As anybody involved with a start-up can attest, they are stressful. With constraints on resources and capital and pressures on time, there are many opportunities for disputes & disagreements to arise between the various stakeholders. Professional mediation, which has long been used in other areas such as family counseling and labour relations is becoming an increasingly more popular mechanism to be used for technology business related issues. I recently spoke with Michael Erdle, managing partner at Deeth Williams Wall and director at the Alternative Dispute Resolution (ADR) Institute of Ontario to learn more on the subject. Michael is a Chartered Arbitrator and Qualified Mediator who specializes in business and technology disputes. Again, standard disclaimers apply that this is purely meant as an informational discussion and not meant to imply specific legal advice.

Craig: Thank you for taking the time to speak today. For technology start-ups, what types of disputes would a mediator get involved with?

Mike: Disputes can be internal or external to the company. For example, founders of the company may disagree on the product strategy the company should pursue. Investors may get into a dispute with the company on whether a company should accept a buy-out offer or continue to let the company grow. The company may get into a disagreement with a supplier over project deliverables due to missed milestones or poor quality.

Craig: So in these situations, what typically happens and how is professional mediation coming in to play?

Mike: In any relationship, a small disagreement can easily escalate over time if the two parties stop communicating and lose trust in each other. Often when this happens each party turns to their respective lawyers and things escalate from there. Since start-ups are typically short of money, getting into a protracted legal dispute can be a company killer.

Craig: We’ve seen many times in business where a larger entity uses its financial position to try crush a smaller entity through its ability to hire better and more numerous lawyers, incur the costs as the legal process works its way through courts, etc. Why would the larger entity be interested in entering mediation?

Mike: If any party in a dispute is interested in winning at all costs, then there is not much that will compel them to mediate. But in most cases, cooler heads will prevail. At some point in the relationship between parties, both parties entered into an agreement because they felt it could provide benefit. If things have fallen off the rails, both parties should hopefully still see value in the original premise of the engagement and want to work to get things back on track. If things have gotten to the point where one side feels they must win at all costs (i.e. slighted investors feeling wronged and they want to cause the company to fold), if they are willing to spend time and money they can probably achieve this. However, in addition to the original promise of the investment being wiped out, this will have potentially larger implications in terms of reputation, future business relationships, etc.

Craig: What should companies be doing to better protect themselves?

Mike: In most disputes I get involved with, a small issue snowballs into a large issue. For example, one party is under the expectation to get something from the other party, this is not delivered to the expectation level of the first party, people do not communicate, and time goes by to the point where both parties lose trust, start to take positions, etc. Something as simple as having a board committee or steering committee structure in place to monitor important projects and ensure regular communication goes a long way to catching issues early and preventing them from escalating.

Craig: When would a professional mediator be brought in?

Mike: If a dispute has gotten to the point where the parties cannot find agreement themselves, a neutral third party facilitator or mediator can help find common ground. Building provisions for use of a mediator into contracts is a good practice as it allows either party to step back and suggest mediation as per the contract terms without feeling as if they have ‘backed-down’ by looking for a solution.

Craig: What happens during mediation?

Mike: Most mediation sessions are between a half day to a full day. Everything in the mediation is agreed to be confidential so cannot be used in any future legal proceedings. Each party prepares a brief on what they feel the issue is, what their position is, reasons for their position, and what they would like as an outcome. Both sides and the mediator start in the same room and review their briefs. This gives them the chance to express their positions face-to face. It also allows the mediator to develop a better understanding of the underlying issues and interests of each party. There are often big hidden elements beneath the surface. Generally the principles involved in the dispute do the talking and their respective lawyers take a back seat role just to provide legal advice for specific issues like interpretation of a contract.

After this initial period parties often split into separate rooms and the mediator starts to go back and forth between the parties. This allows for confidential discussions between the mediator and each party over possible options to resolve the issues. The main job for the mediator is to identify the issues where there is deadlock, get parties to look at the problem differently, come up with alternative suggestions on how to approach a problem, and find common ground on which a solution can be achieved.

Most mediations are resolved within the day with only more complex mediations or mediations where there are many parties involved requiring additional time. Sometimes, the parties need to line up other elements to make the proposed solution work. For example, if the settlement of a shareholder dispute is to have one party buy out the other, the buyer may need some time to arrange financing.

The outcome of the mediation is a course of action that both sides can accept and more importantly a re-building of the trust between the parties to provide a firm foundation for future interactions.

Craig: A related discipline is arbitration. Can you talk about this?

Mike: A mediator or facilitator works interactively with both parties to find a common solution. An arbitration hearing is more like a court case where both parties present evidence, and call witnesses. Based on the evidence, the arbitrator will then pick one side as the winner. Arbitration is used where the situation is more defined in nature (i.e. in the interpretation of a clause in a contract). In this, both parties have a position and just want an impartial entity to provide a decision. By going through an arbitrator, the issue can be settled far quicker and cost effectively than if it went through the courts.

Arbitration has been quite commonly used in a business context and many contracts have clauses in them calling for arbitration to be used when there is a disagreement. Mediation or facilitation is a newer discipline for use in business situations that gives parties a mechanism to work through more complicated differences in opinion. This is especially useful when it is important to re-build a broken relationship since both parties see the value in continuing the relationship forward.

Craig: Its been great talking with you today Mike, thank you for taking the time. In my next post I’ll be talking about how to engineer better exits.

craig at mapleleafangels.com

Continuing my discussion on start-up legal issues, I met with Rubsun Ho, partner and co-founder of Cognition LLP to discuss term sheets. Again, standard disclaimers apply in that topics covered today are meant as general information only and not meant to imply specific legal advice.

Craig: Rubsun, thanks for taking the time to talk with the readership today. I thought we would talk about term sheets today and walk through some of the common term sheet clauses (see here and here). I’ll provide the (angel) investor’s perspective and you can comment on how this would impact things from the start-up and entrepreneur’s perspective. To start off, let’s begin with the type of deal structure: Equity vs. Convertible debt. What are your thoughts on these two approaches?

Rubsun: From a company’s perspective, I would recommend they try for an equity deal. Although as you and I would both agree, the attractive part of a convertible debt deal is that it postpones the valuation discussion, entrepreneurs need to make sure they have a clear understanding of what they would be giving up with a convertible debt based deal. They should work through the calculations on the accrued interest and the percentage discount and see what the share capital structure would look like if the convertible debenture ran its full course. We have seen cases where this can add a significant amount of shares to the company and thus dilution to the founders. Entrepreneurs should also ensure they understand any covenants placed on the company through the debenture. We have seen term sheets that put in place conditions where the debt can be called (i.e. if the company is not cash flow positive by a certain date).

Craig: So if an equity deal is done, what about common vs. preferred shares?

Rubsun: Again, we’d recommend trying to stick to one share class as it makes it easier to govern. To give a judgement on a preferred share deal, a lot would depend on the additional requirements investors are putting on the preferred share class.

Craig: In today’s climate, investors are putting more emphasis on liquidation preference to give them the greatest chance of getting their money back. This can take the form of terms such as upon sale of the company the preferred shares are paid out first (1x or 2x) and then all remaining proceeds are split pro-rata across all shares. What are your thoughts on this?

Rubsun: Obviously this is what an investor would want. The entrepreneur would need to ensure they work out the implications of this. i.e. run though some scenarios of various acquisition prices and show how the proceeds would be distributed to each shareholder. Depending on the amount of preferred shares issued, having a 2x liquidation preference can dramatically raise the price target that a company would need to be acquired at in order to provide other share classes an adequate payout as well. Investors should also do these calculations as they will want to ensure management still has enough equity incentive to want to stick with the venture. A good way to align management and investors is to have a separate carve out where a percentage of proceeds of an acquisition is reserved for management or to have a clause that eliminates the liquidation preference if the acquisition price is above a certain amount.

Craig: After ensuring they can get a good ROI, maintaining governance and control over the company is next on an investor’s priority list. At the seed stage, often companies do not have a board constituted. Do you have any recommendations as to how to structure the board at the seed level to provide governance but still allow for expansion with future investment rounds?

Rubsun: I would advise companies to start with a board of 3 with at least one of the seats being an independent director and another to represent the investors. As the company secures new investors with new financing rounds, this structure makes it easier to expand the board to include representation from the new investors or to bring on other board members that can help the company at their stage of growth. If you start with a large board at the seed stage, it can be hard to ask people to leave the board down the road when new investors come in.

Craig: In addition to the board and the term sheet outlining actions that require board level approval (i.e. setting the compensation of the management team, approving the annual operating budget), investors sometimes put actions in that require shareholder approval (i.e. entering into debt arrangements or contractual commitments over a certain dollar amount). What are your thoughts on this?

Rubsun: Corporate law requires that some fundamental changes such as creating a new class of shares, changing the company name or selling substantially all of the company’s assets need to be approved by holders of two thirds of the shares and potentially by each class or series of shareholders independently. Apart from these items, it’s usually better to try to push other actions to the board as it may increase the administrative burden on the company to call shareholders’ meetings or track shareholders down to approve resolutions.

Craig: A common reasoning I see when talking with entrepreneurs on valuation & how much money they are looking to raise is for them to start off and say they want to retain 51% of the shares so they retain control and then work back from this to figure out a valuation and how many shares they are prepared to give up in relation to how much money they are looking for. Can you comment on why this is a bad approach?

Rubsun: For the reasons we discussed above, using separate share classes, certain rights and vetos in shareholders’ agreements and through having a controlling number of board seats, an investor can easily structure a term sheet to have ‘control’ of the company while owning less than 51% of the total shares. Entrepreneurs are better to first decide what important areas of the company they want to retain control over and then ensure the term sheet is aligned to this.

Craig: In terms of legal fees, usually the term sheet will state the company pays their legal cost and investor’s legal costs. Any advice on this?

Rubsun: I would ensure there is a cap negotiated on the amount of the investor’s fees that are paid. This will limit the exposure to the company and help ensure investors are motivated to work though the closing process without too much back and forth between lawyers while finalizing the documents. There should also be a clause in on what happens regarding the payment of legal fees if the investment does not close – the entrepreneur would normally want each party to be responsible for its own costs.

Craig: Often companies that are engaging angels for their first outside financing round already have some level of friends, family, founder investment that probably has not gone through a formal investment closing process. Any thoughts on how a company should be handing FFF rounds to make angel rounds go smoother?

Rubsun: The main thing would be to ensure the main legal documents that angels will be looking for (e.g. shareholders agreement, employment contracts, terms of any debt arrangements, option grants) are properly documented and can be shown to the investors as they start their due diligence process. This will give investors more comfort and not have to react to ‘surprises’ late in the due diligence process such as finding out some prior FFF investment was actually a debt arrangement compared to common share equity, or that it is unclear what equity or options have been promised to whom.

Craig: With the dearth of funding sources available, what advice would you have to companies when they are presented with a term sheet that has clauses in they do not like. Are they stuck in a ‘take it or leave it’ situation?

Rubsun: The best thing a company can do is ensure they are in the strongest position possible by being a solid investment opportunity and to be in a position where they have multiple options for funding (i.e. other investors, bootstrapping, etc). Regardless, the company should approach an investment negotiation just as with any negotiation. If there are terms they are not comfortable with, they should go back to negotiate and understand the root concerns of the investor that are behind the terms. Often the investor’s concerns can be addressed using another mechanism that is more palatable to the company.

Craig: Any other closing thoughts?

Rubsun: Having a ‘drop dead’ date for the investment to close would be a good idea. This gives both sides the incentive to wrap up the investment so it does not become a distraction to management in growing and operating their business, and it doesn’t allow the investors to delay in committing to the company while they wait to see how the operating results are progressing.

Craig: Well, great talking with you today Rubsun, thanks for you and Joe taking the time to speak to the readership on these topics.

craig at mapleleafangels.com

I thought I would write a couple of posts on legal issues start-ups should be aware of early in their lifecycle. In particular I wanted to cover some issues, that if not handled correctly, can have a detrimental impact at a later stage in the company’s life such as when they are looking for outside financing.

I recently met with Joe Milstone, partner and co-founder of Cognition LLP. Cognition is quite active in the start-up space in Toronto. They work with start-ups by offering a dedicated lawyer to act in the role of in-house counsel on a fractional, as-needed basis, and at a cost that is about a half to a third of a more traditional business law firm.

Craig: Joe, thanks for taking the time to talk with the StartupNorth readership today. Before we start, I guess we should get the formalities out of the way by stating everything we will cover today is meant as general information only and not meant to imply specific legal advice. For this post, I thought we would talk about intellectual property. From an investor standpoint, intellectual property can be a very strong factor in how an investor values a company and forms a big part of their decision in the company’s investment worthiness. When people think about intellectual property, the first thing that probably comes to mind are patents. However, there are many other aspects relating to the ownership of intellectual property that a start-up needs to ensure are in properly place, correct?

Joe: That’s right. Most start-ups will use their own employees, outside consultants, and external vendors to help create a product. Intellectual property ownership rights need to be clearly spelled out in all of these relationships to ensure when a company goes to file a patent, seek investment or often even to complete and comply with their own sales and marketing documentation, that there is no possibility that an outside entity can stake claim to their intellectual property. We work with companies when they are at the stage when they are looking for angel or VC financing and also when they are targets of acquisition. We know that investors or acquirers will look for this in their due diligence so we advise our clients to ensure they have a strong foundation from the start.

Craig: Ok, let’s start with employees. If you have an employee on payroll, doesn’t general law cover this off and give the employer rights to any intellectual property they may develop while employed?

Joe: That is correct as a broad and general proposition, however it is best practice to get an employment agreement in writing that will cover off this and other aspects that can have a determinant on the success of a company. For example, there are certain slippery residual rights that all inventors of intellectual property retain, whether they are employees or not, and that if not handled correctly, can impede what a company can do with the intellectual property. Also, without a specific employment agreement there will be more grey areas that everyone wants to avoid. Like what if one of their employees works on their own computer/equipment on their spare time – the employee may stake claim that some of the intellectual property is his or hers. Additionally, we have also run into situations where everybody in the company has an employment agreement except the founder. This covers the founder’s interests when he or she owns all of the shares, but when outside entities are looking to make an investment, they are obviously investing in the company as an entity, not the founder.

Craig: What about non-competes?

Joe: From a company’s standpoint, the knee-jerk reaction is to seek a broad non-compete clause if it ends a relationship with an employee. However, this is usually counterproductive, because courts believe fundamentally in the rights of people to work wherever they want. As a result, courts have a strong aversion to enforce almost any non-compete against an employee unless it is framed reasonably narrowly so as to address a specific business concern that can’t be protected in other ways. A company would be better off to have a very tailored and proportional non-compete clause that outlines specific timeframes, geographies, narrowly defined businesses, etc. Even better and more likely to be upheld is the use of other mechanisms to achieve generally the same results such as non-disclosure agreements and non-solicitation covenants with respect to employees, customers and even key suppliers of the company.

Craig: Start-ups often use flexible compensation structures in the early days when money is scarce (i.e. giving people below market salaries in exchange for equities). Any comments on legal aspects around this?

Joe: Ideally in those situations, there should be a cash component and the company should ensure that the market value of the overall compensation is sufficient to ensure that the employee has received adequate consideration in exchange for him or her agreeing to be bound by any non-competes, non-disclosure and IP assignments. The main thing is to get the relationship properly documented so both sides have a record of what kind of ownership is actually being provided and on what terms, and so the company can document and comply with corporate and securities legal requirements. Also, companies should ensure that the value of any services they receive is roughly equal to the fair market value of the shares that they grant in return. This is important from a corporate governance perspective as well as a tax perspective, and companies should avoid the temptation to entice an employee by back dating share grants to a period when the market value was lower.

Craig: Any other issues around the topic of employees / employment agreements?

Joe: The other thing would be around termination (either by the company or employee). Notice and severance period should be spelled out so both sides are clear on what their responsibilities are and so, from the company’s perspective, it can set and minimize its exposure. If the wrong language is used, the company can be exposed to a multiple of four or five times. If the employee has stock options, it should be carefully spelled out what happens to unvested options as well as the exercise of vested options. This can often vary depending on whether the notice period is or is not treated as part of the term of employment, and again there is careful language that has to be used to get it right.

Craig: Moving on to consultants and outside vendors, in today’s outsourced business model it is pretty common that start-ups will use outside entities in the development of their offerings. What should start-ups be aware of?

Joe: Dealing with intellectual property ownership is critical with outside entities such as consultants and vendors, because by definition they are separate business entities from the company offering their own distinct services and sometimes products. Each consultant or vendor contract needs to clearly spell out proper IP transfers , waivers and other cooperation and assistance. Unlike employees where the employer has default ownership of the intellectual property, this is not the case for vendors and consultants, so the scope and phrasing of the contractual inclusions is even more paramount.

Craig: Start-ups often hire people on as consultants vs. employees to reduce exposure to EI/CPP payments, wrongful dismissal, etc. Have you seen any issues with this?

Joe: The biggest issue is with the Canada Revenue Agency. They have published a guide as to how they will examine a situation to determine if a consultant is actually an employee, but the criteria often don’t point all in the same direction. Start-ups should ensure their consulting agreements and arrangements fit into the guidelines outlined by the CRA. Otherwise, simply calling someone a “consultant” won’t cut it. If a start-up has been using a consultant on a consulting basis that the CRA determines is actually an employee relationship, the start-up will be exposed to fines. The other issue is to realize that a true consultant is by law an “outside” entity, meaning that more tailored and elaborate IP provisions are necessary, and also that the company has to be mindful of such relationships when entering into non-disclosure agreements, joint ventures, privacy policies and the like, particularly where that consultant will be involved and will receive sensitive information. For example, a consultant will not be bound to a NDA that a company signs with another commercial party, meaning that those terms need to be properly “flowed through” to the consultant’s company and often the consultant individually too.

Craig: A lot of good information here, thanks again for taking the time today Joe. In my next post, I’ll be talking with Rubsun Ho, also from Cognition, to discuss term sheets from an entrepreneur’s point of view.

craig at mapleleafangels.com