Pitfalls of Incorporating and Organizing without Proper Legal Counsel

By Mark D. Hazlett

Many clients incorporate without legal counsel, which I have no problem with.  However, this approach can sometimes lead to issues that require significant effort to resolve, often more than if clients had sought legal guidance from the start.

A. The company’s paperwork is incomplete.  Once the necessary filings are completed with the state/province/federal government, a company is officially established. However, to have a complete minute book, there are a number of resolutions, registers, receipts and other documentation that are required. This preparation constitutes a significant portion of the legal work involved in setting up a company, particularly crucial if the company intends to secure funding or loans. These documents are typically requested during standard due diligence by investors or lenders.

B.  Too many or few shares were issued.  If you incorporated a company with 1 or 10 shares, potentially too few shares were issued. It might be advisable to consider splitting the shares or issuing additional ones. Similarly, if millions of shares are being allocated, each valued at a small fraction, it can appear impractical. The general goal is to avoid fractional shareholding down the line and to enhance the attractiveness of equity offers to prospective employees (e.g., as 1,000 shares sound more attractive than 1 share, even if the same percentage ownership results).

C.  Too many or few share classes created, or the wrong share classes were created.  I always ask clients their reasons for a particular share structure, as both the client and the lawyer (and even the accountant) should understand the reasoning behind the company’s structure.

Given that incorporation only requires for there to be a single, common, share class, I encourage prospective clients to justify the need for additional classes. For self-incorporations, I often find that if another share class or classes exist, there is generally an inadequate specification of their associated rights and restrictions. This will later require an amendment to the articles of the corporation to either create these rights and restrictions or delete the preferred share class altogether in order to make the corporation function properly.

I generally advocate for a simple share structure, especially for early-stage corporations.  If more complex structures are required in the future, they can be created then. Speculating about a corporation’s future needs solely to avoid an eventual filing fee for articles of amendment is an inefficient use of time and resources for everyone involved. Consider creating only those share classes that you know you need now or will need soon.  

Before creating any share class, I suggest asking yourself the following questions:

1. What is the share class to be used for?  You need to understand the purpose of each share class. It is not necessary to create share classes just because you’ve been told to do so or because you have seen other companies with a similar structure. Each share class should have a reason for existing now (or soon).
2. When is the share class to be used?  When planning to use a share class in the future, ask yourself whether it is well-suited for the expected event or if adjustments could be made later to better align with that event. Consider whether the anticipated event is distant or remote. If the shares are unlikely to be used in the immediate future, or if their utilization is in doubt, think about postponing the creation of that class until necessary. An example of an instance when I would suggest to delay the creation of additional share class(es) is when considering preferred shares for unidentified future investors. These cases often warrant revisions, as without the investors input beforehand, you will not know the terms they might want on their shares

D. Registration as a foreign corporation. If your company conducts operations or makes sales outside of its home jurisdiction, it may be required to register as a foreign corporation under each of these jurisdictions.

A common scenario I encounter involves a federally incorporated company operating in any Canadian province or territory.  Despite listing the company’s head office in a particular province, the company must still register extra-provincially as a foreign corporation there and anywhere else it is conducting business.  

Each jurisdiction has different rules defining when your company has to register as a foreign corporation.  Having a major office is just one factor that is considered doing business within a jurisdiction; there are many other ways for a business to find itself subject to the laws of one or more foreign jurisdictions. If you are going to do any kind of business in a jurisdiction outside where your business is incorporated, it is important to ensure that you obtain legal advice as to what constitutes doing business in that jurisdiction and whether a registration needs to be made, amongst other considerations.

E. Nobody cares where you’ve incorporated, so long as you’ve done it properly. Many founders I speak with are concerned about where their business is going be incorporated and how this could impact fundraising opportunities, particularly in the United States.  In reality, this concern is largely unwarranted, and the time, effort, and costs associated with trying to address it prematurely could be better allocated elsewhere. Similarly, incorporating in a far-removed jurisdiction to try and ready yourself for anticipated future investment can significantly impact how your corporation needs to operate now. This may include steps such as needing to obtain visas for your primarily Canadian employees, the need to comply with different information disclosure requirements, and otherwise provide hurdles that distract you from the core objective of growing the business’s value. As I once heard: “if an investor passes because you’re a Canadian company, that’s not the real reason for them passing.”

For these reasons, it is generally advisable to incorporate where you are going to do business (e.g., if your headquarters is in Toronto, then an Ontario corporation likely makes the most sense). For instance, in my view, federal Canadian corporations offer almost no advantage over their provincial counterparts but entail additional annual filings, Canadian director quotas, and the possibility of having the beneficial ownership of your corporation to be a matter of public record.

Where an investor does in fact require your startup to be incorporated in the U.S., there is a simple process for doing this. We can assist you in this process, when it is needed, allowing you to focus on building the business now, without diverting your time to navigating the complexities between laws of different governing jurisdictions.  Sell investors on your business, and any technical issues can be worked out between your legal counsel and that of your investors as needed down the road.

The foregoing is by no means a comprehensive list of the considerations that should go into setting up your new corporation (or fixing your broken one). If you have any questions regarding setting up or running your business organization from the legal perspective, please do not hesitate to reach out to Mark Hazlett at mhazlett@sorbaralaw.com or (365) 509-2029 ext. 101.