This is Part 1 of our series on Legal Fundamentals for Technology Startups, where we provide practical resources for common legal questions for technology startups. Sign up to have the articles delivered directly to your email:
When embarking on a new startup, one of the primary considerations is the type of business structure to adopt. This decision holds significant implications, including taxation, liability, and the ability to raise capital. In this article, we will explore the options of sole proprietorship, partnerships, and joint ventures.
Sole Proprietorship for Canadian Tech Startups
For many entrepreneurs of Canadian tech startups, especially those seeking simplicity and low setup costs, a sole proprietorship may be an attractive option. Often times, startups will begin with a sole proprietorship and when the business begins to generate positive cash flow, transition to a more complicated business structure.
A sole proprietorship allows the owner, known as the sole proprietor, to retain complete control over the business and, in this structure, all income, assets, and obligations of the business belong to the sole proprietor. A sole proprietorship can only have one owner but can employ staff, and the sole proprietor owns all business assets and maintains full control over business operations and decision-making. Unless the business operates under a different name, there are no registration or constitutional document requirements. As many Canadian tech startups will take a few years to become profitable and are often created as a "side gig," this structure allows the sole proprietor to keep costs low while offsetting business losses against other income.
However, because this business structure does not have a distinct legal identity and cannot own assets or grant security in its name, the sole proprietor has unlimited financial liability and is personally responsible for all financial obligations, including potential risks to personal assets. As a result, it is often recommended that the owner transition from this structure as it grows in order to limit the personal liability of the owner.
Partnerships for Canadian Tech Startups
Partnerships are another vehicle available to structure a business for Canadian tech startups. The two most common partnership structures for startups are general partnerships and limited partnerships.
General Partnership
A general partnership allows two or more individuals (or corporations) to work together and share profits. Unlike other business structures like a corporation or limited partnership, general partnerships do not require formal documents or complex registration procedures. A general partnership can be created with a simple verbal agreement, although it is recommended to have a written agreement. A general partnership would make it easier for multiple entrepreneurs to pool their resources and raise capital for the business. This option for Canadian tech startups is often used when two friends or business partners start up a business together, but do not yet have the capital or cash flow to create a more complicated business structure.
To establish a general partnership, all that is needed is a registered trade name, a tax number for tax payments, and a bank account. Profits and losses in a general partnership are passed through to the individual partners, who report them on their personal tax returns. Additionally, dissolving a general partnership is as straightforward as establishing one, with no additional legal obligations beyond reporting the business closure on tax returns.
On the other hand, all partners have unlimited joint liability, and general partnerships face challenges in attracting external investments due to limited credibility and potential risks associated with unlimited liability. One partner's decisions on behalf of the business are binding for all partners, potentially leading to shared responsibility for contracts, assets, and debts incurred by the partnership. Personal assets of individual partners may be seized to cover damages or unpaid business debts. It is crucial to choose business partners wisely and establish a partnership agreement to clarify management accountability, ownership, and profit distribution.
General partnerships are generally unsuitable for passive investors and are not used to raise equity. As a result, it is generally recommended that once a Canadian tech startup wishes to raise capital, it does not use a general partnership.
Limited Partnership
A limited partnership can be formed to carry on any business that a general partnership may carry on. The main feature of a limited partnership is that the liability of each limited partner is limited to the amount of capital such limited partner contributed to the partnership. This option could be used for a Canadian tech startup if a general partnership attracts a silent investor, and the owners do not want to deal with the formalities of a corporation. Limited partnerships raise capital through the issuance of equity (partnership interests) and the incurrence of debt. Partnership interests are typically issued in private placements. Limited partners are prohibited from managing the partnership, making it a suitable vehicle for raising capital with silent investors. However, in order to protect the liability of the general partners, corporations are commonly used as general partners of a limited partnership.
Forming a limited partnership under the Alberta Partnership Act (APA) is advantageous in specific circumstances. It is preferred when most partners reside in Alberta, the firm has Alberta counsel, and the business operations are limited to Alberta. If a partnership is formed in another province or territory and conducts business in Alberta, it must register as an extra-provincial limited partnership.
To form and organize a limited partnership in Alberta, a limited partnership agreement must be drafted, which is a private document outlining the rights and obligations of the partners and overriding default provisions of the APA. A limited partnership must have at least two partners, including one general partner and one limited partner. A person can be both a general partner and a limited partner simultaneously, as long as there is at least one other general partner or limited partner (that is, the requirement for at least two partners at all times is met). A certificate establishing the limited partnership must be recorded with the Registrar of Corporations. It includes the firm name, names, email addresses, and addresses of each general partner, and other required information.
General partners have broad authority to contract on behalf of the firm, and the firm is generally bound by contracts made by the general partners acting within their authority. However, there are limitations on a general partner's authority as specified in the APA. These limitations include acts contrary to the agreement between partners, actions hindering the firm's ordinary business, and other restrictions set out in the agreement.
There are no registration renewal or annual filing requirements for limited partnerships under the APA. However, if there are changes in the information stated in the certificate, the partnership must deliver a notice to amend the certificate to the Registrar.
A limited partner still has certain liabilities that he or she needs to be aware of. Limited partners may become liable for the firm's debts and obligations if the limited partner fails to make their full capital contribution as stated in the limited partnership agreement. he or she becomes liable to the firm to the extent of the agreed capital contribution. Additionally, if a limited partner receives a return of their capital contribution but the firm has unpaid creditors, the limited partner is liable to the extent of the amount returned, including interest, necessary to satisfy the firm's liability to the creditors. If a limited partner's surname appears in the firm's name, they are liable as a general partner to any creditor who extended credit to the firm without actual knowledge that the limited partner is not a general partner. If a limited partner participates in controlling the firm's business, they become liable for its debts and obligations.
Additional Structures: Unlimited Liability Company, Limited Liability Partnership, and Joint Venture
The unlimited liability company, the limited liability partnership, and joint ventures are additional structures for businesses, but these structures are much less common for Canadian tech startups. Therefore, we will only provide a short overview of each.
Unlimited Liability Company
An unlimited liability company is a unique form of business entity in Canada, which can only be incorporated under the provincial laws of Alberta, British Columbia, and Nova Scotia. In an unlimited liability company, shareholders are personally liable for the liabilities of the company. They are generally used by foreign investors to gain advantageous tax treatments in their home jurisdiction. This occurs because, while a unlimited liability company is taxed as a corporation in Canada, they may be eligible for a "check-the-box" election in the United States, permitting them to be taxed as a flow-through entity.
Limited Liability Partnership:
A limited liability partnership may be formed under Alberta law only for the purpose of practicing one or more eligible professions governed by an Act of the Alberta Legislature (section 82(1) of the Partnership Act). An eligible profession is a profession or discipline regulated by an Act of the Alberta Legislature that specifically authorizes members of the profession or discipline to carry on business through a corporation that has the words "Professional Corporation" or the abbreviation "P.C." as part of its name (section 81, Partnership Act).
Joint Venture
Two or more parties may engage in a joint venture where they collaborate on a business venture. There is no specific statutory definition or regulatory scheme for joint ventures in Canada, at either the provincial or federal level. Private equity investors often enter joint ventures with managers or operators, and they are common in the healthcare and infrastructure industries. Cross-border joint ventures are also common because often US private equity firms will invest in Canadian companies, and the Canadian management teams or operators will maintain a stake in the businesses.
Joint ventures can be contractual (two or more entities agreeing to combine resources or expertise to carry out a specific project or venture) or corporate (a corporate joint venture arises where two or more entities decide to use a corporation as the joint venture vehicle and become shareholders of the corporation).
Conclusion
The sole proprietorship, the general partnership, and the limited partnerships are common business structures for Canadian tech startups. The central disadvantage of the sole proprietorship and the general partnership is the difficulty in raising capital due to the unlimited liability of the owners or partners. These structures are generally advised when the business is first starting and the entrepreneurs can offset their losses against other income. A limited liability partnership can be a way for passive investment and raising funds without having to comply with the more formal requirements of a corporation. However, normally once a startup starts turning a profit and has sufficient cash flow, they create a corporate structure to limit their personal liability. In the next post of this series, we will discuss the corporate body.
We help Canadian tech startups structure their business. We offer flat fees to provide you and your business with certainty at this early stage of the process. Contact us today to learn more about how we can assist you.
This article is intended for informational purposes only and should not be considered as legal advice and does not establish an attorney-client relationship. Consulting with a qualified legal professional is recommended for specific legal concerns and requirements related to your business.
© 2023 Andrew Roy