Domestic Joint Venture Franchises
Almost every franchisor is familiar with traditional franchising where the franchisor provides franchisees with the business model, intellectual property, advertising, and supply chain in exchange for agreed upon fees. The franchisor typically (but not always) gets compensated off franchisee’s revenue while the franchisee retains what remains after all costs of doing business are paid.
In joint venture franchising, the franchisor, in addition to its traditional franchises, takes an equity interest in the franchisee, hence the term “joint venture franchising”. The franchisee will be a corporation, limited partnership, or some other suitable investment vehicle. The franchisor grants a standard franchise agreement to the joint venture franchise as it would with any other unit franchisee. In addition, because the franchisor has an equity stake in the new joint venture, it also signs a joint venture agreement, unanimous shareholder’s agreement, partnership agreement, or some document that stipulates the respective parties’ rights and obligations. Frequently, these franchisors also serve as the joint venture’s lenders, and there would be appropriate loan and security agreements. The franchisor could also be the sublandlord pursuant to a sublease.
A small minority of franchisors have adopted, to significant economic advantage, the less-well known joint venture franchising model domestically as an alternative to traditional franchising in order to accelerate growth objectives.
ADVANTAGES OF DOMESTIC JOINT VENTURE FRANCHISING
By virtue of the joint venture relationship, the franchisor has an actual seat at the franchisee’s board table. As such, the franchisor has access to every detail of the franchisee’s business. In fact, in most cases, the franchisor undertakes all of the franchisee’s back office functions because it is more efficient at such tasks than individual franchisees.
This greater level of control can allow franchisors to nurture new franchisees to minimize the risk of making avoidable mistakes. This is particularly helpful in fairly sophisticated businesses where the initial training does not come close to equipping the franchisee with the necessary know-how to build and run a business efficiently. Ultimately, the franchisor’s investment in the franchisee underscores its commitment to the success of the franchisee. However, this comes at the cost of the franchisor having to expend far greater resources in joint venture franchises than it would under the traditional franchise model.
Perhaps the greatest advantage of joint venture franchising results from the high alignment of franchisor and franchisee economic interests. Since the franchisor realizes most of its income from each joint venture franchisee’s bottom line, the sale of goods and services to the franchisee occur at true cost. This eliminates the economic inefficiencies resulting when franchisors gerrymander this function in order to shift income – an activity that is rarely efficient.
Another advantage of the joint venture franchise following its successful establishment is that the franchisor’s interest can be reduced or completely bought out all at fair market value. The relationship would then move closer towards the traditional franchisor-franchisee relationship. However, a future buy-out is not necessary to have a joint venture franchise, and a franchisor might want to have a higher level of control (and investment) on a long-term basis.
Joint venture franchising works particularly well in fairly complex businesses heavy on capital investment with access to competent, trustworthy individuals who would make desirable franchisees but who otherwise would not have the finances to acquire a franchise.
Store managers at franchisor-owned locations (or those at direct competitors) with a proven track record of success in that role but without the financial resources to fund a new franchise make the joint venture franchise model an optimal vehicle for franchise expansion without the hit and miss results of traditional franchising.
Another common scenario for when a joint venture franchise would be desirable is where the employment of regulated professionals is a business requirement. For example, a franchisor of pharmacies or medical clinics would have to recruit pharmacists and doctors. Often recently graduated professionals in these fields will carry student debt and would otherwise not be able to raise the substantial capital for a franchise, no matter how promising they might be. Joint venture franchises present an opportunity for these franchisors to work with young, eager, and freshly trained professionals who would otherwise not be in the pool of franchisee candidates.
Another advantage for joint venture franchises is potentially significant tax advantages for the franchisor. As long as the joint venture franchise is a Canadian-controlled private corporation (CCPC) and is eligible for the small business deduction, and is properly structured, then there is a substantial tax advantage for the franchisor to have some of its revenue come directly from its equity in the joint venture franchise. This assumes the nature of income does not include interest, dividends, or capital gains, as the joint venture is considered to be an active business Corporation. In cases where the franchisor is receiving income considered passive which does include interest dividends or capital gains, the Corporation is deemed to be considered a specified investment Corporation unless more than 5 employees work for the Corporation. This along with other tax planning can re-classify a specified investment Corporation to being active once again.
Income eligible for the small business deduction of up to $500,000 taxable income is subject to a federal rate of 9%, and if the Corporation is resident in Ontario, the combined total rate is 12.2% effective January 15th 2020. By comparison, general income is taxed starting at a federal rate of 15%, increasing to 26.5% for Ontario corporate residents.
Since many franchisors will not meet the small business deduction requirements, they would normally pay the full corporate tax rate on income remitted to them from their franchisees. On the other hand, franchisees would be more likely to qualify for the small business deduction. With joint venture franchises that qualify for the small business deduction, the amount that the franchisor earns through its ownership share of that franchisee could be taxed at the lower small business rates. This strategy can be repeated by the franchisor across its business, potentially owning equity in multiple joint venture franchises to gain access to the lower tax rate on dividends generated by the joint venture. Of course, the income that the joint venture franchisee pays to the franchisor as part of the standard franchise agreement would be taxed at the normal corporate rates.
Ultimately it is the level and type of income combined that determine the assessment of tax. Optimizing such combinations could result in possible reduction of the tax burden.
POTENTIAL ISSUES WITH JOINT VENTURE FRANCHISES
While joint venture franchising offers substantial advantages, there are also potential risks, though many of them can be avoided with good legal and other professional advice.
For example, the franchisor should avoid blurring the lines between its role as a franchisor and as partner in the joint venture franchise. If the franchisor gets too involved in decisions such as employee recruitment or dismissals for example, it could be exposing itself to liability for being a joint employer. Franchise agreements and joint venture arrangements should be clearly and separately maintained with clear delineation of the franchisor’s function in both of its roles.
Similarly, the joint venture agreement should be well-drafted so that each party is clear on what each is contributing to the joint venture and what additional obligations each might have (e.g. non-disclosure, confidentiality). It should also set out what happens if there are irreconcilable differences between the joint venture partners and termination is necessary.
All in all, joint venture franchising is an underutilized business model for franchises in domestic markets. Depending on the context, it can have significant advantages over traditional franchisor-franchisee arrangements. The associated risks can be managed with proper legal and professional advice and can be outweighed by the benefits of properly used joint venture franchising.
Sotos LLP has over forty years of experience in advising on all aspects of franchise structuring, growth and expansion.