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Is it ever wise for a franchisor to become a shareholder of its franchisees?

shareholder

What you need to think about before becoming a shareholder of franchised companies in your network.

From time to time, some franchisors wonder if it would be a good idea to become shareholders (whether it be a majority, a minority or an equal shareholder) in the franchised businesses of their network (or of some of these).

They rightfully see a few interesting benefits in such an arrangement, including:

  • better control over the management and finances of their franchisees (especially if the franchisor is a majority shareholder);
  • the potential for recruiting franchisees who, on their own, would not be able to secure the financing required to start up and carry on their businesses;
  • a share in the profits and in the increased value of their franchised businesses beyond the mere royalty payments, and;
  • sometimes as well a motivational tool for their franchisees as a result of the potential for offering them an increased shareholding as a reward for superior performance.

These franchisors often also believe that, by being themselves shareholders in their franchised businesses, franchisees will be reassured as to their commitment to truly working towards achieving success for the franchised businesses of their network (since they share in their profitability).

Some franchising networks indeed rely on this shareholding/franchising formula and have achieved a certain degree of success in this endeavour.

From a legal perspective, as well as in terms of relations between a franchisor and its franchisees, however, this type of formula does raise some issues and challenges that certainly should not be underestimated.

For instance, under the law, any director of a corporation is required to act in the latter’s best interests. This duty applies wholly (and without exception) to those persons designated by a franchisor to act as directors of a franchised corporation in its network.

Where the interests of the franchisor are in conflict with those of a franchisee (for example, in the event of a dispute with a franchisee), the persons appointed by the franchisor to act as directors of the franchisee could, therefore, find themselves in a very delicate position. For example, if they are officers, directors or employees of the franchisor, they are required, pursuant to their employment agreement and under the law, to act in the best interests of the franchisor and, in their capacity as directors of the franchisee, to act in the best interests of the franchisee.

How will they also be able to simultaneously discharge both conflicting duties if, as a result of the duties they have been entrusted by the franchisor, such persons have knowledge of confidential information (for instance, a planned acquisition or development) which could be contrary to the best interests of a franchisee of whom they are also directors?

On another level, a corporation’s minority shareholders, under business corporations legislation (both provincial and federal), are entitled to exercise significant remedies against a majority shareholder that does not properly abide by their rights.

In many cases, such remedies, in the eyes of a franchisee (and of its legal counsel), can bestow on a franchisee several interesting benefits as opposed to those available to one whose franchisor is not also a shareholder in the business.

As for the contractual aspects of the arrangement, the dual role as franchisor and shareholder in the franchised business requires the drafting of a franchise agreement that is properly tailored to the uniqueness of this relationship as well as of an excellent shareholders’ agreement that is in tune with this reality and in keeping with the provisions of the franchise agreement. The requisite coordination between the shareholders’ agreement and the franchise agreement, in and of itself, represents a serious drafting challenge, which, for the franchisor, entails greater costs for the preparation, drafting and negotiation of its franchising legal documents.

Finally, the fact that a franchisor is a shareholder in franchised businesses in its network increases the risk that lenders and lessors will take advantage of this equity interest to require the franchisor to guarantee the debts and obligations of its franchised businesses.

All in all, the fact that a franchisor is a shareholder in franchised businesses in its network is a business model which, like any other, has its benefits, constraints and challenges.

For some franchisors, it is worth considering but it is, by no means, a universal solution.

Incidentally, there are other models allowing for the achievement of all (or nearly all) of the same benefits as those offered by this model, but through other means.

This leads me to one of the most significant observations resulting from my more than 44 years of experience in franchising: franchisors who are successful in the medium and long term are those who have taken the time to develop and to implement a franchising model that is truly “tailor-made” to their line of business, to their specific features, to their manner of operation, to their values and to their objectives.

In this respect, no franchising model is truly universal or appropriate for all franchisors. That which is the hallmark of success for one may be the millstone that will sink another (sometimes even, in my experience, within the same field of activity).

Is it a good idea for a franchisor to become a joint shareholder in the franchised businesses of its network? Sometimes yes, and often not. It depends… mostly on the franchisor!

Fasken has all the requisite expertise and resources to assist you in properly devising, planning, drafting and implementing a business model, a structure and agreements that are truly appropriate to your needs.

By Jean Gagnon, Fasken

Occasional Contributors

In addition to our regular guest bloggers, Inside Internal Controls blog published by First Reference, provides occasional guest post opportunities from various subject matter experts on the topics of risk management and best practices in finance and accounting, information technology, environmental issues, corporate governance, sales/marketing and operations, not-for-profits and business related issues in Canada. If you are a subject matter expert and would like to become an occasional blogger, please contact Yosie Saint-Cyr at editor@firstreference.com. If you liked this post and would like to subscribe to Inside Internal Controls blog click here.
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