Cash Flow Challenges – Issuing Shares of a Company as an Alternative – A Case Study
XYZ.Co came to K.E. Johnson Law came to us with a common challenge: Cash flow and what they thought may be a solution…
Facts: XYZ Co. is one of many of Victoria’s successful start-up technology companies that has developed a product and is now making sales. Bob is the founder, director and CEO and has convinced about 20 friends and business associates to invest as shareholders at $1.00/share. XYZ Co. has several full time employees and several part time independent contractors.
Predictably with many start-up companies cash flow can be a problem from time to time and Bob wants to issue shares of XYZ Co. to the employees and independent contractors at $1.50 per share in lieu of their regular cash payments until such time as cash flow improves.
Discussion: Can XYZ Co. issue shares to its employees and independent contractors in lieu of their regular cash payments?
The question raises a number of issues. (Corporate law) Firstly, XYZ Co. is governed by the British Columbia Business Corporations Act which contains rules on how a corporation can issue shares.
Bottom line – a share can only be issued for cash consideration, property or past services – not future services. i.e. shares cannot legally be issued before they are paid for. One way around this is to provide options – with a specific strike price and expiry period.
Generally the strike price would be above the present value of the company’s shares and operate as an incentive to the employees.
Secondly, (Securities law) XYZ is governed by the Securities Act of British Columbia which is designed as consumer protection legislation.
Broadly speaking the securities legislation is designed to protect the “public” and ensure that people investing in a company either have sufficient experience or have been provide sufficient information by the company to assess the value of the company and its future prospects.
In the case of the independent contractors it is not clear that they would have a good idea of the present value of the XYZ Co. or its future prospects. How many shares are issued and outstanding; what property does the company own; what liabilities does the company have, etc. Accordingly an issuance of shares to independent contractors may be offside of the Securities Act and hence give the purchaser of those shares a perpetual right of rescission; i.e. give the shares back and get the money they were owed instead. Naturally if the shares of XYZ Co. increased in value this would not be a problem; however, if the reverse were true then this could be a problem for XYZ Co. which is now faced with an unanticipated liability.
Thirdly, (Employment law) insofar as the employees are concerned issuing shares (or other forms of consideration) in lieu of salary is prohibited by section 20 the Employment Standards Act which says wages must be paid in Canadian currency. Bottom line – an employee is not obligated to take some form of consideration that wasn’t agreed at the outset. i.e. instead of paying cash – “here – take this computer or desk instead.” Again, particularly in the case of shares a problem could arise down the road if the value of the company issuing the shares has declined and there is no market for the shares.
The employees in this instance would have become unwitting investors in the company. As with independent contactors, issuing stock options as a performance bonus or other incentive is important.
(Miscellaneous – taxation) Another general topic to be mindful of are the tax implications of issuing shares, options, etc. The Income Tax Act (Canada) contains rules that apply to employees but not contractors – which defer the tax on share consideration until the shares are actually disposed of (not acquired). So, in some cases if a contractor, for example, if receiving non-cash consideration such as shares they could still be liable for income tax on the fair market value of the shares even though they have no cash and the value of the shares is never monetized.
Summary: In many instances, what appear to be small differences in fact can become big differences in law – and accordingly it is often wise for a company to get advice to become aware of the various statutes that govern corporate affairs as well as what is known as the “common law” – essentially the Court’s ability to impose equitable remedies where specific legislation is not in place. An example of a common law remedy would be severance for a senior employee above and beyond the minimum notice periods set out in the Labour Standards Act, for example. Another example would be the share price of a $1.50 in our example – is that fair? The Court may rely on a concept known as “quantum meruit” – even where there is not a precise contract – is the amount of consideration given in exchange for the work provided fair?