Q: What do I need to know about franchising in the cannabis space?

Ask the Legal Expert

On Oct. 17, 2018 Canada put itself on the map by being only the second country in the world – and the first G7 nation – to legalize and regulate the recreational use of cannabis. While the production of cannabis is regulated by the federal government, the distribution of cannabis has been left to each province to regulate. In Ontario, the provincial government has adopted a model in which the online sale and wholesale of cannabis is run by the province, and the bricks-and-mortar retail sale of canna­bis is left to the private sector. This has opened the door to significant business opportunities in the space, and the potential for the franchise business model, or at least parts of it, to play a major role in the industry.

The current Ontario regime restricts the number of cannabis retail store authorizations that may be issued to a single retail store operator and their “affiliates” to 75 stores. There are also restrictions on the involvement of federally licensed cannabis producers (“LPs”) in the cannabis retail market. LPs and their “affiliates” (“affili­ate” is defined very broadly in the regulations) are only permitted to have one retail store, and such retail store must be located on the LP’s licensed premises.

The Government of Ontario has stated that the rea­sons for this limitation are to prevent an inappropriate degree of market consolidation and to promote oppor­tunities for small businesses and investment in the can­nabis retail sector.

Recently, the Government of Ontario decided that it would allow only 25 retail store authorizations before December 13, 2019 and that these 25 applicants would be selected by way of a random lottery. On January 11, 2019, the 25 lottery winners were selected. Absent from the list of winners were any recognized or established cannabis companies. Successful lottery winners are required to open their stores by April 1, 2019 or face fines of up to $25,000.

Many market participants and observers expressed concern regarding the lack of experience and expertise of the lottery winners, and whether they’d be able to have a store operational by the tight April 2019 deadline. Most, if not all, of the lottery winners had little if any experience in the cannabis industry or with running a business. Concerns also arose regarding whether appli­cants would have access to sufficient resources to get a cannabis retail business off the ground.

To many, the franchise model appeared to be the answer. The involvement of sophisticated commercial parties equipped to manage a network of franchisees made sense. So too did the uniformity in management, policies, and procedures typical in the franchise busi­ness model. It was, at the time, also thought to be a potential way around the strict rules regarding the num­ber of retail store authorizations one retail store opera­tor could obtain.

However, according to the Lottery Rules published by the Alcohol and Gaming Commission of Ontario (the “AGCO”), those selected in the lottery to apply for a licence are “not permitted to change their applicant type, ownership and/or corporate structure in such a way that would result in a change of control of the appli­cant or licensee during the lottery process.”

Under the Arthur Wishart Act (Franchise Disclosure) (the “Act”), a “franchise” is generally defined as a right to engage in a business in which (i) the franchisee is required to make a payment or continuing payments to the franchi­sor, (ii) the franchisor grants the franchisee a license to use its trademark in association with the sale of certain goods or services, and (iii) the franchisor exercises sig­nificant control over the franchisee’s operations.

Thus, depending on how one interprets what a fran­chise is under the Act and what a “change of control” means under the Lottery Rules, franchising may or may not be permitted. As a result of this ambiguity and in response to public inquiries around the permissibility of a franchise model, the AGCO published an update to the Expression of Interest Lottery – FAQ which expressly states that a lottery winner may not enter into a franchise agreement without considering its impact on the control of the lottery winner. According to the AGCO, if the fran­chise agreement, or any other agreement, results in a change of control of the lottery winner, it is prohibited and the lottery winner may be disqualified. A common misun­derstanding and important distinction when evaluating the suitability of a franchise structure is that controls exercised in a franchise model are directed to method of operations and adherence to system standards intended to protect the franchisor’s brand, and not “control in fact” over the franchisee or the franchise’s business.

Franchising is a proven format that allows smaller, inexperienced entrepreneurs to enter into business for themselves using the resources, know-how and estab­lished business practices of more sophisticated retail­ers. As a result, we are seeing lottery winners entering into a variety of arrangements in order to address their limited operational expertise and lack of resources. Lot­tery winners are partnering with market players who have the know-how, infrastructure and resources to operate a successful cannabis retail business. Examples of these collaborations include traditional franchise arrangements (with heavily diluted control provisions to allay AGCO concerns), consulting agreements, and man­agement services agreements, to name a few.

Given the high stakes and the current and future value of cannabis retail licenses, the recent statement by the AGCO warning applicants against entering into fran­chise agreements may have caused many lottery win­ners to avoid employing a traditional franchise model. However, when analyzed closely, many of the alternative arrangements being used still exhibit many of the fea­tures implicit in a traditional franchise model and are the same in substance to a franchise model.

The cannabis retail market in Canada is a multi-bil­lion dollar opportunity. The people best equipped to efficiently and profitably run the cannabis retail market should be the ones doing so. Arrangements that facilitate this model should be encouraged, so long as they operate within the parameters of the rules and legislation. For the reasons discussed above, franchising or business models that share qualities with the franchise model are well-equipped to address concerns expressed about the lack of experience, capital, and expertise of lottery winners.

So, if you are approached with an opportunity to par­ticipate in a commercial arrangement in the cannabis retail space, what should you do?

First, whoever you partner with and whatever com­mercial structure is employed, be sure that the distribu­tion of control is your own and accords with the restric­tions imposed by the legislation, the AGCO, and your licence. The types of commercial structures out there will otherwise be limited only by the creativity of the lot­tery winner and their business partners.

Second, be aware that no matter who your potential business partner may be and no matter what licences they may possess, you will still need to apply for and obtain a retail operator licence and a retail store authori­zation from the AGCO. Thus, there is a risk your applica­tion may be unsuccessful. As such, you should always negotiate safeguards in your agreement with a potential business partner to protect yourself. Such safeguards may include guaranteed payments and indemnities.

Finally, lawyer up. Be sure to obtain legal representation as early on in the negotiation process as possible to ensure your interests are adequately protected and that your contemplated business arrangements are onside the rules. Both your lawyer and their law firm should have experience in franchising and in the cannabis retail space.

Helen Fotinos
Partner
Dentons Canada LLP
helen.fotinos@dentons.com

Stuart Ruffolo
Articling Student
Dentons Canada LLP