the business side of the game. A little money spent at the outset can save you a ton of heartache, expense, and lost income down the road.

More on contracts in this other blog post…

Record label contracts

Every record label contract is different. Major labels may use a 50-100 page document, while indie labels might be as short as 5 pages. The gist of them is the same – the artist sells rights to exploit their songs for profit to the label, in exchange for a cut of the profits. In return, the label puts its money and influence into recording and promoting the album. Record label contracts typically include:

  • Term & territory
  • Rights & exclusivity
  • Money – royalties & recoupment
  • Cross-collateralization
  • Creative control
  • Rights
  • Release commitment

I’ll explain each of these in turn.

Term

The duration of the contract. It’s usually a fixed term (perhaps one year), during which time the artist must produce a certain number of tracks or albums to a reasonable standard.

Multi-album, multi-year deals are usually not set in stone. Typically the contract will cover the first year and first album, and give the label the option to extend it for successive terms. If the first album does well, the label will likely use its option to extend for another. If it tanks, the label probably won’t extend, and may drop you. Most labels won’t make a firm commitment to release anything beyond the first album.

It’s a good idea to set a “long stop” – or a maximum number of years the contract can run for. This gives a successful artist (as labels will likely only keep successful acts) a chance to negotiate a better deal down the road. Six or seven years is advisable.

Even after the term of the contract ends, the record company must continue to pay royalties for the artist’s work it sells.

Territory

This is the geographic area that the label has the right to exploit the work for profit. Most deals these days are “worldwide” or “universal” thanks to the internet. Smaller labels may buy only North American rights, or for certain countries.

Just because the label has rights worldwide doesn’t mean it has to release the work worldwide. Think practically about the reach of the label, and whether or not it can actually push the work in the whole territory. If not, it may be worth carving some areas out of the territory in favour of a local label or distributor, or having the label give up its rights where, after a period of time, it doesn’t release the work.

Rights & Exclusivity

Rights are what the artist sells – or rents – to the label. These may include:

  • Assignment of copyright
  • Ownership of masters and unreleased tracks/versions
  • Use of name and likeness; merchandise
  • Mechanical rights – who owns the underlying work?
  • Profits from off-stage sales

An exclusive right to the work means the label may exploit any recorded performances during the term of the contract – albums, concert videos, live recordings, etc. The artist (or any member of the group) may not record any material for another record company.

Some acts may sign under a specific stage name, which could leave them free to contract with other labels under a different pseudonym.

If the artist wants to do outside projects, such as making guest appearances with another act, a “sideman” provision should be negotiated.

Show me the money!

For the artist, the financial terms of the contract are some of the most important. They can get pretty complicated, so this is where your lawyer and accountant earn their keep. 80% of acts never sell enough albums to see a cent of artist royalty payments, so understanding the math how much will need to be sold for the artist to earn a profit is ever so important.

At its simplest, the math is:

(Artist Royalties) – (Recoupment) + (Mechanical Royalties)

Royalties

Royalties are the act’s cut of the profits. There are two types:

  • Artist Royalties – money paid to the act for its recorded performances – usually defined as a percentage of the sales price (typically between 9-18% of retail)
  • Mechanical Royalties – paid to the publishers/songwriters for the underlying composition

Royalties for music videos, secondary uses (like commercials or movies), and live performances are sometimes included as well. If you want to be certain who owns them, put it in writing.

Artist Royalties

The money paid to the artist when albums are sold, usually a percentage of the wholesale or retail price. 9-18% of revenue sounds alright… but that’s a gross percentage, not net. The label will deduct every expense that it can – recording costs, reserves against returned albums, free goods, packaging costs, and often pay only reduced royalties for foreign, discounted, and TV sales. The artist is usually expected to pay the producer royalty as well, which is usually around 3% – but shouldn’t be on the hook for income advances paid to the producer.

After all of those deductions, the artist has to pay back the label’s costs out of the artist royalties, known as “recoupment”. Once the label recoups all of its costs, the artist gets paid the excess. I’ll talk recoupment in a bit… but long story short, 80% of acts never see a penny of artist royalties.

Mechanical Royalties

The record label has to pay the songwriter for the use of their songs. Mechanical royalties are not recouped, and shouldn’t be cross-collateralized either (below). That means the songwriter gets paid on every song or album sold. For most singer-songwriters, this is the only payment they’ll ever see. Outside writers get paid first.

Mechanical royalty clauses usually limit the number of songs mechanical royalties are paid on, and the per-song amount the label will pay.

Recoupment

Record labels often spend a bunch of money to get an album to market, which the artist pays back through its artist royalties. Once all of the costs are paid, the artist royalties start being paid to the artist. These costs include:

  • Advances – money paid by the label to the artist up-front to cover cost of living, management commissions, legal fees, etc.;
  • Recording costs, which are either a budget or a fund to cover studio time, production, mixdown/mastering, etc.:
    • Budget – a guaranteed minimum amount. If it’s not spent, the label keeps the money; or
    • Fund – an amount is set aside for recording, and anything left over is paid to the artist when the album’s done;
  • Tour support – money spent by the label to promote the tour;
  • Video production costs – are typically paid 50% by the label, and 50% recoupable from artist royalties

These costs are “non-returnable” – which means that if the album doesn’t earn enough artist royalties to pay for the costs expended, the label takes a loss. The label’s other costs – manufacturing, advertising, promotion – should be wholly paid by the label. That’s why it gets its 82-91% cut of every album.

Some labels reach outside of industry norms to find creative ways to get the artist to reduce the label’s risk on an album, including:

  • A clause in the contract that makes the money “returnable” – meaning that the artist must reimburse the label for the entire cost, and
  • Recoupment from other sources – such as mechanical royalties or through cross-collateralization (below).

Both of these are exploitative, and certainly not standard industry practice.

Now, musical interlude:

Cross-Collateralization

Cross-collateralization allows the label to use royalties from one contract (such as publishing, production, other mechanical licenses, or a separate album-by-album deal) to recoup its costs from another.

Creative Control

How much can the label tell the artist what to do? Usually singer-songwriters have more creative control, while groups assembled by a label will get less. Creative control could mean the right of approval, the right of consultation, etc. Creative control rights include:

  • Videos – song choice, concept, budget, editing
  • Producers and remixers – who, costs, royalties
  • Song selection – what gets recorded, and what goes on the album
  • Use of the act’s name and likeness
  • Marketing & merchandise
  • Artwork
  • Secondary exploitation – commercials, movies, etc

Unless it’s stated otherwise in the contract, once the contract ends, so to does the artist’s creative control over the rights they’ve given up.

Release Commitment

What’s the use of putting together an album that nobody will ever hear? It’s often worthwhile for the act to get a firm commitment from the label to make a meaningful release of the album in the territory of the contract, including a minimum budget. If not, the artist may buy back the masters.

Conclusion

So, those are the nuts and bolts of record label contracts. Often there’s a lot more to them, and there’s a ton of little things that can come back to bite you – whether you’re a label or an artist. As with any contract, it’s a smart idea to get a lawyer to help you write or review it, and most importantly to understand what it is that you’re signing. I happen to know a guy… 😉

Rock on.

 

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw