Managing Risks when Growing a Business

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Starting up a business and turning an idea into a successful venture is no small task.  Every entrepreneur will attest to the fact that turning an idea into a successful business model is far from easy.  Through hard work some small businesses beat the odds and position themselves well in the business community and thrive.  Interestingly enough, it is often the case that small business owners do not consider the next step which is growing a successful operation in order to generate greater revenue.  The reality is that in order to grow a small business the owner has to venture outside of their comfort zone.  The key question for them to consider is:  how do they expand their existing business into new markets?  For smaller operations there are generally two ways of growing: (1) you can continue to manage all aspects of the operation as you grow your business; or (2) you can sell your idea/business model to someone else and let them manage a new location.

 

The process of growing a successful small business for a business owner is exciting. Let’s assume that a business owner decides that the business is doing well and he/she is prepared to bring in other people in order to grow the operation.  At that stage, the business owner needs to appreciate the various methods that can be used to bring in and involve other parties within the existing business.  For example, a business owner can choose to distribute their products/services through existing outlet(s); they could enter into agreements with sales agents to sell their product/services; they could also grant a license to other parties to use their ideas and expertise for a fee; or they could sell the business as a franchise.  At the end of the day, despite the course chosen, it is important for the business owner to understand their obligations and potential liabilities with any new business structure.  

For the purposes of this article let’s focus on an owner expanding a small business by way of franchise. There are many benefits from forming a franchise, one being that it can be a structure/vehicle that can produce significant revenue with less time and effort once it is set up.  The down side of creating a franchise, particularly in Ontario, is the amount of disclosure that is required by law.  In Ontario, franchise disclosure requirements are governed by the Arthur Wishart Act (Franchise Disclosure) 2000, S.O. 2000, ch. 3 (the “Act”).  The Act contains an extensive list of the information that must be disclosed to potential franchisees.  The list is not exhaustive, and franchisors have a duty to disclose any material information that a franchisee may want to know when deciding whether to purchase a franchise.  The Act also sets out when a franchisor is required to disclose information and a franchisee’s rights if a franchisor fails to disclose all of the necessary information, or fails to disclose on time.  

In brief, a franchisor must disclose all required information at least 14 days before a franchisee signs an agreement or pays any money to the franchisor.  Failure to disclose will bring about consequences.  For example, if a franchisor is late in disclosing information or fails to disclose in accordance with the Act; the franchisee has the right to rescind the franchise agreement within 60 days after they have received full disclosure. If the required information is never received by the franchisee, then the franchisee can rescind the agreement within two years of signing it.  In that instance, where a franchisee rescinds an agreement, the franchisor is then required to: (a) refund any funds received (with the exception of funds expended on inventory, supplies and equipment); (b) purchase any inventory that the franchisee has purchased at the date it rescinds the franchise agreement (at a price equal to the price the franchisee paid); (c) purchase any supplies and equipment that the franchisee purchased in accordance with the franchise agreement (at a price equal to the price that the franchisee paid); and (d) compensate the franchisee for any other losses it incurred in acquiring, setting up and operating the franchise.  

 

At first glance, with such strict disclosure obligations and the potential liability associated with them, franchising may seem like the least attractive option for expanding a business.  However, with the right team of professionals a business owner can successfully franchise and capitalize on the potential of its business model.  The other aspect to consider when determining a structure for business growth in order to expand is that it is also quite possible that any of the other options listed above for expansion of a business may qualify and be deemed to be operating as a franchise despite the intent of the owner.   In other words, a business owner may find themselves subject to the Act and all of its requirements even when they are not set up to be operating as a franchise.  The purpose of the Act is to protect investors from buying into businesses without all of the information required to make a sound investment decision.  The courts have had no problem looking past the format of a business relationship and determining that it is, in fact, a franchise and that the franchisee is protected by the Act.  Again, consulting with a team of professionals is absolutely critical as professionals can assist a business owner grow while taking measures to protect their interests and minimize their risk.

 

In Di Stefano v. Energy Automated Systems Inc. (2010 ONSC 493 [Ont. Sup Ct J]) (“Di Stefano”), the plaintiff claimed that the distribution agreement, into which they had entered with the defendant, was actually a franchise agreement. It was further claimed that the defendant, not only failed to make the required disclosure, but also made false representations.  The plaintiff sought to rescind their agreement and claimed damages for $640,000.  The Court ultimately stayed the action in Ontario because all parties had agreed to resolve disputes in the Tennessee courts.  However, the Court did set out a three part test for determining whether an agreement is a franchise in accordance with law:

 

(i) the franchisee is required by contract ... to make a payment or continuing payments ... to the franchisor ... as a condition of acquiring the franchise or commencing operations;

 

(ii) the franchisor grants the franchisee the right to sell ... goods or services that are substantially associated with the franchisor's ... trademark; and

 

(iii) the franchisor ... exercises significant control over, or offers significant assistance in, the franchisee's method of operation, including building design and furnishings, locations, business organization, marketing techniques or training.

 

In Di Stefano, the Court found that there were payments required and that the goods were associated with the defendant’s trademark.  On the third point, the only control exercised by the defendant was a 5-day training program to teach distributors about the products.  This, it was determined, was not enough to consider the distributorship a franchise under Ontario law.  The control exercised by a franchisor must be continuous and must be relative to the business’ method of operation.

 

Therefore, at the time a small business owner is contemplating expanding their business, it is imperative that they seek legal advice early on in the process.  A business owner will be well served by consulting their lawyer to discuss options available and the steps to be taken before they expand in order to minimizing the owner’s risk and potential liability.

 

Jeysa Martinez is an Associate at BrazeauSeller.LLP.  Jeysa specializes in real estate law, but also practices in the areas of corporate and commercial law, and will and estate administration. To learn more about Jeysa, please visit www.brazeauseller.com.  Jeysa can be reached at jmartinez@brazeauseller.com or 613-237-4000 ext. 272.

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