A sole proprietorship is a business owned and operated by an individual. Of all business structures, it is the one that requires the least amount of time, effort and money to establish. Besides its simplicity, its benefits include: flexibility; control; minimal government regulations; and potential tax advantages. Drawbacks for sole proprietorships include: unlimited liability; limited financial resources; time commitment; limited growth; and limited life span of the business. If a sole proprietor carries on business under his or her own name, he or she is not required to register his or her name as a business name. Otherwise, he or she must register the trade name used under a provincial business name legislation, such as the Ontario Business Names Act. The owner/operator of the sole proprietorship is taxed at his or her personal income tax rate.
A partnership exists when two or more individuals combine resources in a business with a view to sharing the profits among the partners. Unlike a corporation, a partnership is not a separate entity from its partners. Meaning, the partners share in the profits and the losses of the partnership.
The Benefits of partnership include ease of organization, shared management, flexibility and potential tax benefits (particularly in the early stages of a company). Disadvantages include: unlimited liability (in most cases), potential conflicts between partners, and a higher marginal tax rate compared to corporations.
There are three types of partnerships: general partnerships, limited partnerships, and limited liability partnerships.
In a general partnership, the partners share in the management of the partnership and each partner is liable for the company’s debts and obligations. The general partnership is very much like a sole proprietorship, except instead of all profits and losses accumulating to the sole proprietor, they are split out among the partners.
In a limited partnership (commonly known as an “LP”), one or more “general” partners manage the company and take on the bulk of the liability of the partnership. The other “limited” partners play a role more like passive investors: they are prohibited from participating in the management of the partnership, but as a result their liability is limited only to the amount that they contributed to the partnership (unless otherwise agreed in the Partnership Agreement).
A limited liability partnership (commonly known as an LLP) is a legal structure that is prohibited for all but a small group of regulated professions such as lawyers and accountants (although British Columbia also allows LLP for businesses). In the LLP each partner’s liability is limited to a certain extent.
Regardless of the type of partnership you want to create, a written partnership agreement is recommended to properly structure the partnership and set out how it will operate and to create processes to deal with disputes among partners.
One key benefit of partnerships is that they are taxed similarly to sole proprietorships. This means that tax losses and gains flow through the partnership to each partner’s personal income. A key benefit of this is that, among other things, losses accumulated by the partnership, can be offset against each partners’ tax payable on income from other sources. For this reason partnerships are a popular choice for early-stage businesses that are expected to accumulate losses in the first few years of operation.
The defining feature of a corporation is that it is a legal entity separate from its owners, which allows the so-called “corporate veil” to protect owners and directors of a corporation from liability for the debts and obligations of the corporation (with some exceptions).
Structurally speaking a corporation is organized with the shareholders (who own the corporation through shares) appointing directors to manage the day-to-day business and affairs of the corporation. Directors may, in turn, appoint officers, such as presidents, CEOs, secretaries and treasurers to carry out more specific duties for the corporation. The directors and officers are responsible for most of the decision-making on behalf of the Corporation, although more significant decisions often require shareholder approval as well.
The benefits of structuring your business by way of incorporation include, among other things: perpetual existence (as long as annual filings are completed, the corporation will outlive its founders); limited liability; ease of changing ownership and raising capital, and a lower marginal tax rate than any other legal entity.
The drawbacks of incorporation include: more regulation than most other corporate structures; double taxation on dividends; more paperwork and upkeep than most other structures; and a higher start-up cost compared to sole proprietorships and partnerships.
On the issue of taxation, corporations are taxed as a separate legal entity from its owners, and enjoys the benefit of a lower marginal tax rate than individuals. However, when income is distributed to shareholders through dividends – capital gains taxes apply to dividend income which means 50% of dividend income will be taxed at the personal rate.
In Canada, you can incorporate either federally or provincially. Whether you choose one over the other will depend on your specific business. For instance, if you plan to do business across Canada or internationally, incorporating federally might be the better choice. On the other hand, if your business will be restricted to a particular province, incorporating provincially might make sense. As an example, incorporating federally will provide better business name protection across Canada. Meaning, once you incorporate federally, your business will be able can use its business name all across Canada without any concerns. On the other hand, if you incorporate provincially and wish to expand into other provinces, your business’ name may be in use in another province, meaning you will have to choose a different to carry business in that province.
When a corporation involves multiple shareholders, it is often advisable for the shareholders to enter into what is known as a “shareholders’ agreement”. A shareholders’ agreement is a very versatile document which typically binds the shareholders of a company to a certain set of rules, and sets out certain decision-making authority in respect of the governance of the corporation. A typical shareholders’ agreement will clearly define, among other things, how certain decisions are made within the corporation, how shareholders may go about transferring or selling shares, how the company may go about issuing additional shares, and how disputes between shareholders may be resolved.
Shareholders’ agreements can also be useful to control the dilution of shares so that existing shareholders do not lose their stake in the company when new shares are issued, to impose non-competition and non-disclosure clauses upon shareholders to prevent a departing shareholder from setting-up shop across the street or stealing clients, and to define shareholder responsibilities with respect to raising capital in the future.
Business partners often consist of a close circle of friends or family members. Unfortunately, disagreements can arise between even the best of friends and the importance of having a shareholders’ agreement in place is often only realized once something goes wrong, in which case it is already too late.
Incorporation can bring many advantages, whether you choose to incorporate provincially or federally (as discussed in the Corporations section). However, certain professionals (such as doctors, accountants, and lawyers) have the unique privilege of being able to incorporate a professional corporation (a “PC”) under provincial law.
PCs are useful in many respects, not the least of which are the various tax planning opportunities that they create. However, before you decide to incorporate a PC to take advantage of these opportunities, you will have to consider the various unique rules and regulations that apply to PCs under provincial law. These rules typically restrict who can own a PC, and what types of business they can carry on.
The three key tax planning benefits of using a PC are income splitting, the small business deduction, and the capital gains exemption. Each of these will be explained below.
One of the main benefits of incorporating a PC is the ability to split income with a spouse or an adult child. Where the rules allow, you can benefit from income splitting where your spouse and adult children are allowed to subscribe for shares of the corporation and receive dividends from the profits of the PC. The advantage is the ability to have the dividends taxed in the hands of more than one person, which generally means that the overall tax on the dividends is lower.
However, it is important to consider the ownership rules of PCs, as they vary from province to province (and one industry to the next) and will determine whether this benefit is available in the circumstances. For example certain provinces prohibit anyone who is not a licensed member of the profession (e.g. a doctor) from owning shares in a PC. Where family ownership is allowed, some provinces also restrict the use of trusts.
In all cases, a person hoping to take advantage of this tax benefit should consult professional legal advisors to ensure that they are in compliance with all the applicable rules and regulations.
The Small Business Deduction
The second main benefit of incorporation is the ability to access the small business deduction. A PC owned by a professional resident in Canada will be a Canadian Controlled Private Corporation (a “CCPC”), meaning the PC may be able to benefit from the small business deduction. With this deduction, a CCPC’s federal and provincial tax on active business income is reduced up to certain limits. Currently in Ontario, a maximum of $500,000 of active business income qualifies for the federal small business deduction, however this limit varies from province to province.
When determining whether your PC can benefit from the small business deduction, you need to consider the following rules:
Partnerships: If your PC is a member of a partnership of companies, the specified partnership income rules will affect how the deduction applies. Under these rules only one small business deduction is available to reduce corporate tax on income from the partnership. In the case of a partnership of PCs, all of the PCs must share one small business deduction.
For example, if your PC earns 1/4 of its income from a professional partnership, only $125,000 of the income (1/4 of $500,000) will be eligible for the federal small business deduction. These rules effectively mean that partners of large partnerships do not get any significant small business deduction on their partnership income. Certain structures can be used to effectively allow PCs of partners in professional partnerships access to a full small business deduction limit, but they require careful planning to implement.
Personal Services Business: Generally, if you provide services through a corporation and, would be considered an employee of the entity to which you provide the services, the corporation may be considered a personal services business (a “PSB”). Where the PSB rules apply, income from the PSB will not be eligible for the small business deduction. As well, deductions claimed by the PSB will be restricted.
Capital Gains Exemption for Qualifying Small Business Shares
The third significant tax advantage of a professional corporation that may be available is the capital gains exemption for qualifying small business corporation shares. If you or a family member who own shares in a PC are able to sell their shares, up to $750,000 of gross proceeds can be exempted from tax for each individual.
To qualify for the exemption, the following general conditions must be met: (i) at the time of the sale, at least 90% of the corporation’s assets (on the basis of fair market value) must be business assets; (ii) more than 50% of the corporation’s assets (on the basis of fair market value) must have been used in an active business carried on primarily in Canada throughout the 24-month period immediately before the sale; and (iii) and the shares must not have been owned by anyone other than the vendor or someone related to the vendor during the 24-month period immediately before the sale.
Unfortunately due to the nature of PCs and the restrictions on share ownership that often exist, selling shares in a PC is not always possible.
Some other key considerations when considering whether or not to incorporate as a PC are as follows:
Individual Pension Plan: Instead of contributing to an RRSP, another retirement savings option is available to you as a professional if you incorporate. Under the rules for defined benefit pension plans, an individual pension plan (an “IPP”) can be set up for business owners who are employed and earning employment income. The benefits under an IPP are set by reference to your salary earned from your PC, and contributions are made to build sufficient funds to pay for this defined pension benefit. For many individuals (generally, in their 50s or older), the use of an IPP can allow for greater contributions when compared to an RRSP. Additional benefits of an IPP include the ability to make up for poor investment performance and the possibility of making lump-sum contributions for past service.
Employment Benefits: If you incorporate, you may also be able to take advantage of employee benefits that have preferential tax treatment such as private health service plan benefits and benefits from the use of a leased company car. As a shareholder of your PC, it will be important to ensure that the benefit is received as an employment benefit and not as a shareholder benefit — otherwise preferential tax treatment will be lost.
Regulations and Housekeeping: One minor disadvantage of incorporation is that a corporation, compared to other legal structures, requires more paperwork and regular upkeep. This includes filing annual returns, preparing annual shareholders’ and directors’ resolutions, preparing a corporate tax return and completing the appropriate tax filings for salaries or dividends paid by the corporation.
Start-up Costs: As with any corporation, start-up costs will be slightly higher with a corporation than with another less complex legal structure.
There are many factors to consider when deciding whether or not incorporation makes sense for you as a professional. The provincial rules for your profession need to be balanced with the potential tax benefits and the additional costs you may incur. All factors considered, the decision can seem overwhelming, but your legal advisor at HazloLaw can help you make the decision that is right for you and your practice.
Trusts are a very flexible legal structure that are often looked to because of the considerable tax benefits that can be derived from their use. Specifically, if used properly, family trusts can facilitate income-splitting and capital gains exemptions, thus allowing for the flexible and tax-efficient management and distribution of appreciating assets.
A trust, simply-put, is a form of legal relationship centered around the management of certain property. What falls within the scope of the trust’s property, and how it is to be managed is information that will be set out in the Deed of Trust, the document that forms and structures the trust in the first place. Once formed, the “trustees” must manage the property of the trust for the benefit of the “beneficiaries” in accordance with the Deed of Trust.
From a tax planning perspective, family trusts offer two distinct tax-planning benefits that can be leveraged for owners of small closely-held businesses with respect to the distribution of their assets. These are: (1) income splitting among beneficiaries; and (3) capital gains deductions.
If a family trust owns shares in the capital of the family business, earnings retained by the corporation can be paid out to the trust. The trustees then (provided the trust is properly organized) will have full discretion to distribute the funds to the beneficiaries of the trust in the most tax efficient manner. As with any tax planning method, there are also pitfalls to avoid when it comes to income-splitting, and care must be taken not to trigger any unintended tax consequences.
Capital Gains Deductions
The Income Tax Act provides every individual taxpayer with a lifetime capital gains deduction on the sale of shares in a qualified small business corporation. Because it is individual taxpayers that are entitled to this deduction, if structured properly, a trust can be used to multiply the overall value of the deduction by the number of beneficiaries of the trust.
An Estate Freeze may be necessary prior to making use of the capital gains deductions, to help ensure that the most tax-efficient structure is in place and the greatest tax benefit is realized.
Those considering implementing a family trust for tax or estate planning purposes are encouraged speak to one of our professional advisors to ensure an efficient distribution of assets and to avoid triggering any unintended tax consequences.
An “Estate Freeze” is a process used for estate planning purposes in which the current value of shares (or other property) owned by a business-owner is frozen at a certain point in time, after which point, all value accrued by that property is attributed to someone else. This is often used as a way to pass down the control of a family-run corporation to the next generation without causing any negative tax consequences.
Typically the process unfolds with the parent-owner of a family business redeeming their voting common shares for voting preferred shares at a fixed-value, which is equal to the value of the common shares just redeemed. At the same time the company will issue common shares with no value to the adult-child(ren) of the owner-parent.
Because the value of the redeemed and newly issued preferred shares is the same, there is no capital gains tax payable as a result of this exchange of shares. Furthermore, because the value of the owner’s shares is not fixed, the amount that the next generation will need to pay to purchase the business from them is also fixed, which is useful for planning purposes.
There are a number of other benefits that can be derived from an Estate Freeze including ensuring a smooth transition of the business to its successors, providing long-term income to the owner, allowing efficient income splitting among family members, and providing protection from creditors. That said, the Estate Freeze is a complex process that can trigger adverse tax consequences if done incorrectly. Anyone considering implementing an Estate Freeze is encouraged to consult with one or our professional advisors as a first step.
Simply put, a holding company is a company that owns shares in another company. Holding shares is the holding company’s sole purpose for being, and therefore it typically does not engage in any sort of business activity directly. Holding companies can be a very useful tool in a number of corporate, estate and tax planning situations. The key benefits of a holding company can be summarized as follows:
If your company generates a significant amount of profit, it may be that not all the profit will be paid out to shareholders as dividends (for reasons such as income tax). A company retaining large sums of money within itself can be exposed financially to different types of risk such as litigation by consumer/customer, suppliers, and creditors. By moving funds from an operating company to a holding company, the holding company will be insulated from claims by creditors or contractors against the operating company. This can be an effective strategy for protecting the assets of the operating company from potential future claims.
Transferring Ownership of a Business
Holding companies can also be a very useful tool for helping individuals gradually transfer ownership of a company to the its successors while maintaining ownership of the company in the short term, and minimizing tax consequences for all involved. This is achieved through a process known as an “Estate freeze”. For more information on the Estate Freezes, click here.
Depending on the proportion of shares in the operating company that the holding company owns, it is often possible to pay out after-tax profits accumulated by an operating company to a holding company on a tax-free basis. This is particularly useful as a means to moving funds for purposes of minimizing the risk to the assets of an operating company, as discussed above.
Notwithstanding the many benefits of using holding companies, there are not always the best tool for the job. For instance, the cost of creating and maintaining a holding company can outweigh the benefits that you will receive depending on the size of your business operations. Furthermore, the shares of an operating company will generally be considered an investment asset not an asset that is used to generate active business income, meaning shares in holding companies are not generally eligible for the capital gains exemption (although there may be ways around this).
Whether a holding company is the right vehicle to meet the needs of you and your business will depend on your specific circumstances. We invite you to speak to one of our professional advisors to discuss which corporate, estate and tax planning vehicle is right for you.
In privately held company there are generally two ways to raise money, these are through private placements, and debt financing.
A private placement refers to raising capital through offering shares (or other securities) directly to private investors as opposed to via a public offering. Private placements are a very popular way to raise capital for small, medium and large companies, and can be advantageous to public offerings in that they are much less expensive and time intensive, and they only require the interest of a few investors to make for a successful financing. A corporation may find that a private placement will be more cost-effective and time-efficient than a public offering. Also, there may not be enough public demand for the corporation’s securities in which case, a private placement can provide an offering to few sophisticated private investors.
Because private placements involve the issuance by a company of its securities to a third party, the most important thing to consider when carrying out a private placement transaction, is compliance with applicable securities laws.
The Prospectus Requirement
The general rule in Ontario is that in order to issue shares to an investor a company must prepare a qualifying prospectus which describes the issuer and the offering in considerable detail. Preparing a qualifying prospectus can be very time consuming and complex, therefore, to avoid this, companies will often issue shares to investors under an exception to the prospectus requirement. There are a number of exceptions to the prospectus requirement depending on the investor and in some cases their relationship to the company and its management.
Private Placements have the benefit of simplicity, cost-effectiveness, and limited oversight from securities regulators, they also do not trigger ongoing disclosure obligations on the part of the issuer, as qualified offerings do.
A company cannot issue shares to investors unless it falls within one or more exemptions to the prospectus requirement. The most commonly used exemptions are the following:
- Private Issuer Exemption;
- Accredited Investor Exemption;
- Employee, Executive Officer, Consultant Exemption; and
- Minimum Amount Exemption.
Each of these will be briefly explained, as will the more recent crowd-funding exemption introduced in certain provinces across Canada.
Private Issuer Exemption
Whereas most of the available prospectus exemptions relate to the characteristics of the investor, the Private Issuer Exemption uniquely depends on the size and characteristics of the company issuing shares. Under this exemption, if a company meets certain criteria, it can issue securities to a list of permitted persons.
To qualify as a Private Issuer, a company must:
- Not be a reporting issuer (e.g. it must not have filed a prospectus) or an investment fund;
- Have fewer than 50 shareholders; and
- Have some restriction on the transfer of its shares reflected in its articles of incorporation.
If all of the above criteria are met, a Private Issuer can issue shares to the following groups of persons without filing a prospectus, or any other document with the securities authorities:
- directors, officers, employees, founders and control persons of the issuer and its affiliates;
- close family members of directors, officers, founders and control persons of the issuer;
- close personal friends and business associates of directors, officers, control persons and selling security holders (and their spouses) of the issuer;
- existing security holders of the issuer;
- accredited investors; and
- entities owned by or of which the majority of directors are persons listed above.
The private issuer exemption is a popular exemption for smaller companies, as it imposes a very low burden on the issuing company and the investors in terms of reporting and paperwork. However, once a company has reached a certain size, and a certain number of shareholders this option is no longer available, and companies must turn to other exemptions for their private placements.
Accredited investor Exemption
The most popular exemption is what is known as the Accredited Investor Exemption. This allows an exemption for offerings made to so-called “Accredited Investors”. The term “Accredited Investor” is defined very specifically by securities regulators and generally refers to investors who meet certain thresholds of earnings or currently held assets. If an investor meets the Accredited Investor criteria, and fills in the applicable forms, they can freely invest in a company, without any need for the company to satisfy the prospectus requirement. There is no limit to the amount of money an accredited investor can invest in a company.
The policy underlying this exemption is that individuals and companies within these categories are more likely to be sophisticated investors capable of sustaining financial loss and are more likely to seek out independent advice on the investment. Therefore, as the reasoning goes, they are less in need of the protection of the prospectus requirement than the general public.
Employee, Executive Officer, Consultant Exemption
Under this exemption companies are able to sell shares to employees, officers, directors or consultants of the company (or its affiliates) without meeting the prospectus requirement. Certain affiliated persons are also permitted to invest under this exemption. The key factor to consider when making use of this exemption is to ascertain that the investment is “voluntary” meaning it cannot be induced by expectation of future or continued employment, or similar circumstances.
Minimum Amount Exemption
Any investor that is not an individual person (e.g. a corporation, partnership, trust, or similar legal entity) can purchase securities of a corporation under this exemption, provided it invests a minimum of $150,000 into the company, which must be paid in cash at the time the securities are issued. In order to qualify for this exemption the legal entity must not have been created solely for the purposes of making the investment.
The more recently introduced crowdfunding exemption provides companies, particularly start-ups and SMEs the opportunity to raise capital from the public through registered online funding portals. Although, this exemption is available to any investor, there are limits to how much investors can invest, for instance:
- a retail investor cannot invest more than $2,500 per investment, and cannot invest more than $10,000 in total in the same calendar year;
- an accredited investor (other than a permitted client) cannot invest more than $25,000 per investment, and cannot invest more than $50,000 in total in the same calendar year; and
- “Permitted Clients” have no such investment limits (these include entities such as the Government of Canada and Canadian financial institutions).
Unlike other categories of exemptions, the crowdfunding exemption requires the issuer to provide the investors with a prescribed crowdfunding offering document and the investors then have the right to withdraw from an agreement to purchase the securities within 48 hours.
Various other prospectus exemptions exist as well, such as, for example, the offering memorandum which allows companies to issue securities provided they prepare and provide investors with a prescribed offering memorandum document, or the “Private Investment Club Exemption” which is available to investment funds and their managers with Canadian clients.
Securities regulators in Canada have considerable authority to impose sanctions on companies and investors for non-compliance with securities laws and regulations. Due to the highly technical nature of securities laws and the highly prescribed methods of complying with them, it is advised that you consult one of our professional advisors before engaging in any private placement transaction, either as investor, or issuer.
Debt financing, in contrast to equity financing, is the process of raising capital through the issuance of bond, bills, or notes to investors. The investors who purchase the debt instruments become lenders and are promised the repayment of the principal plus interest.
There are two main sources that businesses rely on for debt financing: institutional lenders and individuals. Businesses typically rely on institutional lenders when obtaining capital for expansion or continued operations. Banks and other institutional lenders often require that the loan they are providing be backed by security. This is typically accomplished by way of a general security agreement (GSA) or mortgage/charge against the real property of the borrower. And in most cases, the lenders seek priority ranking ahead of other secured creditors of the borrower.
Businesses also often rely on individuals, such as friends, family members, or close business associates to provide financing to a company. These loans are often accomplished through the exchange of funds for a promissory note secured by a lien against the property of the corporation.
Debt financing avoids many of the legal and regulatory issues that go along with equity financing and the issuance of shares in the company. And unlike equity financing, debt financing does not involve giving up an ownership stake in the company. However, the terms of security agreements are generally very onerous, meaning if a payment on a loan is missed, the borrower may risk losing its assets, real property, or a personal guarantee was involved, the guarantor may risk losing their house and personal assets.
If you are considering financing options for your company we encourage you to reach out to one of our professional advisors to discuss the best option for you.
Establishment of Franchise System
The idea of establishing a franchise can be simple and attractive to any businessperson: set up the franchise system, sit back, and let the money roll in via royalties. However, this can be far from reality. When you are contemplating turning your existing business into a franchise, you need to consider many different issues.
There is no federal legislation that regulates franchises. Instead, it is done under the provincial legislation. If you are looking to get involved in the franchise business in Ontario, you need to be aware of the Arthur Wishart Act (Franchise Disclosure). Under the Act, the franchisor is obligated to provide a prospective franchisee with a disclosure document no later than 14 days before the earlier of (1) the date of the signing of the franchise agreement and (2) the date of the payment of consideration by the franchisee to the franchisor. The disclosure document must be one document and delivered to the prospective franchisee personally or by registered mail.
There are 5 elements that must be contained in the disclosure document as outlined in subsection 5(4) of the Act:
1. All material facts, including material facts as prescribed
As set out in subsection 1(1) of the Act, material facts are any information such as those that relate to the business, operations, and the franchise system that would reasonably be expected to have a significant effect on the value or price of the franchise to be granted or the decision to acquire the franchise. Examples include the franchisee’s costs associated with the establishment of the franchise and a description of any training or other assistance offered to franchisees by the franchisor.
2. Financial statements as prescribed
The financial statements must be audited and reviewed in accordance with the generally accepted auditing and accounting principles that are at least equivalent to those set out in the Canadian Institute of Chartered Accountants Handbook.
3. Copies of all proposed franchise agreements and other agreements relating to the franchise to be signed by the prospective franchisee
The proposed franchise agreements and any other relevant agreements must be provided to the prospective franchisee.
4. Statements as prescribed for the purposes of assisting the prospective franchisee in making informed investment decisions
Examples include a commercial credit report on the franchisor’s business background and independent legal and financial advice in relation to the franchise agreement.
5. Other information and copies of documents as prescribed
Examples include the business background of the franchisor and details of any bankruptcy or insolvency proceedings against the franchisor.
Prospective franchisors should know the structures that can be used to expand the franchise:
Single-unit – franchisor grants a franchisee the right to open a store.
Multi-unit – franchisor grants a franchisee the right to open multiple stores
Master franchise – franchisor grants a franchisee the right to a territory in which he/she can then sub-franchise to others.
Area development – franchisor grants a franchisee the right to open a fixed number of stores within a fixed period of time in a given territory.Area representative – franchisor grants a franchisee the right to open store(s) with area representative (usually a franchisee) providing assistance to the new franchisee.
Other issues that a prospective franchisor should think about are:
The duration of training to be provided to franchisees
The duration of training that a franchisor provides to the franchisee will largely depend on the type of business. A prospective franchisor should be careful not to expand too quickly after the franchise is established because a franchisor cannot be at multiple locations at once to provide on-site training. However, this shortfall is often covered by providing group training in the initial stages followed by on-site check-ups.
A prospective franchisor should define the geographical area or territory in which the franchisee can operate their stores. Territory is often divided into cities or towns and is especially important in deciding where to locate the distribution centres. It also allows franchisees from competing with each other and supports long-term viability of the franchise.
Whether to require franchisee to buy equipment and materials from franchisor
The price of equipment and materials needed to start a store is usually included in the purchase price. Franchisor often requires the franchisee to buy subsequent equipment and materials from franchisor directly or only from authorized sources. It makes sense to require franchisees to buy from the franchisor as everyone can benefit by buying in bulk.
The most important document when it comes to franchising, a franchise agreement is effectively what governs the franchisor-franchisee relationship. Franchise agreement includes many components in addition to those found in a licensing agreement. The main components include:
Duties of franchisor
The duties can include training to be provided to the franchisee.
Duties of franchisee
The duties can include the payment of fees to the franchisor and to uphold the good nature of the franchise image.
These cover trade secrets or recipes that are essential to the franchise.
Any logos or systems that the franchise developed/owns. Franchisor allows the franchisee to use the franchise’s intellectual property.
Fees (royalties, marketing fees, etc)
Fees can be royalties, marketing fees, professional development fees, etc.
If there are any trademarks, the franchisor might allow the franchisee to use them.
Defines the territory in which the franchisee can carry out the business. Can be boundaries defined by cities/towns or kilometers.
Quality check provisions
The minimum level of quality that the franchisee must uphold. Quality is checked periodically and failure to uphold the minimum level can lead to severe consequences for the franchisee.
How franchisor can scoop in and take over if the franchisee fails to comply with the provisions in the franchise agreement.
A licensing agreement or components found in a licensing agreement often form part of the franchise agreement. In a licensing agreement, the licensor gives the licensee the right to use its products such as its intellectual property, brand, or business system. As compared to a franchise agreement, licensing agreement by itself (or the licensing model) is often used by businesses that want more of a hands-off approach to expansion. In this sense, licensor is not telling the licensee how to run its business operations but is simply giving them the tools to do so. This also means that the licenses are non-exclusive and licensor might grant the same type of licenses to multiple licensees. Ultimately, whether you will use the franchise model or the licensing model will depend on the type of your business. For a software development company, the licensing model makes sense. As for a restaurant company, the franchise model is more often used.
Mergers & Acquisitions
Sale of Shares
A share sale involves the sale of everything in the company including the incorporated company itself. It is like you are taking over the company as the new owner. Unlike an asset sale, only an incorporated company can be sold through a share sale.
There are risks involved when buying a business through a share sale. You, as a buyer, are responsible for all the liabilities that comes with the business. For example, if there was an excessive amount of tax write-offs by the previous owner, you will be liable to the CRA if they decide to carry out an audit. As a buyer, you may want to include a clause in the sales agreement to protect yourself from any pre-sale liabilities so that the seller is responsible.
If you are selling your business through a share sale, you may be eligible to receive the capital gains exemption given that your business meets certain requirements. Click here for more information on the capital gains exemption.
Sale of Assets
An asset sale involves the sale of all or substantially all of the assets of a business but not the shares of the business, assuming it is incorporated. Thus, it can include equipment, inventory, intellectual property, and accounts receivable.
As a buyer, one main advantage is that you are not responsible for the liabilities of the existing business. This is crucial if it is suspected that the existing business has any unknown liabilities, since by buying only the assets, the liabilities remain with the vendor, effectively providing the buyer with a fresh start. Also, if you are purchasing the assets of a business, you are not obligated to keep any of the non-union employees. Furthermore, as a buyer, you can negotiate the price of the assets to achieve the most tax benefit.
However, since the licenses will be in the existing company’s name, the buyer might need to apply and/or transfer for a new license. Also, lease agreements might need to be transferred and contracts renegotiated with the new buyer.
If you are selling your business through an asset sale, you are not eligible to receive the capital gains exemption since such exemption applies to sale of shares, not assets. Click here for more information on the capital gains exemption.
A leveraged buyout (LBO) refers to an acquisition of a company utilizing debt as a significant source of funds. LBO is similar to but different than the traditional financing whereby the acquiring uses its own assets as collateral in securing a loan. This means that the person or company puts forward little of their own capital when using LBO. The assets of the acquired company are instead used to secure the loan. Sometimes, even future cash flow is used to secure the loan for companies with a strong potential for growth. Therefore, the LBO targets are often companies with a strong cash flow, little debt existing on its balance sheet, and valuable assets that are tangible. Since LBO will increase the acquired company’s debt, the acquiring company should calculate whether the deal will be feasible in the long run. LBO is often used as a strategy to turn around an underperforming company or to turn an average company into a highly profitable company. The source of funding for LBO usually comes from financial institutions or private equity investors.
A Letter of Intent (LOI) is a document used as a preliminary agreement between the parties which outlines the terms of the deal. For instance, it may contain terms such as the purchase price, proposed structure of acquisition/sale, financing provisions, and indemnification provisions. LOI may be binding when it contains clauses such as confidentiality and non-solicitation. Once a LOI is full executed, the parties work towards a formalized and binding document called Share Purchase Agreement or Asset Purchase Agreement depending on the structure of the transaction.
A Share/Asset Purchase Agreement is a binding document that formalizes the terms of the deal. Depending on the structure of the sale, Share Purchase Agreement or Asset Purchase Agreement may be used. It contains terms that are comprehensive in that they may cover all the little details of the business being acquired or sold.
A Term Sheet is similar to a letter of intent in content but is generally different in structure. Compared to a letter of intent which is more formal, a term sheet contains terms of the deal in bullet-points. A Term Sheet is generally not binding but is an expression of interest by the buyer. It generally contains essential terms such as the purchase price and the proposed structure of acquisition/sale.
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