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Small businesses and start-ups that incorporate, as well as the individuals who will manage them, should be familiar with basic legal requirements with respect to the appointment, duties, liabilities and removal of directors and officers - and the potentially unique issues created by the use of separate advisors or advisory boards.
Some new businesses start with one founder and start life as a form of sole proprietorship. Some new businesses are formed by a number of founders (often a mix of idea; effort, expertise and capital) and among these founders you will often hear references to each other as partners. Still others are started, maintained or eventually transitioned among family members exclusively. While each of these origins have important legal, structural and organizational issues that should be addressed early in consultation with experienced legal counsel (and will be the topic of assorted future articles), this article and its follow-on article (see here) will focus on the step in the life of a small business or start-up that follows inception – the growth of a business in terms of addition of directors, advisers, management, employees or contractors.
Growth of people and expertise within an organization may be, and often is, a simple response to a lack of bandwidth or expertise of the founder, founders or family – but can also be a smart investment in the future in terms of revenue growth, geographic expansion, capital raising efforts and/or future divestiture.
Regardless of the reason there are very important considerations to be addressed and, while founders or families should not fear getting help and seeking growth by adding people, any founder or family should understand the implications of doing so and manage any risk appropriately. For the purposes of the discussions below, we will assume that the new business is structured as a corporation (as is generally typical) regardless of whether it is started by one founder, a group of founders or a family.
Directors and Boards of Directors
Applicable corporate legislation, and related corporate law, will govern much of the discussion regarding the directors of a corporation. Directors, more or less, have the responsibility of managing the corporation on behalf of the shareholders (subject to unanimous shareholder agreements and the provisions of the British Columbia Business Corporations Act (BCBCA) or the Canada Business Corporations Act (CBCA), as applicable). Every entrepreneur should understand, at the very least, the following:
Corporations Must Have Director(s). Both the BCBCA and CBCA require every corporation to have at least one director (public corporations must have at least three). Specific requirements and qualifications for directors can be found in the BCBCA or CBCA. Founders may be the first directors but expansion of the board may be the product of business necessity or the demands of future financing. Remember, applicable corporate legislation and the articles of the corporation may specify or limit the number of directors, how they are elected or appointed and when and how they can be removed.
Directors Have A Statutory Duty To Manage A Corporation. A director, or the directors, is/are responsible for managing and supervising the activities and affairs of the corporation (and have the authority to appoint officers to attend to the day-to-day affairs of the corporation). Directors are accountable to the shareholders of a corporation generally in terms reporting to, and seeking re-election from, shareholders at annual general meetings. Directors cannot be “fired” (and can only be removed by prescribed mechanisms in corporate legislation, by-laws or articles); suspended; told to leave or not attend a meeting of directors; or told they cannot vote or that their vote does not count (save perhaps where there is a legal reason to do so like a recognized and legitimate conflict of interest).
Directors Have (and this is important) Fiduciary Duties. Directors are fiduciaries - which is a high standard indeed. Generally, directors are (a) required to exercise at least the level of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances; and (b) required to act honestly, in good faith and in the best interests of the corporation, rather than in their own personal interest or in the interest, generally, of any other particular stakeholder (such as a shareholder). This need not be much of a concern when a business has one shareholder and one director – all the same person. This simplicity falls away quickly when there are more than one shareholder and/or director.
Directors Must Be Free To Act In Accordance With Their Fiduciary Duty. Generally, the law in Canada is that a director may not “fetter” (restrain or hamper) his or her discretion by contracting with other directors, shareholders or with third parties to act in a certain way in the future. Effectively, a director’s obligation to act in accordance with his or her fiduciary duties described above would take precedence over any course of conduct he or she may have previously agreed with such co-directors, shareholders or third parties (note, however, that both the BCBCA and the CBCA have mechanisms that permit certain directors’ powers to be transferred to shareholders (and such shareholders also then also assume any corresponding duties and liabilities of the directors)). Getting an agreement that the other directors will vote the way the founder wants them to simply does not work – or at least subjects those other directors to potential legal risk for failing to adhere to their fiduciary duty in certain circumstances.
Directors Have (potential) Personal Liability. Being a director exposes the individual to other potential personal liability under various federal and provincial laws such as:
corporate statute or legislation (in certain circumstances, such as the issuance of shares without payment or the declaration of dividends or repurchase of shares while insolvent);
Canada’s income tax statutes (generally directors are jointly and severally liable to pay employee income tax deductions that the corporation fails to remit for two years following ceasing to be a director);
Canada’s environmental laws (generally directors are required to take reasonable care to ensure that the corporation complies with the provisions of applicable environmental laws dealing with air and water pollution, as well as with those involving proper storage and disposal of toxic substances);
Canada’s anti-spam legislation (often referred to as CASL, for non-compliance with CASL requirements);
employment and employment benefit related legislation (generally, directors can be held liable for unpaid employee wages and vacation pay; for a corporation’s failure to remit source deductions such as Canada Pension Plan and Employment Insurance on behalf of its employees; if a corporation commits an offense under provincial pension benefits legislation; or a corporation’s failure to comply with provincial occupational health and safety legislation requirements); and
under provincial securities laws (yes, securities laws apply to private corporations as well as public corporations regardless of their size).
Entrepreneurs must also understand the balance between control, efficiency and effectiveness. If a founder owns 100% of his or her business, he or she may not want to appoint any other directors to run the business and instead simply rely or their own expertise (for better or worse) or on an advisory board (discussed below) that provides advice and direction to the sole director. However, often a larger board of directors is mandated by the number of original founders, new investors and lending institutions or otherwise implemented to expand the expertise and capacity of an existing sole director. If so, a few items that should receive consideration:
Select an odd number such as three or five so as to avoid a voting tie; and select a reasonable number (perhaps, say, not eleven directors) to facilitate meetings, discussion and execution of consent resolutions (resolutions in writing signed by all directors). While corporate legislation, and in particular a corporation’s articles or by-laws (as applicable), may provide for a chair of the board to have a second and deciding vote, remember, the chair of the board is determined by the board and any particular individual may not always be the chair.
Often board representation is modeled along the lines of the equity ownership of the corporation. Be mindful, however, that if you own 51% of the company and two other shareholders share the other 49%, appointing three directors does not reflect your control as a shareholder and, in fact, provides control at the board level to any two directors who then form a majority of the board. Further, if you have two shareholders holding approximately the same percentage of equity ownership of the corporation or one founder director and an outside investor who takes a board seat despite any particular percentage of ownership, it may make sense to appoint a third outside or “independent” director to be involved that has a non-biased perspective on the business and it stakeholders and who, in essence, can break any voting deadlock at the board level. Determining an appropriate outside director can be difficult but the founder or founder group may want to retain the right to identify and nominate that outside candidate for approval by the investor rather than have the new investor or minority shareholder do so.
Corporate statute or legislation prescribes certain requirements for directors (like age, capacity and bankruptcy status) and residency (CBCA requires that 25% of the number of elected directors must be considered to be “resident Canadians” while the BCBCA has no residency requirements) which should be considered with any potential candidate. All corporate statutes or legislation require that a director consent to act as such, in writing, and such consent should be obtained at or prior to any election or appointment and filed in a record book. Further, all corporate statutes and legislation prescribe when directors may cease to be directors but if resigning as a director, the resignation should be in writing, specify an effective date and be delivered both the Chairperson of any board, if any, and the corporation’s registered and/or records office.
Finally, other than those directors who are also significant shareholders (and therefore would generally have some say in who the directors of the corporation are), each addition to the board of directors of a corporation should: be generally friendly to the collective vision so as to avoid unnecessary battles in the board room; bring real and unique value to the make-up of the board through start-up expertise, specific industry knowledge or financial, legal or product skill set; and be a real participant in board meetings and advocate of the corporation and not simply a passive board member who simply signs consent resolutions when asked to, attends meetings once and awhile or wants to collect, in some circumstances, stock options or other offered compensation.
Advisory Boards
There is no legal requirement under corporate law, or technically any formal role, for an Advisory Board. The existence of an Advisory Board does not diminish the responsibility to manage the affairs of a corporation by the directors or senior officers. Advisory Boards have certainly become fashionable and, if properly constituted and performing, can be a valuable component in attracting business partners, customers and/or investors.
The existence, membership, role and frequency of the meeting of any Advisory Board is generally up to the founders and/or management but the goal is usually the same – either to form a sometimes symbolic Advisory Board made of well-known and respected individuals in the corporation’s business “space” or to form a functioning working group based on needed skills or identified gaps within the corporations management (for example, legal or finance expertise; public relations or branding specialists; former entrepreneurs with expertise in growing a corporation and/or selling to corporation to an acquirer; industry influencers or specialists for depth of knowledge and/or partnership development; and/or VC or investment banking expertise fundraising advice). A sole director or board of directors, regardless of the breadth of expertise of such board, can benefit from advisers however formal or informal. In certain circumstances, and perhaps more accurately industries, the existence of an Advisory Board is likely an expectation. However, regardless of the legal informality (or perhaps because of it), some items for consideration include:
Advisory Board members are not fiduciaries, nor are they usually referred to in the context of individually retained consultants. Therefore, confidential or proprietary information shared with advisory board members do not enjoy, generally, the protections provided as a result of the fiduciary relationship or the protections contained within a carefully worded consultancy agreement. If confidential or proprietary information is going to be shared with advisors, particularly in the context of an Advisory Board, there should be a form of agreement in place that attends to matters like disclosure, use and ownership of confidential and proprietary information and the development and ownership of intellectual property.
As stated above, well-known and well-connected members of an Advisory Board can be a great help to a start-up in terms of attracting business partners, customers and more often, investors. However, too often these arrangements are actually only symbolic arrangements where an Advisory Board member lends his or her name to a particular start-up and perhaps provides some advice, very infrequently, all in exchange for some sort of equity compensation. If third parties determine, with some simple due diligence, that particular Advisory Board members are advisors in name-only and not actually knowledgeable of, or contributing to, a business; then it that can reflect poorly on the founders and the corporation and can lead to a perception that the advisor’s name is added to the pitch deck just for marketing purposes and there is no substance, and therefore benefit, to the relationship.
While the attraction of well-known and well-connected Advisory Board members can be a substantial public and investor relations benefit to a start-up, the exit of those same well-known and well-connected advisors, particularly if their name is then subsequently added to the Advisory Board of a potential competitor, can be immediate and sometimes unfair burden to the promotion of your corporation. Due to the informality of the role and obligations of Advisory Boards it is often easier, and more common, to see named advisers come and go. What was once seen as a PR benefit, can quickly become a perception that there are better options out there in your space.
In British Columbia, being a member of an Advisory Board does not necessarily entitle the adviser to stock options of the corporations under many common forms of Incentive Stock Option Plans, nor does the designation qualify for exemptions from the securities distribution requirements under applicable securities law. While any distribution of securities should only be done in consultation with an experienced securities lawyer, any compensation of Advisory Board members with securities such as stock options should require the adviser enter into a written agreement for bona fide business advisory services, similar to a consultant.
Officers
Both the BCBCA and CBCA permit the directors of a corporation to designate officers to manage that the day-to-day operations of a corporation. However, it should be understood that the term “officer” is defined but not prescribed by either the BCBCA or CBCA – to put that another way both the BCBCA and CBCA recognize the concept of officers, but they do not necessarily prescribe that there has to be certain officers or that if there are officers they need particular titles. The old British Columbia Company Act did require that every company have a “President” and a “Secretary” but the new BCBCA does not. Publicly traded companies in Canada are required to have a CEO and CFO or at least named individuals that have similar responsibilities. Securities law does distinguish, by title and responsibility, between “executive officers”, “senior officers” and “officers” which may be important to start-ups with plans for substantial capital-raising and/or public listing plans.
Often other third-party institutions like banks will assume (and administratively require) that corporations have officers that include someone in a role of President or CEO, and someone either in the role of CFO or Secretary. The result is that you often see corporations continue to use these references and immediately seek to appoint officers.
Trends in certain technology and service industries now use titles that fit their respective culture as opposed to more traditionally references. It should be noted that you can be deemed to be an officer by virtue of the title given – if your title is “President” you are likely deemed to be an officer of the corporation.
Officers are, generally, also considered to be fiduciaries and can have similar duties to the corporation (and legal liability under various federal statutes and provincial legislation) as directors – particularly senior officers with broad board designated discretion or responsibility over the affairs of the corporation. Officers can also have similar liabilities as directors under tax, environmental, privacy, employment, securities (and other laws). If thinking of being named as an officer of a corporation, particularly if not employed by the corporation, attention should be given to the role and responsibilities that come with the proposed title.
One area of continued confusion is the conflation of corporate law appointed officers, on the one hand, and corporation employed officers on the other hand. If a director appoints a “President”, “Secretary” or any other title of a corporation as the director is entitled to do under either the BCBCA or CBCA, that does not deem those officers to automatically be employees of the corporation – entitled to such things as salary and notice of termination. Employment is a legal arrangement based more on an employment agreement (or at least the intentions of the parties) and may be deemed to exist upon an analysis of certain factual matters such as pay, control and reporting (among other things). If an individual is to be employed as an officer of a corporation – as opposed to acting as an officer at the pleasure of the directors – that arrangement should be documented in a written employment agreement.
Adding outside direction, advice or day-to-day management to your business is a big step. Entrepreneurs will most certainly have a grasp of the why and what such personnel will add. However, a quick consultation with your business’s legal counsel will ensure that any formalities are attended to and any risks are at least identified and discussed – thereby avoiding immediate unintended liabilities or future conflicts that can compromise your business plans and the valuation of your undertaking. Endeavor Law is pleased to help any founder, founders or family with any contemplated appointment or any proposed director, adviser or officer about any concerns they may have or matters they should attend to and offers legal advice and services on terms and at rates structured for new and growing British Columbia businesses.
Does not constitute legal or other advice and must not be used as a substitute for legal advice from a qualified legal professional in your jurisdiction who has been fully informed of your specific circumstances. Information may not be up-dated subsequent to its initial publication and may therefore be out of date at the time it is read or viewed. Always consult a qualified legal professional in your jurisdiction.