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 some or all of their resources in a business undertaking (including the pursuit of a profession) with a view of sharing profits among partners. Benefits of partnership include: ease of organization; shared management; and combined knowledge and skills. Disadvantages include: unlimited liability (for most types of partnership); potential conflict between partners; and the responsibility of partners for the business activities of other partners. There are three types of partnership: general partnership; limited partnership; and limited liability partnership. In a general partnership, each partner is liable for the actions of other partners. In a limited partnership (LP), the liability of the limited partner(s) is limited to the amount of their investment. A limited liability partnership (LLP) is reserved for professionals such as lawyers and accountants (although British Columbia also allows LLP for businesses) and each partner’s liability is limited to a certain extent. In order to protect partners in case of disagreements or dissolution of a partnership, a written partnership agreement is recommended. Generally, the legal element (such as LLP) must be set out in the firm name and registered with the relevant provincial authority. Partnerships are taxed similarly to sole proprietorships because the profits are shared between the partners. Each partner is taxed at his or her personal income tax rate.
A corporation is a legal entity separate from its owners that is created under provincial or federal statute. A firm/company incorporated under the federal statute can operate its business in all of Canada. Governance of a corporation is the responsibility of Board of Directors and ownership of a corporation is established through stocks or shares. Benefits include: perpetual life (subject to annual filing); limited liability; ease of ownership change; and ease of raising capital. Downsides include: close regulation; double taxation; paperwork; and higher initial cost compared to sole proprietorship and partnership. Corporations are taxed differently than sole proprietorships or partnerships. A corporation is considered a legal entity which means that the corporation itself is taxed at a corporate tax rate. There will be additional personal taxes when income is distributed to shareholders through dividends. – taxes apply to dividend income (capital gains) which means 50% of dividend income will be taxed at the personal rate. However, the tax you pay as an individual can be lower if you are a shareholder/owner of a corporation than if you are a sole proprietors or a partner.
In Canada, you can either incorporate federally or provincially. Whether you choose one over the other will depend on you and your business. 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. Essentially, incorporating federally will provide better business name protection across Canada. For instance, if your business is incorporated federally, you can use that business name all across Canada even if there already exists a business that uses a similar name as your corporation.
On the other hand, if you have provincially incorporated and you want to expand into other provinces, the name you are currently using may have already been taken, which means you will have to carry on a business using a different name in that province.
As a shareholder, it is strongly recommended that you enter into a shareholders’ agreement early on, in order to have a safety measure when things potentially go wrong in the future. In essence, a shareholders’ agreement is a legal document that sets out the rules that must be observed by the shareholders of a company. The shareholders’ agreement should include, among other provisions, the roles and responsibilities of each shareholder and procedures to follow when there is a dispute. Business partners can often comprise of best friends or family members. Unfortunately, disagreements can arise between even the best of best friends and the importance of having a shareholders’ agreement is magnified in these situations.
Some of the advantages of having a shareholders’ agreement include:
- Defines the roles and responsibilities of each shareholder in writing so that they are bound by them;
- Defines the dispute resolution process so that the shareholders know what steps to take in case of dispute;
- Inclusion of “shotgun” clause where a shareholder makes an offer to buy out the other shareholder and the other shareholder has to either accept it or buy out the offering shareholder. It allows for a fair and speedy exit of a shareholder;
- Controls the dilution of shares so that existing shareholders do not lose their stake in the company;
- Inclusion of non-competition and non-solicitation clauses which stops a shareholder who is exiting to set up shop across the street or steal the clients;
- Defines the obligations of the shareholders when raising money in the future; and
- Defines the process of kicking out a shareholder in case of events such as a shareholder not carrying out their responsibilities or death.
A shareholders’ agreement can provide provisions that can help shareholders avoid unnecessary cost and time when disagreements happen between them. Also, in case of unforeseeable events such as one of the shareholders suddenly becoming ill, disagreements may arise as to how to continue on the business. Just as you don’t buy insurance after the disaster has already happened, it will be much more advantageous for shareholders to sign the shareholders’ agreement before the disagreements arise as an insurance to minimize the harm suffered by the shareholders and ultimately the company. It is crucial that the shareholders enter into a shareholders’ agreement when they are in good terms with each other as to remain objective.
Incorporation can bring many advantages and it can be done either provincially or federally as discussed under the Incorporations section. [Link the Incorporations section]. Certain professionals (such as doctors, accountants, and lawyers) can incorporate a professional corporation under the provincial Business Corporations Act. Professional incorporations may be useful for professionals as there are tax planning opportunities that become available upon incorporation. Before you decide to incorporate to take advantage of these opportunities however, there are a number of important points to consider. Unlike business people in general, you must consider the specific rules that govern your profession when determining whether incorporation makes sense for you. In particular, you need to determine the ownership rules that apply, as certain provinces restrict who can own shares of a professional corporation (PC). You also need to determine what activities your profession will allow your PC to engage in. Both can have an impact on the tax planning available.
There are three main benefits for professionals in the context of a professional incorporation: income splitting; the small business deduction; and the capital gains exemption.
The ability to split income with a spouse or an adult child is one of the main benefits of incorporation for businesses. However, it is necessary for professionals to consider the ownership rules of their profession as this will determine whether income splitting benefits are available. In particular, you will need to consider who is allowed to hold shares of the PC. Certain provinces will allow shareholders of the PC to include the professional along with their family members, while other professions will allow only members of the profession to hold shares of the PC. Where family ownership is allowed, some provinces also restrict the use of trusts.
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 here 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. Note that due to the income-splitting tax (often referred to as the kiddie tax), the benefit of splitting dividend income with minor children is not available.
In the case of your spouse, you’ll also need to ensure you don’t run afoul of the corporate attribution rules. These rules may apply if you transfer property or make a low-interest loan to your PC and your spouse is or will become a shareholder. Where these rules apply, an imputed interest penalty will be included in your income and income splitting will not be achieved. Note however that the corporate attribution rules will not apply for any period that the corporation qualifies as a small business corporation (SBC). A corporation qualifies as a SBC if:
- It’s a Canadian-controlled private corporation (CCPC); and
- All or substantially all of its assets are used in an active business carried on primarily in Canada. The CRA interprets this to mean that at least 90% of the fair market value of all assets are used for business purposes.
The corporate attribution rules will be an issue for professionals who want to have a spouse as a shareholder of their PC and passive investments have already been built up in the PC. Also, keep in mind that even where a PC is currently a SBC, if passive assets accumulate in the PC, the corporate attribution rules can still present a problem.
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 CCPC, such that the PC may be able to obtain the benefit of 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, a maximum of $500,000 of active business income qualifies for the federal small business deduction. The limit varies by province.
A benefit can be achieved by retaining business income in the corporation. The lower corporate tax rate leaves greater after-tax dollars in the corporation to pay expenses and reinvest in assets. A smaller tax deferral will also be available for general rate business income (i.e. income not eligible for the small business deduction). In provinces that do not allow non-professionals to hold shares of a PC, the tax deferral will be the largest tax benefit.
When determining whether your PC can benefit from the small business deduction, you need to consider the following rules:
Partnerships – If you carry on business as a member of a partnership, the small business deduction rules will apply differently. The rules that will apply are known as the specified partnership income rules. Under these rules only one small business deduction will be 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. Note that 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 and generally require that non-competition clauses in partnership agreements be eliminated.
Personal Services Business – Generally, if you provide services through a corporation and, but for the corporation, you would be considered an employee of the entity to which you provide the services, the corporation may be considered a personal services business (PSB), unless certain exceptions do not apply. In other words, you would be considered an “incorporated employee”. 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. Consequently, to fully benefit from incorporation, you must ensure that you avoid the PSB rules. In most cases, this means that you have to be an independent contractor and not an incorporated employee. The PSB rules are not a concern for partners of a professional partnership who are generally not considered to be employees of the partnership.
Capital Gains Exemption for Qualifying Small Business Shares
The third significant tax advantage of incorporation that may be available is the capital gains exemption for qualifying small business corporation shares. Due to the nature of a PC as well as the restrictions on its ownership, selling shares and realizing a gain eligible for the exemption may be difficult. Purchasers may prefer to buy goodwill or client lists, rather than shares, and they may also have concerns about inheriting the professional liability of the vendor. An incorporated partner of a professional partnership will likely not be able to sell shares of his PC. However, if you or family members are able to sell shares of the PC, up to $750,000 of gross gains can be exempted (for each individual).
To qualify for the exemption, the following general conditions must be met:(i) at the time of the disposition, 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; (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.
In addition to claiming the capital gains exemption on an actual sale of shares, it may be possible to trigger a capital gain, claim the exemption and step-up the tax cost of your shares in anticipation of a future sale. This planning will be especially useful if you believe your corporation will lose its status as a SBC in the future.
There are other benefits, as well as potential minor disadvantages, that you should consider if you want to incorporate.
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 (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 from your PC, and contributions are made to build sufficient funds to fund 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.
Additional Compliance – One minor disadvantage of incorporation is that it does mean that you have additional paperwork. This will include preparing a corporate tax return and completing the appropriate tax filings for salaries or dividends paid by the corporation.
Payroll Taxes – Another potential disadvantage is that certain jurisdictions levy a payroll tax on remuneration paid to employees. Therefore, a payroll tax may apply to remuneration paid to employees of a PC.
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 tax rules to ensure that you benefit from the tax planning opportunities available from incorporation, given 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.
Establishment of Trusts
Trusts are used for a variety of different purposes and can be especially useful in achieving tax efficiency. For instance, trusts can be used to further a charitable purpose. In many cases, however, trusts are established to further benefit the family as part of the corporate structure. Therefore, family trusts will be discussed below.
A family trust is a relationship between the trustees and beneficiaries. The trust is established when the settlor transfer property to the trustees for the benefit of the beneficiaries. The settlor should settle the trust for a nominal value (sometimes a gold coin is used) and should no longer be involved. The settlor should not be a beneficiary. The trustees (often the parents) are responsible for the administration of the trust property in accordance with the terms of the trust. The beneficiaries (often the children) are those who will receive income and capital from the trust property. The trust itself is considered a legal entity for tax purposes.
Subject to specific tax rules, dividends paid to the family trust may be distributed to the beneficiaries with lower income to achieve income splitting. Also, by having a corporation as a beneficiary, you may be able to pass down the dividends not used by other beneficiaries on a tax-deferred basis. Family trust can be used in an estate freeze whereby the parents would still retain the voting shares and instead of the value shares being given directly to the children, they could be given to the trust for the benefit of the beneficiaries.
Estate freeze is a process used for estate planning purposes to “freeze” the current value of the shares (or other property) owned by a person (usually the parent) while attributing the future value of the shares to another person (usually the adult child). This is often used as a way to pass down the control of a privately held corporation to the next generation. In this case, the parents will own voting fixed-value preferred shares and maintain the control of the corporation while their adult children will own non-voting growth common shares.
Estate freeze is a complex process that can cause adverse tax implications if it is not done properly. Timing is very important because wrong timing can eliminate the benefits that come with estate freeze. Also, the parents wishing to pass down the corporation to their adult children should consider when they will retire and whether there is enough value in the corporation to maintain their lifestyle after retirement.
To put it simply, a holding company is a company that holds shares in another company. For example, one could create a holding company to hold shares of 5 operating companies. The holding company itself usually does not engage in any business activity. There are advantages and disadvantages to creating a holding company and as such, it may not be for everyone.
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). The 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. Subject to certain rules, by creating a holding company you may be able to pay out dividends from your company to your holding company tax-free. By moving any excess money from the company to the holding company, you are effectively protecting the assets of the company should there be any claim against the company.
Holding company is also used for estate planning and income splitting purposes. For example, the income may be split in the form of dividends among the parents and adult children to minimize the overall tax. A process called “Estate freeze” is used in estate planning. For more information on the Estate Freeze, click here. [Insert link to Estate Freeze]
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. Since a holding company will be incorporated, there will be legal and accounting costs associated with creating and maintaining a corporation.
The shares of the operating company will generally be considered an investment asset not an asset that is used to generate active business income. Therefore, another disadvantage is that holding companies are not generally eligible for the capital gains exemption. The holding company may become eligible for the capital gains exemption through a process called purification. However, this process can be costly and complex depending on the circumstances.
A private placement refers to raising capital through an exempt offering of securities by an issuer directly to private investors as compared to offering to the general public. There are many reasons why a corporation would use private placement as a way to raise capital. 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.
Generally, under the Ontario Securities Act, a person or a company (“issuer”) cannot make an offering of securities unless they meet the registration and prospectus requirements.
If the issuer is not “in the business of issuing securities”, it is not legally required to be registered as an exempt market dealer in order to facilitate private placements. The question of determining what sorts of activities constitute the business of issuing securities is somewhat complex. At a much simplified level, based as much on the probability of exposure to a review by the Ontario Securities Commission (OSC) as the interpretation of the OSC’s guidance on the matter, raising money through the issuance of shares for one project that will be an active business conducted by the individual in charge of such business, i.e., you, is likely not to trigger the registration requirement. Any other individual earning a commission on the sale of such shares however is almost certainly required to be registered as an exempt market dealer. Registration is an onerous process that is simply out of reach of most persons (and this includes companies) that do not have a background in securities.
Certain exemptions from the prospectus requirement are available if an offering of securities is made under these main categories of exemptions:
- Accredited investor;
- Family, friends and business associates (FFBA);
- Offering memorandum (OM); and
- Minimum amount investment
Offering made to accredited investors is exempt from the registration and prospectus requirements. Accredited investors are individuals with income or assets above a certain level that make them more likely to withstand financial loss or to obtain expert advice. For instance, accredited investors are individuals with:
Net income before taxes was more than $200,000 (or $300,000 if combined with spouse) in each of the two most recent calendar years and is expected to be more than $200,000 (or $300,000 if combined with spouse) in the current calendar year;
Financial assets, alone or together with a spouse, of more than $1 million before taxes but net of related liabilities; or
Net assets, alone or together with a spouse, worth more than $5 million
Accredited investors can also be non-individuals such as governments. There is no limit on the amount an investor can invest. The issuer must ensure that Risk Acknowledgement Form (RAF) is signed by the accredited investor. In addition, the issuer must file a report of exempt distribution with the OSC within 10 days of the distribution of the securities.
2. Family, friends and business associates (FFBA)
The FFBA exemption allows a company to raise capital from directors, executives, control person or founder of the company (“principals”) without having to comply with the registration and prospectus requirements. This exemption also extends to certain family members, close friends, and close business associates of the principals. As with the accredited investor exemption, a RAF must be signed by the investor, the principal (if applicable), and the issuer. In addition, a report of exempt distribution must be filed with the OSC within 10 days of the distribution of the securities.
The crowdfunding exemption is relevant for companies, especially start-ups and SMEs that are looking to raise capital from the public through registered online funding portal. Although, this exemption is available to any investor, there are limits to how much investors can invest:
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.
On the other hand, there are no investment limits for “permitted clients” (this term is defined in NI 31-103
Registration Requirements and Exemptions and includes entities such as the Government of Canada and Canadian financial institutions. A RAF must be signed by the investor and a report of exempt distribution must be filed with the OSC within 10 days of the distribution of the securities. Unlike other categories of exemptions, crowdfunding exemption requires the issuer to provide the investors with the crowdfunding offering document and the investors are given the right to withdraw from an agreement to purchase the securities within 48 hours.
4. Offering memorandum (OM)
The OM exemption is available to any investor. An issuer who is relying on the OM exemption must prepare and provide investors with a prescribed offering memorandum document and file it with the Ontario Securities Commission within 10 days of the first issuance of the securities. Investors that are not individuals such as companies do not have limits on how much they can invest. However, for investors that are individuals, the limits on the amount depend on whether an individual is an “eligible investor”. An eligible investor is a person who has:
Net assets, alone or together with a spouse that exceeds $400,000; or
Net income before taxes that exceeded $75,000 (or $125,000 together with the spouse) in each of the two most recent calendar years and who reasonably expects to exceed that level in the current calendar year
Investors such as those who qualify as an accredited investor or under the FFBA exemption are considered an eligible investor. An eligible investor can invest up to $30,000 in any 12 months period. An eligible investor who is an individual can invest up to $100,000 in any 12 months period if he/she receives advice from portfolio managers or the like, that an investment above $30,000 is suitable. Non-eligible investors can only invest up to $10,000 in any 12 months period. As with most other categories of exemption, an investor must sign a RAF. Also, an investor has the right to withdraw from an agreement to purchase the securities within two business days. Lastly, the issuer must file a report of exempt distribution with the OSC within 10 days of the distribution of the securities.
5. Minimum amount investment
Any investor that is not an individual can buy the securities under this exemption. There is no limit on the amount an investor can invest, although the purchase price of the securities must be at least $150,000 and must be paid in cash at the time of distribution of the securities. The investor is not required to sign a RAF but the issuer must file a report of exempt distribution with the OSC within 10 days of the distribution of the securities.
Debt financing, in contrast to equity financing (raising of capital through private placements or public offering), is raising of 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 rely on institutional lenders when obtaining capital for expansion or continued operations. The banks and other institutional lenders often require a general security agreement (GSA) or mortgage/charge against the real property. The banks and institutional lenders will almost always seek priority ranking ahead of other secured parties. Businesses rely on individuals who may be those directly involved in the business or their family and close friends. For instance, a director may seek money from his or her relatives. The loans may be set out as a promissory note secured by a lien against the property of the corporation. If the business already has liens by individuals and wants to obtain loans from banks or other institutional lenders, they may ask for any existing security to be subordinated before the loan is extended to the business.
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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