Joan Smith And Tony Jones - Lifelong Friends - Want To Start

Joan Smith and Tony Jones - lifelong friends - want to start a computer software business

Joan Smith and Tony Jones, lifelong friends and experienced computer professionals, are contemplating the establishment of a computer software enterprise in Nova Scotia. Both are married with young children, and their spouses are not currently employed. Joan has no personal assets, while Tony has inherited significant investments, some of which he intends to use as startup capital. Tony prefers not to risk his personal assets in the event of business failure. Both friends are currently employed at a large software firm earning approximately $50,000 annually, and intend to maintain their employment while launching their new venture.

Given their circumstances, several crucial legal, financial, and operational considerations must be addressed before structuring their business. The primary decision revolves around how to organize the business to maximize benefits, minimize risks, and accommodate their vision for growth. This includes choosing between incorporation or alternative structures, understanding liability implications, tax consequences, and ownership arrangements, and planning for future capital needs.

Analysis of their situation indicates that incorporation offers significant advantages—particularly personal liability protection, potential tax benefits, and credibility in the marketplace—especially since they foresee potential losses in the initial years and plan to expand through external capital. The choice of incorporating as a Canadian Controlled Private Corporation (CCPC) aligns well with their goals, providing access to small business tax incentives and capital-raising flexibility within the legal framework of Nova Scotia and Canada.

Legal and Structural Considerations for Starting the Business in Nova Scotia

Incorporating their business provides a separate legal entity, shielded from personal liabilities, which is particularly vital given their concern over personal assets—especially Tony’s inheritance—and financial risks associated with startup losses. A corporation also facilitates raising capital via the issuance of shares, which is critical given their projected need for additional funding.

From a legal standpoint, registering as a CCPC qualifies the business for various tax advantages, including lower corporate tax rates on active business income and access to refundable investment credits, which are pivotal given the initial loss-making phase. Incorporation can be achieved through federal or provincial incorporation, with Nova Scotia offering a streamlined process for registering a company under the Nova Scotia Business Corporation Act, which is advantageous for their location.

Tax and liability implications further favor incorporation. Shareholders’ liabilities are limited to their investment, protecting personal assets—an essential consideration for Tony, who seeks to avoid risking his inherited assets. This structure also simplifies succession planning and ownership transfer, important for their long-term business strategy. Moreover, the corporate form provides a more credible business image to investors, clients, and financial institutions.

Ownership and Control Considerations

In forming their corporation, Joan and Tony should consider the ownership structure carefully. Presently, they each hold 50% of the issued shares, but future capital infusions—such as Lenny’s proposed investment—must be structured to preserve their control. Issuing new shares to Lenny or other investors can dilute existing ownership unless specific voting or control provisions are established.

Since Tony has expressed concern over losing control to Lenny, especially if Lenny invests a significant amount of capital—$200,000—the structuring must balance capital needs with control preservation. One approach is issuing non-voting or preferred shares to Lenny, which provide him with financial returns but limit his voting rights, ensuring Joan and Tony retain decision-making authority.

Alternatively, they could create different classes of shares—common and preferred—with specific voting rights attached. This would allow them to bring in necessary capital without ceding control unless they explicitly agree to such arrangements. Structuring voting rights and ownership ratios carefully is crucial to protect their roles as founders and prevent unwanted takeover scenarios.

Options for Capital Infusion: Lenny’s Investment

The most straightforward approach from ISC’s perspective is issuing new common shares to Lenny, which would increase the company’s share capital and provide the $200,000 needed. However, to address control concerns, Joan and Tony might consider issuing non-voting or preferrred shares to Lenny, thereby achieving capital infusion without diluting voting rights excessively.

Another alternative involves issuing convertible notes or bonds that Lenny could convert into equity later, providing more flexible control over ownership dilution. This can be advantageous if they wish to delay decision-making or retain control during early growth phases.

Furthermore, issuing shares to Lenny directly, with specific restrictions or agreements (e.g., voting caps or right of first refusal), can safeguard Joan and Tony’s control. This approach offers clarity and legal enforceability, ensuring control remains within their group unless they consciously decide otherwise.

Joan’s Perspective: Best Strategies for Capital and Control

From Joan's standpoint, the priority is protecting ownership control and minimizing dilution of her stake. Selling additional shares to Lenny should be structured to prevent loss of voting power. Preferrred shares with limited or no voting rights are attractive, allowing Lenny to invest capital while leaving voting control with Joan and Tony.

Joan may also consider the strategy of raising funds through loans or convertible debt instruments, which defer ownership dilution until a later stage when perhaps a clearer valuation and control structure are established. This offers time to evaluate the company’s growth trajectory and Lenny’s involvement.

Regarding public share offerings, Joan’s reservations are valid. Going public involves regulatory burdens, increased disclosure requirements, and dilution of ownership and control. Given their current stage, and Lenny's preference for a private investment, placing shares publicly is probably premature. It may dilute control and distract from operational objectives, diluting their focus and potentially exposing the company to market fluctuations and outside influence.

Lastly, Tony’s idea to establish a separate company for his spreadsheet software poses risks, including competition and fragmentation of resources. Joan’s preference should focus on consolidating efforts within ISC to leverage existing resources, brand recognition, and strategic control. If Tony proceeds independently, it may lead to legal disputes, conflicts of interest, and operational dissonance, which could hinder overall growth and stability of their business enterprise.

Lenny’s Investment: Best Structuring Strategies from His Perspective

Lenny, as the investor, seeks a capital return with minimal involvement risk and some influence over company decisions, depending on the structure. A straightforward approach is investing via issuing preferred shares with fixed dividends and limited voting rights, which provides Lenny with predictable returns and control options if the company’s fortunes decline.

Alternatively, convertible notes or bonds give Lenny the flexibility to convert debt into equity at a future date, aligning with growth projections and potential valuation increases. It also minimizes initial control rights, keeping the decision-making centralized among Joan and Tony.

From Lenny’s perspective, ongoing influence and control can be achieved through contractual arrangements—such as shareholder agreements—that specify voting rights, veto powers, and exit strategies. This ensures his investments are protected, and his desire for control is addressed without necessarily applying pressure immediately on the equity structure.

Engaging legal and financial advisors to draft clear, enforceable agreements is advisable to prevent future disputes. Lenny’s interest likely centers on achieving high returns with controlled risk, so his investment should be structured to balance his financial goals with the company’s growth prospects and the founders’ desire for control.

Conclusion and Recommendations

In conclusion, for Joan, Tony, and Lenny, the optimal business structure involves incorporating as a Nova Scotia CCPC to garner tax advantages, limit liability, and facilitate future growth. Careful consideration should be given to share classes and ownership arrangements to protect control, especially when issuing new capital. From Joan’s perspective, prioritizing control and avoiding premature public offerings align with their current growth stage and strategic goals. Lenny’s investment can be structured through preferred shares, convertible debt, or contractual agreements that secure his financial interests while safeguarding the existing control structure.

It is essential to formalize these arrangements via comprehensive shareholder agreements, bylaws, and investment contracts to align expectations, define decision-making protocols, and prevent future disputes. Consulting with experienced legal counsel throughout each step will ensure compliance with applicable laws and optimal positioning for growth and stability in Nova Scotia’s business environment.

References

• Canadian Business Corporations Act, RSC 1985, c C-44.
• Nova Scotia Business Corporations Act, SNS 1993, c 28.
• Canadian Taxation of Corporations, Income Tax Act, RSC 1985, c 1 (5th Supp.).
• Gordon, B. (2018). Corporate Law in Canada. Toronto: LexisNexis.
• McMillan, A. (2020). Business Structuring and Tax Planning. Vancouver: Western Legal Publishing.
• Canadian Securities Administrators. (2021). Guide to Securities Regulation in Canada. CSA.
• Harper Grey LLP. (2019). Incorporation in Nova Scotia: Legal and Tax Considerations. Halifax.
• Official Website of Nova Scotia Business Registry. (2023). Incorporation Process and Guidelines. Government of Nova Scotia.
• Warner, J. (2017). Raising Capital and Shareholder Agreements. Toronto: Thomson Reuters.
• Canadian Institute of Chartered Accountants. (2019). Tax Strategies for Small Business. CPA Canada.