Chapter 17 Small Business Organizations

Chain-Style Business Operation

A franchise operates under a franchisor's trade name and is identified as a member of a select group of dealers that engage in the franchisor's business Often, the franchisor insists that the franchisee maintain certain standards of performance

Management Rights

All partners have equal rights in managing the relationship. Each partner has one vote in management matters regardless of the proportional size of his or her interest in the firm. The majority rule controls decisions on ordinary matters. Decisions that significantly affect the partnership require unanimous (full) consent of the partners.

Agency Concepts and Partnership Laws

Each partner is deemed to be an agent of the other partners and of the partnership. In their relationships with one another, partners, like agents, are bound by fiduciary ties

Partnership at Will

If no fixed duration is specified, the partnership can be dissolved at any time

Liability of Partners

Partners are personally liable for the debts of the partnership.

Business Organization

The franchisor may require that the business use a particular organizational form and capital structure.

Taxes (Advantages of the Sole Proprietorship)

A sole proprietor pays only personal income taxes on the business's profits, which are reported as personal income on the proprietor's personal income tax return.

Partnership Formation

As a general rule, agreements to form a partnership can be oral, written, or implied by conduct/partnership by estoppel

Franchises fall into one of three classifications:

1) Distributorships 2) Chain-Style Business Operations 3) Manufacturing Arrangements

Fiduciary Duties

1) Duty of care; a partner must refrain from "grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law" 2) Duty of loyalty; a partner must account to the partnership for "any property, profit, or benefit" derived by the partner in the conduct of the partnership's business or from the use of its property A partner must also refrain from competing with the partnership in business or dealing with the firm as an adverse party. (Breached by self-dealing, missing partnership property, disclosing trade secrets, or usurping a partnership business opportunity)

In selecting an organizational form, the entrepreneur will consider a number of factors:

1) Ease of creation 2) Liability of the owners 3) Tax considerations 4) Ability to raise capital

Three major business forms:

1) Sole Proprietorship 2) Partnership 3) Corporation

A court will not presume that a partnership exists, however, if shared profits were received as payment of any of the following:

1. A debt by installments or interest on a loan 2. Wages of an employee or for the services of an independent contractor 3. Rent to a landlord 4. An annuity to a surviving spouses or representative of a deceased partner 5. A sale of the goodwill (the valuable reputation of a business viewed as an intangible asset) of a business or property

Essential Elements of a Partnership

1. A sharing of profits or losses 2. A joint ownership of the business 3. An equal right to be involved in the management of the business

Unanimous consent is likely to be required for any decision to:

1. Alter the essential nature of the firm's business as expressed in the partnership agreement 2. Change the capital structure of the partnership 3. Amend the terms of the partnership agreement 4. Admit a new partner 5. Engage in a completely new business 6. Assign partnership property to a trust for the benefit of creditors, or allow a creditor to enter a judgment against the partnership, for an agreed sum, without the use of legal proceedings. 7. Dispose of the partnership's goodwill 8. Submit partnership claims to arbitration 9. Undertake any act that would make further conduct of the partnership business impossible

A partner can be dissociated from a partnership in any of the following way:

1. By the partner's voluntarily giving notice of an "express will to withdraw" 2. By the occurrence of an event specified in the partnership agreement 3. By a unanimous vote of the other partners under certain circumstances, such as when it becomes unlawful to carry on partnership business with a partner 4. By order of a court or arbitrator if the partner has engaged in wrongful conduct that affects the partnership business. 5. By the partner's declaring bankruptcy, assigning his or her interest in the parntership for the benefit of creditors, becoming physically or mentally incapacitated, or by the partner's death

The rights of partners in a partnership relate to the following areas:

1. Management 2. Interest in the Partnership 3. Compensation 4. Inspection of books 5. Accounting 6. Property

A partnership's assets are distributed according to the following priorities:

1. Payment of debts, including those owed to partner and nonpartner creditors. 2. Return of capital contribution and distribution of profits to partners

Pass-Through Entity

A business entity that has no tax liability -- the entity's income is passed trough to the owners of the entity, who pay income taxes on it. Thus, the income or losses the partnership incurs are "passed through" the entity framework and attributed to the partners on their individual tax returns.

Charging Order

A court order to attach the partner's interest in the partnership (proportionate share of the profits and losses and the right to receive distributions) to satisfy the partner's obligations

Opportunity to Cure a Breach

A franchise agreement may state that the franchise may attempt to cure an ordinary, curable breach within a certain period of time after notice so as to postpone, or even avoid, the termination of the contract. Franchise terminated immediately when franchisee breaches the duty of honesty and fidelity (material breach)

Distributorship

A manufacturer (the franchisor) licenses a dealer (the franchisee) to sell its product Often, a distributorship covers an exclusive territory

Liability of Incoming Partners

A partner newly admitted to an existing partnership is not personally liable for any partnership obligations incurred before the person became a partner. The new partner's liability to existing creditors of the partnership is limited to her or his capital contribution to the firm

Breach and Waiver of Fiduciary Duties

A partner's fiduciary duties may not be waived or eliminated in the partnership agreement. In fulfilling them, each partner must act consistently with the obligation of good faith and fair dealing. A partner may pursue his or her own interests without automatically violating these duties. The key is whether the partner has disclosed the interest to the other partners. A partner cannot make secret profits or put self-interest before his or her duty to the interest of the partnership, however.

Limitations on Authority

A partnership may limit a partner's capacity to act as the firm's agent or transfer property on its behalf by filing a "statement of partnership authority" in a designated state office

Joint and Several Liability

A third party has the option of suing all of the partners together (jointly) or one or more of the partners separately (severally). All partners in a partnership can be held liable even if a particular partner did not participate in, know about, or ratify the conduct that gave rise to the cause of action.

Articles of Partnership

A written agreement that sets forth each partner's rights and obligations with respect to the partnership. A partnership agreement can include almost any terms that the parties wish, unless they are illegal or contrary to public policy or statute

Effects of Dissociation: Buyouts

After a partner's dissociation, his or her interest in the partnership must be purchased according to the rules in UPA 701.

Effects of Dissociation: Rights and Duties

After a partner's dissociation, his or her right to participate in the management and conduct of the partnership business terminates. The partner's duty of loyalty also ends

Accounting of Partnership Assets or Profits

An accounting of partnership assets or profits is required to determine the value of each partner's share in the partnership. Under UPA 405(b), a partner has the right to bring an action for an accounting during the term of the partnership, as well as on the partnership's dissolution and winding up

Franchise

An arrangement in which the owner of intellectual property--such as a trademark, a trade name, or a copyright--licenses others to use it in the selling of goods or services

Partnership Buy-Sell Agreements/Buy-Out Agreements

An express agreement made at the time of partnership formation for one or more of the partners to buy out the other or others should the situation warrant--and thus provide for the smooth dissolution of the partnership

Dissolution: Illegality or Impracticality

Any event that makes it unlawful for the partnership to continue its business will result in dissolution. A court may order dissolution when it becomes obviously impractical for the firm to continue--for instance, if the business can only be operated at a loss

State Disclosures

Approximately 15 states have laws similar to the federal rules that require franchisors to provide presale disclosures to prospective franchisees. Many state laws require that a disclosure document (Franchise Disclosure Document, or FDD) be registered or filed with a state official State laws may also require that a franchisor submit advertising aimed at prospective franchisees to the state for approval

Partnership

As defined by the UPA: "an association of two or more person to carry on as co-owners a business for profit" "person" includes corporations "intent" one cannot join a partnership unless all other parties consent

Aggregate

At common law, a partnership was treated only as an aggregate of individuals and never as a separate legal entity. Thus, at common law a lawsuit could never be brought by or against the firm in its own name. Each individual partner had to sue or be sued.

Laws Governing Franchising

Because a franchise relationship is primarily a contractual relationship, it is governed by contract law. If the franchise exists primarily for the sale of products manufactured by the franchisor, the law governing sales contracts as expressed in Article 2 of the UCC applies.

Wrongful Termination

Because a franchisor's termination of a franchise often has adverse consequences for the franchise, much franchise litigation involved claims of wrongful termination. The termination provisions of contracts are more favorable to the franchisor than to the franchisee.

Winding Up and Distribution of Assets: Creditors' Claims

Both creditors of the partnership and creditors of the individual partners can make claims on the partnership's assets. If the partnership's liabilities are greater than its assets, the partners bear the losses (in the absence of a contrary agreement) in the same proportion in which they shared the profits.

The Importance of Good Faith and Fair Dealing

Both statutory law and case law emphasize the importance of good faith and fair dealing in terminating a franchise relationship. If a court perceives that a franchisor has arbitrarily or unfair terminated a franchise, the franchisee will be provided with a remedy for wrongful termination.

Industry-Specific Standards

Congress has enacted laws that protect franchisees in certain industries. These laws protect the franchisee from unreasonable remands and bad faith terminations of the franchise by the franchisor

Personal Assets (Disadvantages of the Sole Proprietorship)

Creditors can pursue the owner's personal assets to satisfy any business debts. Although sole proprietors may obtain insurance to protect the business, liability can easily exceed policy limits.

Pricing Arrangements

Depending on the nature of the business, the franchisor may require the franchisee to purchase certain supplies from the franchisor at an established price. The franchisor cannot, however, set the prices at which the franchisee will resell the goods

Compensation

Devoting time, skill, and energy to partnership business is partner's duty and generally not a compensable service. A partner's income from the partnership takes the form of a distribution of profits according to the partner's share in the business.

Duties and Liabilities of Partners

Each partner is an agent of every other partners and acts as both a principal and an agent in any business transaction within the scope of the partnership agreement. Every act of a partner concerning partnership business and "business of the kind" and every contract signed in the partnership's name bind the firm.

Interest in the Partnership

Each partner is entitled to the proportion of business profits and losses that is specified in the partnership agreement. If the agreement does not apportion profits, the UPA provides that profits will be shared equally. If the agreement does not apportion losses, losses will be shared in the same ratio as profits.

Dissolution: Good Faith

Each partner must exercise good faith when dissolving a partnership. Some state statutes allow partners injured by another partner's bad faith to file a tort claim for wrongful dissolution of a partnership.

Effects of Dissociation: Liability to Third Parties

For two years after a partner dissociates from a continuing partnership, the partnership may be bound by the acts of the dissociated partner based on apparent authority. If a third party reasonably believed at the time of a transaction that the dissociated partner was still a partner, the partnership may be liable. A dissociated partner may be liable for partnership obligations entered into during a two-year period following dissociation. To avoid this possible liability, a partnership should notify its creditors, customers, and clients of a partner's dissociation.

The Scope of Implied Powers

If a partner acts within the scope of her or his authority, the partnership is legally bound to honor the partner's commitment to third parties. In an ordinary partnership, the partners can exercise all implied powers reasonably necessary and customary to carry on that particular business.

Entity

In contract, a majority of the states (except Louisiana) follow the UPA and treat a partnership as an entity. As an entity, a partnership may hold the title to real or personal property in its name rather than in the names of the individual partners

Joint Property Ownership

Joint ownership of property does not in and of itself create a partnership. The parties' intentions are key

Tax Treatment of Partnerships

Modern law does treat a partnership as an aggregate of the individual partners for federal income tax purposes. The partnership is a pass-through entity and not a taxpaying entity. The partnership itself pays no taxes and is responsible for filing an information return with the IRS

Notice Requirements

Most franchise contracts provide that notice of termination must be given. If no set time for termination is specified, then a reasonable time, with notice, is implied. A franchisee must be given reasonable time to wind up the business

Winding Up

Once the firm is dissolved, it continues to exists legally until the process of winding up all business affairs (collecting and distributing the firm's assets) is complete

Inspection of the Books

Partnership books and records must be keep accessible to all partners. Each partner has the right to receive full and complete information concerning the conduct of all aspects of partnership business. Each firm retains the books for recording and securing such information. Partners contribute information, and a bookkeeper typically has the duty to preserve it. The partnership books must be kept at the firm's principal business office. Every partner is entitled to inspect all books and records on demand and can make copies of the material.

Property Rights

Partnership property is owned by the partnership as an entity and not by the individual partners. A partner is not a co-owner of partnership property and has no right to sell, mortgage, or transfer partnership property to another. Partnership property cannot be used to satisfy the personal debt of an individual partner.

Advantages of the Sole Proprietorship

Proprietor owns the entire business and receives all of the profits (because she or he assumes all of the risk). Starting a proprietorship is often easier and less costly than starting any other kind of business, as few legal formalities are required. Generally, no documents need to be filed with the government to start a sole proprietorship.

The Franchise Rule

Requires franchisors to disclose certain material facts that a prospective franchisee needs in order to make an informed decision concerning the purchase of a franchise The Franchise Rule requires the following: 1. Written (or electronically recorded) disclosures 2. Reasonable basis for any representations 3. Projected earning figures 4. Actual data 5. Explanation of terms

Joint Liability

Shared liability. Partners incur joint liability for partnership obligations and debts. If a third party sues a partner on a partnership debt, the partner has the right to insist that the other partners be sued with him or her. The partnership's assets must be exhausted before creditors can reach the partners' individual assets.

State Regulation of Franchising

State legislation varies but often is aimed at protecting franchisees from unfair practices and bad faith terminations by franchisors

Authority of Partners

The UPA affirms general principles of agency law that pertain to a partner's authority to bind a partnership in contract.

The Uniform Partnership Act (UPA)

The UPA governs the operation of partnerships in the absence of express agreements and has reduced controversies in the law relating to partnerships.

Buyout Price

The amount payable to a partner on his or her dissociation from a partnership, based on the amount distributable to that partner if the firm were wound up on that date, and offset by any damages for wrongful dissociation.

Partnership by Estoppel

The court can prevent those who present themselves as partners (but who are not) from escaping liability if a third person relies on an alleged partnership in good faith and is harmed as a result Also imposed when a partner represents, expressly or impliedly, that a nonpartner is a member of the firm

Quality Control

The day-to-day operation of the franchise business normally is left up to the franchisee. However, the franchise agreement may specify that the franchisor will provide some degree of supervision and control so that it can protect the franchise's name and reputation

Franchise Termination

The duration of the franchise is a matter to be determined between the parties

Federal Regulation of Franchises

The federal government regulates franchising through laws that apply to specific industries and through the Franchise Rule, created by the Federal Trade Commission (FTC)

Business Premises

The franchise agreement may specify whether the premises for the business must be leased or purchased outright. Sometimes, a building must be constructed to meet the terms of the agreement.

Grounds for Termination Set by Franchise Contract

The franchise agreement specifies that termination must be "for cause" and then defines the grounds for termination. Cause might include, the death or disability of the franchisee, insolvency of the franchisee, breach of the franchise agreement, or failure to meet specified sales quotas.

The Franchise Contract

The franchise contract specifies the terms and conditions of the franchise and spells out the rights and duties of the franchisor and the franchisee.

Payment for the Franchise

The franchise ordinarily pays an initial fee or lump-sum price for the franchise license. Franchise agreement may require the franchisee to pay a percentage of the franchisor's advertising costs and certain administrative expenses

Degree of Control

The franchisor has a legitimate interest in maintaining the quality of the product or service to protect its name and reputation. If a franchisor exercises too much control over the operations of its franchisees, however, the franchisor risks potential liability. A franchisor may be held liable--under the doctrine of respondeat superior--for the tortious acts of the franchisees' employees

Manufacturing Arrangement/ Processing-Plant Arrangement

The franchisor transmits to the franchisee the essential ingredients or formula to make a particular product. The franchisee then markets the product either at wholesale or at retail in accordance with the franchisor's standards

How does Partnership law differ from Agency law?

The partners in a partnership agree to commit funds or other assets, labor, and skills to the business with the understanding that profits and losses will be shared. Thus, each partner has an ownership interest in the firm.

Partnership for a Term

The partnership agreement can specify the duration of the partnership by stating that it will continue until a designated date or until the completion of a particular project Withdrawal from a partnership for a term before the expiration date constitutes a breach of the agreement, and the responsible partner can be held liable for any resulting losses

Disadvantages of the Sole Proprietorship

The proprietor alone bears the burden of any losses of liabilities incurred by the business enterprise. The sole proprietor has unlimited liability, or legal responsibility, for all obligations that arise in doing business. Any lawsuit against the business or employees can lead to unlimited personal liability for the owner of a sole proprietorship.

Raising Capital (Disadvantages of the Sole Proprietorship)

The proprietor is limited to his or her personal funds and funds from any loans that he or she can obtain for the business.

Sole Proprietorship

The simplest form of business, in which the owner is the business. The owner reports business income on his or her personal income tax return and is legally responsible for all debts and obligations incurred by the business

Flexibility (Advantages of the Sole Proprietorship)

The sole proprietor is free to make any decision he or she wishes concerning the business. The sole proprietor can sell or transfer all or part of the business to another party at any time and does not need approval from anyone else A sole proprietor can benefit in a lawsuit from the fact that the business is indistinguishable from the owner.

Dissolution

The termination of a partnership; commencement of the winding up process The occurrence of a partner's death or bankruptcy will dissolve the partnership. A partnership for a fixed term is dissolved by operation of law at the expiration of the term.

May Require Good Cause to Terminate the Franchise

To protect franchises against arbitrary or bad faith terminations, state law may prohibit termination without "good cause" or require that certain procedures be followed in terminating a franchise.

Means of Control

Typically, the contract will state that the franchisor is permitted to make periodic inspections to ensure that the standards are being maintained. As a means of controlling quality, franchise agreements also limit the franchisee's ability to sell the franchise to another party

Location of the Franchise

Typically, the franchisor determines the territory to be served. Some franchise contracts give the franchisee exclusive rights, or "territorial rights," to a certain geographic area.

Dissociation of a Partner

When a partner ceases to be associated in the carrying on of the partnership business. Entitles the partner to have his or her interest purchased by the partnership. Terminates the partner's actual authority to act for the partnership and to participate in running its business. Partnership may continue to do business without the dissociated partner.

Wrongful Dissociation

When a partner's dissociation breaches a partnership agreement, it is wrongful. A partner has the power to dissociate from a partnership at any time, but if she or he lacks the right to dissociate, then the dissociation is considered wrongful under the law.

Nonpartner Agents

When a partnership by estoppel is deemed to exist, the nonpartner is regarded as an agent whose acts are binding on the partnership

Lack of Continuity (Disadvantages of the Sole Proprietorship)

When the owner dies, so does the business--it is automatically dissolved

Winding Up and Distribution of Assets: Duties and Compensation

Winding up includes collecting and preserving partnership assets, discharging liabilities (paying debts), and accounting to each partner for the value of his or her interest in the partnership. Partners continue to have fiduciary duties to one another and to the firm during the process. UPA 401(h) provides that a partner is entitled to compensation for services in winding up partnership affairs. A partner may also receive reimbursement for expenses incurred in the process

Indemnification

With joint and several liability, a partner who commits a tort can be required to indemnify (reimburse) the partnership for any damages it pays. Indemnification will typically be granted unless the tort was committed in the ordinary course of the partnership's business